Central Counterparty Clearing Research Articles

Climate risk and central counterparty risk management

In today’s world, the word “climate” is sure to strike a conversation wherever you go; equally so in the world of clearing houses, where the risks arising from the climate, or “climate risk”, are examined. In this paper, the European Association of CCP Clearing Houses discusses several aspects of climate risk, beginning with an overview of the various types of climate risk, such as physical and transitional effect risk, discussing how these are currently integrated into the key activity of central counterparty (CCP) stress testing. This then leads to a brief overview of the metrics within climate risk. The key questions here are how climate risk metrics are developed, used and disclosed across the industry. Lastly, the paper discusses the possible future business impact of climate risk and looks forward at how central counterparties will adapt to a changing climate in the coming years and decades in order to continue to contribute to safe, robust and transparent financial markets.

The Economics of Central Clearing

Central clearing counterparties (CCPs) have a variety of economic rationales. The Great Recession of 2007–2009 led regulators to mandate CCPs for most interest-rate and credit derivatives, markets in which large amounts of risks are transferred across agents. This change led to a large increase in CCP studies, which along with classical studies are surveyed in this article. For example, multilateral netting, the insurance against counterparty risk, the effect of CCPs on asset prices and fire sales, margins setting, the default waterfall, and CCP governance are discussed here. We review both CCP theory and empirical work and conclude by discussing regulatory issues.

Euro clearing after Brexit: shifting locations and oversight

PurposeThis paper investigates the impact of moving Central Counterparty Clearing Houses (CCPs) that clear euro-denominated transactions to the Eurozone after the withdrawal of the UK from the European Union. Prior to Brexit, the City of London had a dominant position in euro-clearing, but in the aftermath of Brexit, clearing houses might decide to move to the EU27. This paper aims to investigate the impact of moving euro-clearing to the EU27.Design/methodology/approachThis paper provides an economic, political and legal investigation based on desk research. It studies the relevant materials, as they relate to the functioning of Central Counterparty Clearing in the aftermath of Brexit, with specific attention to the potential shift of locations and oversight.FindingsThe development of a EU27 financial hub and the possibility to increase oversight over euro-denominated financial transactions, which were partly at the roots of the financial and Eurozone crisis, could strengthen the market shaping of European financial markets. However, localizing euro-denominated transactions in Europe could potentially give rise to efficiency losses and a higher risk for companies and investors. Furthermore, the European regulatory framework currently faces certain weaknesses, obstructing the regulatory potential of the EU.Research limitations/implicationsAs the Brexit negotiations are not yet finished, this paper does not intend to set out a definite outcome of the processes currently taking place.Practical implicationsShifting locations and oversight of CCPs as a result of Brexit could lead to the establishment of a large financial centre within the EU-27. At the same time, it is to be expected that such a development will have a significant impact on the financial infrastructure of the City of London.Originality/valueThere exists an important trade-off with regard to shifting locations that need to be at the forefront of the discussions and the negotiations when dealing with Brexit. This seems to be neglected in a lot of the current policy debates. This paper takes stock of the ongoing debate and how it relates to the functioning of CCPs.

The Value of Central Clearing

ABSTRACTI study a contracting innovation that suddenly insulated traders of hedging contracts against counterparty risk: central clearing counterparties (CCPs) for derivatives. The first CCP was created in Le Havre (France) in 1882, in the coffee futures market. Using triple difference‐in‐differences estimation, I show that central clearing changed the geography of trade flows Europe‐wide, to the benefit of Le Havre. Inspecting the mechanism using trader‐level data, I find that the CCP solved both a “missing market” problem and adverse selection issues. Central clearing also facilitated entry of new traders in the market. The successful contracting innovation quickly spread to other exchanges.

CDS Central Counterparty Clearing Default Measures: Road to Recovery or Invitation to Predation?

Following the 2008 financial crisis, regulation mandates the clearing of the CDS market through Central Clearing Counter-parties (CCPs). Large CCPs are now designated as ’Global Systemically Important Institutions’ (GSIIs), whose unlikely-but-plausible failure threatens global financial market stability. This work examines CCP resilience following a large dealer member’s default and the ensuing default contagion. In unwinding the defaulter’s positions, the CCP faces the price impact of constrained member liquidations and unconstrained members’ predatory selling. The variation margin captures the effect of price-mediated contagion and its amplification. A novel spatial measure captures the covariance between members’ CDS holdings and the CDS being unwound. Key results show: Liquidations by constrained members lower the CCP’s profits and make cds-spreads less informative. There exists a strong conflict between predatory competition and dealer distress, which inadvertently makes dealers prey on themselves. In turn, the adoption of a risk-sharing guarantee fund structure would provide a natural disciplinary mechanism for predation – minimizing overall CCP and member losses. A dynamic simulation, calibrated to OTC market data, supports these theoretical results with parameter magnitudes and sensitivities. Examination of three market liquidity scenarios provides intuition for effective liquidity injection by a Lender of Last Resort.

