OFR Researchers Consider Risks of CDS Client Clearing

Researchers from the Treasury Department's Office of Financial Research ("OFR") analyzed confidential credit default swap ("CDS") data and found that client clearing improves pricing and competition but introduces operational fragilities in times of stress.

In a newly published OFR working paper, the authors analyzed why nonmember clients adopt central clearing and how it affects their interactions with dealer banks. Using proprietary data from the Depository Trust & Clearing Corporation, the researchers found that client clearing "enhances netting efficiency for dealers." This consolidation of offsetting contracts reduces margin and regulatory costs for dealers, which in turn generates "pricing advantages for clients" on centrally cleared trades compared to comparable uncleared transactions.

The OFR explained that the adoption of central clearing significantly alters market structure and dealer competition. According to the findings, clients that adopt clearing expand their networks of dealer trading partners and reduce counterparty concentration. However, because clients cannot access central counterparties ("CCPs") directly, they depend heavily on a small subset of clearing member firms to act as their agents.

According to the findings, this reliance on clearing agents presents distinct tradeoffs. While clients generally select clearing members with stronger credit quality and established trading relationships, the researchers observed that offering these services produces spillover benefits for the dealers. Specifically, dealers that act as clearing agents capture a greater share of the client's overall transaction volume and are able to leverage this enhanced market power to extract pricing concessions when acting as both a client's trading partner and clearing agent.

The researchers also highlighted the systemic vulnerabilities created by this concentrated operational dependence. Using the 2021 collapse of Archegos Capital Management and the subsequent financial distress of Credit Suisse as an experiment, they noted that clients who relied heavily on a distressed clearing agent faced impaired access to the CCP and were forced to reduce their cleared positions. They said this analysis offers novel insights into the structural fragilities of client-agent relationships and stated that the findings are particularly relevant for regulators monitoring the ongoing mandatory clearing implementation in the U.S. Treasury cash and repurchase agreement markets.