Using Central Counterparties to Limit Global Financial Crises

Abstract

Conventional economic analysis assumes that Central Counterparties (CCPs) may help to reduce systemic risk and avoid future financial crises by mandating the central clearing of over-the-counter (OTC) derivatives. This view largely goes unchallenged by governments, regulators, practitioners, and many international standard setting bodies. But if this assumption is correct, why are we increasingly confronted with the potential failure of CCPs? Why do these potential failures threaten significant spillover and cascade effects, which may cause financial crises rather than preventing them? This article attempts to provide a compelling explanation for these negative effects. In this article, I question the received wisdom about the role that CCPs play in preventing financial crises. I further challenge the conventional view about how counterparties should be used by focusing on CCP recovery and resolution mechanisms in the U.S. context. This article analyzes why the current approach, which assumes that CCPs serve as financial risk mitigators, is problematic and may cause future global financial crises.