Mitigating Fire Sales with Contracts: Theory and Evidence

I argue that one rationale for central clearing counterparties (CCPs) is to mitigate inefficiencies associated with distressed asset sales. First, I build a simple model where asset sales give rise to multiple equilibria, and show that a contract resembling a CCP ensures coordination on the Pareto-dominating equilibrium. Second, I empirically study the first event in economic history during which a CCP successfully eliminated inefficient asset sales: the global wool crisis of 1900.

CDS Central Counterparty Clearing Liquidation: Road to Recovery or Invitation to Predation?

Recent regulation mandating the clearing of credit default swaps (CDS) by a Central Clearing Counterparties (CCP), has rendered the latter a systemically important institution, whose failure poses a serious threat to global financial stability. This work investigates the potential failure of a CCP initiated by the default of a large dealer bank and the unwinding of its positions. The theoretical model examines variation margin exchange between dealer banks and the price impact of liquidation and predatory selling. It provides a measure of covariance between assets in banks’ portfolios; price impact affects assets to varying degrees, based on their relative distance to defaulted assets. Key results show that liquidation lowers CCP profits, and how predation decreases the profits of all members, pushing banks to default. Furthermore, a hybrid CCP (vs. current) structure provides a natural disciplinary mechanism for predation. Also, it more incentive compatible for the CCP, in expectation of a large loss. A multi-period, dynamic simulation, calibrated to market data, provides parameter sensitivities, as well as, regulatory implications for a Lender of Last Resort in various liquidity scenarios.

The Pitfalls of Central Clearing in the Presence of Systematic Risk

Central clearing counterparties (CCPs) were created to reduce default losses for market partic- ipants in derivatives markets. We show that not all market participants benefit, and some are worse off. Loss sharing rules and their interaction with market network structure affect who are winners and losers. The loss sharing rule most widely used by CCPs is based on net risk. We develop a simple model which shows that this rule largely benefits market participants with flat portfolios but not participants with directional portfolios or those located in the periphery of the network. This result is consistent with the reluctance of peripheral participants to voluntarily clear in practice. We investigate how to offset cross-sectional differences in loss sharing benefits, and highlight alternative loss sharing rules and centralized trading as potential remedies.

Examining the Prudential Regulation and Resolution Regimes for Central Clearing Counterparties in Europe

As part of financial market infrastructures, central counterparties (CCPs) have long been deemed systemically important and are likely to gain in importance due to the regulatory developments mandating central clearing for an increasing number of financial products. This paper focuses on the regulation as well as the recovery and resolution of CCPs in Europe. The existing CCP regulatory framework consists of ex-ante measures, including, among others, capital and liquidity requirements, initial and variation margins, and loss sharing mechanisms. In addition, the European proposal for the recovery and resolution of CCPs (the Proposal) contains several ex-post regulatory measures mainly in the form of rules for recovery and orderly resolution. Having studied the prudential regulatory measures for CCPs contained in the European Market Infrastructure Regulation and the ex-post recovery and resolution measures of the Proposal, this paper puts a spotlight on the specific shortcomings of the existing and proposed rules, in particular in terms of misaligned incentives, externalities, collective action problems, and certain practical impediments, and concludes that it would be misguided to inordinately rely on ex-post measures. Highlighting the limitations of the recovery and resolution mechanisms, this paper proposes that given the systemic importance of CCP functions, it is critical to improve the ex-ante measures whose objective is to prevent the failure of a CCP, rather than ex-post measures, which kick in after its failure. Accordingly, recommendations for making such improvements are proposed.

Basel III Credit Valuation Adjustment Capital Charge and Wrong Way Risk

As part of a very dynamic financial environment, regulations are always being improvedand enhanced in order to keep the financial markets as transparent and regulated aspossible. Basel is currently shifting towards central clearing of derivatives productsand amending a capital charge, Credit Valuation Adjustment (CVA) capital charge, forthose that are not cleared through Central Counterparty Clearing Houses. In this work,a first part explains the newly proposed approaches for computing the regulatory CVAcapital requirement. Afterwards, the importance of incorporating the Wrong Way Risk(WWR) in the computation of the CVA is detailed. An approach based on Error Correction Models highlights the differing impact of such risk for several counterparties.Applications on interest rate swaps with a single investment grade sovereign counterparty are considered. A first conclusion discusses the divergence between the tworegulatory approaches when dealing with different counterparties within the samerisk bucket. In addition, another result is interpreted following the ECM methods reflecting the changing impact of the WWR for the counterparties considered: even forthe three European investment grade sovereigns, the model reflected a higher WWRfor Spain than the one observed for Ireland or France. A proposed modified scale forBasel methodologies would account for the effective credit quality and WWR of eachspecific counterparty in a way that converges the requested charge under both possible regulatory capital charge methodologies.

