Thursday, July 1, 2010

>Are we building the foundations for the next crisis already? The case of central

1. Introduction
Counterparty credit risk has played a pivotal role in the credit crisis due to the insolvency of large prestigious financial institutions such as AIG, Bear Sterns, Lehman Brothers, Fannie Mae and Freddie Mac. The size of over-the-counter (OTC) derivatives markets means that counterparty risk is a key concern for financial institutions and many corporate users of derivatives. OTC derivatives are widely seen as having the natural ability to create systemic risk. Due to the increased focus on
counterparty risk in OTC derivatives, especially credit derivatives, there has been a significant interest in central clearing. A central counterparty (CCP) is an entity that stands between parties with respect to some or all contracts traded between them.

Because a CCP intervenes between buyers and sellers, it bears no net market risk but does take the counterparty risk. An institution trading through a CCP no longer needs to worry about the credit quality of its counterparty. Effectively, the CCP is the counterparty to all trades.

A CCP may reduce systemic episodes that were so highlighted within the financial markets during the 2007-2009 period. If an institution becomes insolvent then the CCP will guarantee all the contracts of that counterparty executed through them. This will mitigate concerns faced by institutions and may prevent any extreme actions that could worsen the situation, behaviour characterising the domino effect that is so associated with a severe systemic risk episode. The CCP will have initial margin and reserves to absorb losses due to the insolvency of a member. It may also require that excess losses caused by the failure of one or more counterparties be at least partially shared amongst all members of the CCP.

Whilst the presence of one or more CCPs might seem like a “silver bullet” with respect to counterparty risk, it is not all good news. A CCP must have a fine tuned structure with respect to margining, settlement and risk management and ultimately should be extremely unlikely to fail. The bigger a CCP becomes, the more catastrophic its failure would be. Furthermore, the homogenisation of counterparty risk and removal of the need for institutions to assess their counterparty’s credit quality may cause problems. The aim of this article is to discuss the strengths and weaknesses of CCPs and assess their viability in reducing counterparty risk.

2. The drive towards central clearing
The housing crisis, credit crunch and financial and economic downturns during 2007- 2009 led policymakers to propose laws that would require most standard OTC derivatives to be centrally cleared. This was largely driven by fears surrounding the credit default swap (CDS) market. A CDS is a derivative instrument whereby the credit quality of one of more underlying assets is traded. Due to their nature, CDS contracts can lead to large exposures being built up in rather small periods. The failure of American International Group (AIG) and some monoline insurers was
linked to CDS contracts and so surely having all such contract derivatives cleared will be a big step forward in terms of limiting counterparty risk?

To read the full report: CENTRAL COUNTERPARTY