FIA Global Issues Recommendations on Central Clearing Risks
Commentary by Bob Zwirb
FIA Global issued a report titled "CCP Risk Position Paper." The report addresses the risks that central counterparties ("CCPs") "bring to clearing members, their clients, and the market generally". The report refers to this as "CCP Risk," and makes recommendations for managing those risks.
Noting that the clearing members of a CCP ("CMs") face "credit, liquidity, operational and legal enforceability risks that they are unable to identify, let alone manage," the report recommends a number of reforms to ensure that such members are "not exposed to unquantifiable and unmanageable risk." These reforms include greater transparency to allow CMs to quantify that risk and determine how well their CCPs manage such risk; higher initial margin requirements to minimize broader consequences from a default; ensuring that CCPs have sufficient capital and insurance to cover non-default losses; improving CCP rulebooks to provide greater clarity regarding the CCP rights and obligations; and enhancing CCP governance to reduce conflicts of interest, manage risk assumption, and improve risk controls and management oversight.
See: FIA Global CCP Risk Position Paper.
Commentary
One of the central arguments advanced by the proponents of mandatory clearing for swap transactions is that the procedure reduces risk. K. Rowe, "A New Era for U.S. Financial Market," John F. Kennedy School of Government (Apr. 22, 2013) (citing former CFTC Chair Gary Gensler's proposition that mandatory central clearing "reduces the risk of cascading defaults across firms"). When he led the CFTC, Gary Gensler often referred to "the risk reduction that comes with central clearing." Testimony of Chairman Gary Gensler before the U.S. House Committee on Agriculture, Washington, DC (Mar. 14, 2013). Yet the latest recommendations from the primary industry association for "centrally cleared futures, options and swaps" warn its members about the risks of central clearing.
Instead of reducing the risk of counterparty default, clearing merely shifts that risk from the counterparties to the clearinghouse. As the FIA report accurately observes, clearing "entails [CMs'] outsourcing the management of certain of these potentially concentrated, opaque and unquantifiable risks" to CCPs. In the process, it concentrates that risk and shifts it to one entity, which belies another claim of proponents - that "moving standardized swaps into central clearing . . . will reduce interconnectedness in the swaps markets." Opening Remarks of CFTC Chairman Gensler, Conference on Commodity Markets (Aug. 25, 2011).
The FIA report notes that CMs "are wholly dependent on CCPs' effective management of this risk"; that, in times of distress, CMs may be "motivated to withdraw their unprotected financial resources" rather than work to ensure the continuity of the CCP; and that, in remote scenarios, "CCP default waterfall resources [might be] inadequate to absorb default-related losses." All of which only offers more reason to question the underlying assumptions behind this central tenet of Dodd-Frank.