Wednesday, February 3, 2010

In-house agree on risks of central clearing

Original posted on the International Financial Law Review by Elizabeth Fournier:

Instead of controlling and mitigating risk, forcing derivatives through central counterparties (CCP) could exacerbate risk in the system, creating a delicate structure that really is too big to fail.

That was the opinion of a panel of in-house bankers’ counsel, speaking at the PLI conference on Securities Regulation in Europe last week.

“Central clearing is not a panacea that removes systemic risk from the market,” said Simon Dodds, general counsel at Deutsche Bank in London. “It centralises and concentrates risk so that the central counterparty truly is too big to fail.”

Central clearing is designed to reduce settlement risks between two parties by taking on the risk of one of the parties failing, and offsetting it against its members.

But unless CCPs are well capitalised and closely monitored, they can add systemic risk to the financial markets. Before requiring central clearing, regulators must be certain they have addressed all its possible downsides.

The panel highlighted some of the key questions that will need to be answered before regulated central clearing can go ahead. Clear plans must be developed for how to manage the default of a clearing member, how to decide whether counterparty names will have to be disclosed, and whether increased margin requirements could discourage participation in the derivatives market completely.

There were also fears that each country would want its own domiciled clearing house, reducing the benefits of a central system and putting a high premium on interoperability.

“The regulators haven’t mitigated counterparty risk yet, just changed it,” said Dodds.

Reforms to how derivatives are traded are at the centre of regulatory proposals in both Europe and the US.

The UK Financial Services Authority released a consultation paper entitled Reforming OTC Derivative Markets in December, in which it outlined plans to increase capital charges for non-centrally cleared trades and to require all trades to be registered.

And on Friday, Gary Gensler, chairman of the Commodities Futures Trading Commission (CFTC) said that central clearing and greater transparency were essential to ensure that risk was removed from the derivatives market.

More general liquidity requirements also risk exacerbating the problems that they are attempting to resolve. If local regulators each have their own set of capital requirements for nationally domiciled institutions, they could trap capital and add inefficiency and risk to the system.

“Placing constraints on banks’ ability to move liquidity around could increase the risk in that banks’ model, and so increase systemic risk,” said David Greenwald, general counsel at Goldman Sachs.

Sajid Hussein, in-house counsel at Bank of America Merrill Lynch, agreed. “Balkanisation of the regulatory regime creates huge inefficiency and systemic risk,” he said.

See also:

How changes to the Basel guidelines could help force derivatives onto regulated exchanges

How the derivatives industry is trying to stay one step ahead of the regulators

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