Four out of five investors agree that mandatory central clearing of derivatives have helped the markets safer, despite not knowing all of the details surrounding clearinghouse practices and processes.
Despite 80 percent of investors feeling comfort with regards to clearing, there lack of understanding about the processes clearinghouses use to manage defaults contributes to a widespread belief that additional measures are needed to mitigate risk, according to a new report on systemic risk and central clearing by market consultancy Greenwich Associates.
Nearly 70 percent of institutional investors interviewed by Greenwich Associates in its “Systemic Risk and the Impacts of Central Clearing” report believe the major clearinghouses have adequate financial resources to handle a major multiple bank default. That finding, the consultancy said, represents a strong vote of confidence in both the risk frameworks and the clearing firms operating them. Fewer than one in five say they have a clear understanding of the default management waterfalls at the CCPs that clear their trades.
“Investors recognize the many benefits of central clearing, including counterparty risk reduction, improved transparency, better mark-to-market pricing, and a more efficient OTC derivatives market,” said Kevin McPartland, head of market structure and technology research at Greenwich Associates. “While major clearinghouses have been transparent about their stress testing and risk management procedures, there is an overall lack of understanding among market participants about clearinghouse default management processes.”
Furthermore, when asked how clearinghouses can help stop or mitigate bank failures, investors suggested that clearinghouses get more access to central bank liquidity and requiring them to have more “skin-in-the-game.”
Clearinghouse Requirements Not Well Understood
Central bank liquidity has broadly been addressed and the Bank of England has, in fact, provided registered CCPs with access to its Sterling Monetary Framework. In the U.S., the major clearinghouses have been designated Systemically Important Financial Market Utilities (SIFMU), which while burdening them with additional regulatory oversight and capital requirements, also allows the U.S. Federal Reserve to provide them with liquidity in the event of a crisis.
Clearinghouse capital and “skin-in-the-game” requirements are more complicated issues, Greenwich noted.
“The cost of holding extra capital will ultimately be passed on to clearing members and their clients,” Greenwich said in the report. “With the cost of clearing already a sore spot for institutional investors, a structural change like increasing “skin-in-the-game” requirements for CCPs must be examined carefully.”
The report is the culmination of 4,036 interviews in 2014 with global fixed-income investors about their dealer relationships and use of various fixed-income products, including interest-rate derivatives. In the fourth quarter of 2014, Greenwich Associates conducted an additional 72 interviews with key research participants to more deeply understand their views on systemic risk, the impacts of central clearing and their expectations for the interest-rate derivatives market.
