Central Counterparties: Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives

Chapter 14

Risks Caused by CCPs

When Black Friday comes I’ll collect everything I’m owed and before my friends find out I’ll be on the road.

Steely Dan (‘Black Friday’)

14.1 OVERVIEW

This chapter discusses the risk created by the mandatory clearing of OTC derivatives. We will cover the risks that CCPs themselves face and the corresponding risks to which clearing members (and their clients) are exposed. It is important to keep in mind that the risks of central clearing should be balanced against those of not; after all, bilateral OTC derivatives markets have been proven to contribute to significant instability in financial markets. Central clearing of OTC derivatives is not a panacea but may be a safer alternative to the previous bilateral setup.

14.1.1 General risks created by CCPs

By taking initial margin, a CCP transforms counterparty risk into other forms of risk. Most obviously, funding liquidity risk arises due to the nature of margining, as discussed at length in the previous chapter. However, operational and legal risks also exist, which we will consider later in this chapter.

Regarding the general risk posed by CCPs (especially those clearing significant volumes of OTC derivatives), two obvious concerns arise:

• Central nodes of failure: Mandatory clearing will increase the importance of CCPs as key central nodes within financial markets. As such their failure or even distress could initiate a major disturbance. This also creates a too big-to-fail dilemma: if a CCP would ...