Although the derivatives industry has been moving toward a central clearing model for over-the-counter derivatives for years, and the Dodd-Frank Act requires OTC derivatives to be centrally cleared unless they are subject to an exception, efficient and safe central clearing may be easier said than done, especially when it comes to clearing credit default swaps (CDSs).
A Risk.net story from the September 20th ISDA conference in London highlights some of the technical difficulties in coordinating multiple central counterparties:
Interoperability between central counterparties (CCPs) in the over-the-counter derivatives market is not a realistic prospect in the near term, according to a panel of clearing experts. . . while CCP interoperability now exists in the cash equities market, it will be much harder to achieve in the OTC space. One hurdle is the different margin standards and default fund requirements used by individual clearing houses, meaning it would be difficult to calculate the exposures between two entities. Even if a best guess were made, the exposures between CCPs would then need to be collateralised – which may not be straightforward.
Numerous localized (i.e., non-interoperable) CCPs may increase systemic risk, the participants noted.
But systemic risk from CCPs may increase even if they achieve interoperability simply because they are required to clear CDSs. The following was also reported today about separate remarks made by the COO of the Depository Trust Clearing Corporation:
Credit-default swaps are “scary, scary products,” Bodson said in a discussion of the transaction infrastructure that is emerging after the 2008 global credit crisis. The exchange of risks involved in these swaps may not fit well on a transaction model that has been used for futures contracts, which are simpler forms of derivative securities....“We may be creating a much higher level of risk,’’ he said, by requiring swaps to be turned into standardized products, traded on electronic exchanges and where risks are covered by a central counterparty, backing up the two sides of a trade.
If CCPs may increase risk due to not being interoperable anytime soon, and cleared CDSs may increase risk for independent reasons as well, the central clearing model for CDSs is something market participants and regulators may want to reconsider. Indeed, there is strong academic research on why CCPs may increase systemic risk, which I note here (on pages 31-32).
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