Central counterparties and sale and repurchase agreements: regulating financial markets in the light of yet another false dawn

Abstract

ABSTRACTIn this article it is argued that the burgeoning faith of policymakers and regulators in the ability of central counterparties (‘CCPs’) to absorb both counterparty and collateral risk in ‘sale and repurchase agreements’ (otherwise known as ‘repos’) – and, in turn, in helping to forestall contagion in the form of so-called ‘repo runs’ – is misplaced. In developing this contention, three major claims are advanced. First, for all their benefits, CCPs exhibit a major design flaw in as much as they are unable to diversify away market-wide systemic risk when counterparty failures become correlated – as exemplified by the global financial crisis (‘GFC’). Second, this design flaw is remarkably similar to the flaw which the modern trend towards market-based finance exhibits, again, as revealed during the GFC, and as persists in its more recent ‘fund-based’ guise, and that this parallel cautions against viewing CCPs in an unduly favourable light. That is to say, in much the same way that market-based finance helped to neutralise systemic risk in good or moderately turbulent times pre-crisis, but amplified it in times of acute market turbulence, so too CCPs are liable to exhibit similar tendencies. Finally, although the UK’s new regulatory and supervisory regime applicable to CCPs has much to commend it, these measures are, in fact, likely to be of limited assistance in ensuing that CCPs are able to perform their mutualisation role, or that they do not disrupt financial markets, when things go seriously wrong.