Analysis of Asymmetric GARCH Volatility Models with Applications to Margin Measurement

We explore properties of asymmetric generalized autoregressive conditional heteroscedasticity (GARCH) models in the threshold GARCH family and propose a more general Spline-GTARCH model, which captures high-frequency return volatility, low-frequency macroeconomic volatility as well as an asymmetric response to past negative news in both autoregressive conditional heteroscedasticity (ARCH) and GARCH terms. Based on maximum likelihood estimation of S\&P 500 returns, S\&P/TSX returns and Monte Carlo numerical example, we find that the proposed more general asymmetric volatility model has better fit, higher persistence of negative news, higher degree of risk aversion and significant effects of macroeconomic variables on the low frequency volatility component. We then apply a variety of volatility models including asymmetric GARCH, GARCH and EWMA in setting initial margin requirements for central clearing counterparties (CCPs).

The Demand for Central Clearing: To Clear or Not to Clear, That Is the Question

This paper analyses whether the post-crisis regulatory reforms developed by globalstandard-setting bodies have created appropriate incentives for different types of market participants to centrally clear Over-The-Counter (OTC) derivative contracts. Beyond documenting the observed facts, we analyse four main drivers for the decision to clear: 1) the liquidity and riskiness of the reference entity; 2) the credit risk of the counterparty; 3) the clearing member’s portfolio net exposure with the Central Counterparty Clearing House (CCP) and 4) post trade transparency. We use confidential European trade repository data on single-name Sovereign Credit Derivative Swap (CDS) transactions, and show that for all the transactions reported in 2016 on Italian, German and French Sovereign CDS 48% were centrally cleared, 42% were not cleared despite being eligible for central clearing, while 9% of the contracts were not clearable because they did not satisfy certain CCP clearing criteria. However, there is a large difference between CCP clearing members that clear about 53% of their transactions and non-clearing members, even those that are subject to counterparty risk capital requirements, that almost never clear their trades. Moreover, we find that diverse factors explain clearing members’ decision to clear different CDS contracts: for Italian CDS, counterparty credit risk exposures matter most for the decision to clear, while for French and German CDS, margin costs are the most important factor for the decision. Moreover, clearing members use clearing to reduce their exposures to the CCP and largely clear contracts when at least one of the traders has a high counterparty credit risk.

Completing Markets With Contracts: Evidence From the First Central Clearing Counterparty

I study a contracting innovation that suddenly insulated traders of hedging contracts against counterparty risk: central clearing counterparties (CCPs) for derivatives. The first CCP was created in Le Havre (France) in 1882, in the coffee futures market. Using triple difference-in-differences estimation, I show that central clearing changed the geography of trade flows Europe-wide, to the benefit of Le Havre. Inspecting the mechanism using trader-level data, I find that the CCP solved both a missing market problem and adverse selection issues. Central clearing also facilitated entry of new traders in the market. The successful contracting innovation quickly spread to other exchanges.

Repurchase Agreements and the European Sovereign Debt Crises: The Role of European Clearinghouses

This article investigates the European repo market and its role as an amplification channel for sovereign-debt crises. We focus on the centrally cleared segment, representing the majority of European repos. A novel data set on repo and margin haircuts applied to sovereign bonds by central clearing counter parties (CCPs) is gathered, allowing us to assess the haircut methodologies used by the major European CCPs. We document that following increases in sovereign risk, haircuts set bymajor CCPs on peripheral sovereign bonds increased significantly. The procyclicality of haircuts and the concentration of bilateral repos raise concerns about the CCP-intermediated repo market as a source of systemic risk in the Eurozone. This is however mitigated by the counter cyclical monetary policy of the European Central Bank (ECB).

Bilateral vs. Central Counterparty Clearing in OTC Markets: Counterparty Exposures, Allocation Efficiency, and Applications

I construct a model of over-the-counter (OTC) trading to study equilibrium allocation properties under bilateral clearing (BC) and central counterparty (CCP) clearing of OTC derivatives. I show how CCP mutualizes individual counterparty exposures and prevents massive equilibrium defaults. I define allocation efficiency, show inefficient allocation under BC, and that CCP may improve efficiency. I also apply the model to produce different levels of equilibrium collateral requirement under CCP and to illustrate an aggregate risk-induced systemic CCP default.

