The Importance of a Systemically Important Financial Market Utility

Traders Magazine Online News, November 7, 2018

Following the global financial crisis in 2008, policy makers identified one of the major risks to the financial system to be contagion with the unregulated over-the-counter (OTC) market. This was caused by the opaqueness associated with the health of one's counterparties, which ultimately resulted in the freezing up of the OTC market.

At the same time, however, the regulated exchange-listed market functioned in an uninterrupted fashion. This was largely attributable to the performance of central counterparties such as OCC, which is the world's largest equity derivatives clearing organization. A central counterparty (CCP) interposes itself between counterparties to contracts traded in financial markets, essentially becoming the buyer to every seller and the seller to every buyer and ensuring the performance of open contracts.

These CCPs effectively serve as a systemic risk buffer for the markets and investors by absorbing the risk associated with a disruption in the financial ecosystem, e.g., the failure of a clearing firm, through a mutualized pool of credit and liquidity resources. This pool, funded by market participants, is designed to temporarily allow the CCP to step into the open financial obligations of the failed clearing firm until it can re-establish its matched book of business and transfer the risk of the defaulted clearing firm back into the ecosystem.

Based largely on the performance of CCPs like OCC to absorb market disruptions during the global financial crisis, policy makers, through regulatory rule-making, began to develop incentives to move financial products primarily traded in the OTC markets into the centrally cleared markets. As a result, CCPs like OCC immediately moved into the forefront given their role, which was critical to supporting the infrastructure of financial markets globally.

Due to the markets becoming increasingly more dependent on CCPs, policy makers began to identify which CCPs were critical to the functioning of financial markets, i.e., should be designated as systemically important, and what standards should be applied to ensure these entities operate with the highest level of resilience from a financial and operational perspective.

The Dodd-Frank Act provides the Financial Stability Oversight Council with the authority to designate a financial market utility (FMU) as one that is or is likely to become systemically important. The failure of or a disruption to the functioning of the CCP that has been designated as a systematically important FMU could create or increase the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the U.S. financial system. Currently, there are eight FMUs designated as systemically important in the U.S. and about 100 globally.

For more information on related topics, visit the following channels:

• Insights/Viewpoints