Systemic risk in clearing houses: Evidence from the European repo market

We study how crises affect Central Clearing Counterparties (CCPs). We focus on a large and safe segment of the CCP-cleared repo market during the Eurozone sovereign debt crisis. We develop a simple model to infer CCP stress, which is measured as repo rates’ sensitivity to sovereign credit default swaps (CDS) spreads and jointly captures (1) the effectiveness of haircut policies, (2) CCP-member default risk (conditional on sovereign default), and (3) CCP default risk (conditional on both sovereign and CCP-member default). During 2011, repo rates strongly respond to sovereign risk, particularly for Greece, Italy, Ireland, Portugal and Spain (GIIPS): Repo investors behaved as if the conditional probability of CCP default was substantial.

Value at Risk and Expected Shortfall Performance Versus Currents Regulation Applied to Colombian Exchange Rate Futures Market

In this paper we propose a Value at Risk (VaR) and Expected Shortfall (ES) with normal and t-student distribution to estimate the daily market risk in the Colombian futures market Exchange rate with US dollar, the current regulation by the (CRCC) Colombian Central Counterparty Clearing House establish a constant 7% of guarantee to mitigate the counterparty risk, we found in the backtestings that the current method does not capture the current volatility and the leptokurtosis of the gain/loss distribution which conducts in a overestimation of risk, maybe that moves away the market from efficiency according to classical economy statements, we suggest that this is one reason for the lack of development of the Colombian Exchange future market.

CDS Central Counterparty Clearing Liquidation: Road to Recovery or Invitation to Predation?

Recent regulation, mandating the clearing of credit default swaps (CDS) by a Central Clearing Counterparties (CCP), has rendered it's possible failure a serious threat to global nancial stability. This work investigates the potential failure of a CCP initiated by the default of a large dealer bank and the unwinding of its positions. The theoretical model examines variation margin exchange between dealer banks and the price impact of liquidation and predatory selling. It provides a measure of covariance between assets in banks' portfolios; price impact affects assets to varying degrees, based on their relative distance to defaulted assets. Key results show that liquidation lowers CCP profits, and how predation decreases the profits of all members, pushing banks to default. Furthermore, a hybrid CCP (vs. current) structure provides a natural disciplinary mechanism for predation. Also, it is more incentive compatible for the CCP, in expectation of a large loss. A multi-period, dynamic simulation, calibrated to OTC market data, provides parameter sensitivities concerning the magnitude of CCP and predatory bank gains/losses, specifically, the minimisation of those losses with a hybrid fund structure. Furthermore, regulatory implications concerning the timing of liquidity injection for a Lender of Last Resort (LoL) are determined for various liquidity scenarios; stable and decreasing market liquidity, as well as, a liquidity dry-up at the bottom of a financial crisis.

On Collateral: Implications for Financial Stability and Monetary Policy

This paper examines the role of collateral in the financial system, with special emphasis on the implications for financial stability and the conduct of monetary policy. First, we review what drives the demand and supply for both real and financial collateral assets. Then we examine financial stability issues and the case for regulating the use of collateral. We discuss the role and design of market infrastructures such as central clearing counterparties (CCPs). Finally, we examine the interaction of standard and non-standard monetary policy and the functioning of private collateralised markets. We show that the use of collateral is neither a sufficient nor a necessary condition for financial stability. To ensure the stability of collateralised markets a mix of micro- and macro-prudential regulation, as well as a sufficient supply of safe public assets that can be used as collateral, are needed.

Systemic Risk in Clearing Houses: Evidence from the European Repo Market

How do crises affect Central clearing Counterparties (CCPs)? We focus on CCPs that clear and guarantee a large and safe segment of the repo market during the Eurozone sovereign debt crisis. We start by developing a simple framework to infer CCP stress, which can be measured through the sensitivity of repo rates to sovereign CDS spreads. Such sensitivity jointly captures three effects: (1) the effectiveness of the haircut policy, (2) CCP member default risk (conditional on sovereign default) and (3) CCP default risk (conditional on both sovereign and CCP member default). The data show that, during the sovereign debt crisis of 2011, repo rates strongly respond to movements in sovereign risk, in particular for GIIPS countries, indicating significant CCP stress. Our model suggests that repo investors behaved as if the conditional probability of CCP default was very large. JEL Classification: E58, E43, G01, G21