UC Berkeley

In the aftermaths of the global financial crisis of 2007-2009 (GFC), policymakers and regulators around the world embarked on far-reaching reforms of the over-the-counter (OTC) derivatives market. A key element in their agenda was the introduction of central clearing mandates for OTC derivatives, which was largely driven by the belief shared among policymakers and regulators that central counterparties clearing OTC derivatives (OTC CCPs) could reduce the counterparty risk and mitigate the systemic risk associated with their trading. During the past seven years, however, the scale and complexity of the process of implementation of central clearing mandates of OTC derivatives have gradually emerged. In particular, a dawning debate has arisen around the question of how OTC CCPs may themselves generate and/or exacerbate systemic risk within the financial system. The present work investigates this question in detail.

After providing some background on OTC derivatives and related financial risks, the present work examines the operations and functions of OTC CCPs, covering aspects such as novation, margins, multilateral netting and the coordinated default management process. Following this preliminary analysis, the present work discusses multiple benefits and risks of OTC CCPs and, then, investigates relationships and dynamic interactions existing among them. This risk/benefit analysis of OTC CCPs, in turn, helps gain a realistic appreciation of OTC CCPs’ systemic-risk implications.

Significantly, a number of procedures and mechanisms through which OTC CCPs can generate and/or exacerbate systemic risk are identified, which include the following:

• OTC derivatives trading through OTC CCPs may create excessive concentration of multiple risks into one single focal point. This reduces the possibility for diversification and may increase the probability that the failure of an OTC CCP could have system-wide destabilizing effects. Furthermore, by concentrating the risk associated with the trades being cleared, OTC CCPs may themselves become systemically important entities and their failure may expose many market participants to severe losses.

• By changing the topology of the network of connections in the OTC derivatives market, OTC CCPs essentially replace one set of interconnections with another, which could be as vulnerable to systemic failures as (or even more vulnerable than) the one existing prior to the implementation of central clearing mandates. The resulting interconnected structure is, then, made even more complex by the raise of “alternative forms” of clearing of OTC derivatives, which have emerged over the past few years driven by unprecedented developments in new technologies, including blockchain and hyperledger technologies.

• Rigorous margin requirements enforced by OTC CCPs may have the effect of increasing operational complexity and rigidity within the OTC derivatives market, which, in turn, may lead to a more tightly coupled financial system. In addition, as shown in the aftermaths of the Brexit vote, OTC CCPs’ rigorous margining may create pro-cyclicality problems, and in the event of large price moves it may trigger “systemic margin calls.” In such a scenario, many OTC CCPs’ members (CMs) with losing positions would be required to make large variation margin payments in a very tight frame, and would be forced to raise funds simultaneously. This rush to liquidity may, then, create severe strains for CMs with destabilizing effect for OTC CCPs, as well. Moreover, the need to raise liquidity to meet large margin calls and the need to reduce (or close) positions because of the inability to meet such calls may create tight coupling and may lead to chaotic fire sales that further exacerbate price movements. The fire sales of assets may have spillover adverse effects that go far beyond derivatives transactions to impact any institution or firm holding the assets subject to fire sales, including those that don’t have any (direct or indirect) counterparty exposure to market participants trading cleared derivatives. Last, uncertainty about the solvency of market participants may induce chaotic information contagion and further assets liquidations, which may exacerbate price volatility and may result into severe declines in trading market liquidity.

• Multilateral netting and setoff through OTC CCPs change creditor priority by increasing the priority of the OTC CCP and the derivatives counterparties over other claimants on a defaulted CM. In so doing, multilateral netting and setoff through OTC CCPs essentially redistribute value from one group of creditors to other creditors and re-allocate risks of losses from one set of claimants to another. This redistributive effect may be systemically damaging if the risk is transferred to parties that are as systemically important and as vulnerable as (or even more systemically important and more vulnerable than) OTC derivatives market participants.

• OTC CCPs’ loss mutualization and risk sharing mechanisms may expose OTC CCPs to problems of adverse selection and moral hazard, and may increase the opacity of OTC derivatives trading, which, in turn, may create the risk of runs on OTC CCPs in the event of default of one or more of their CMs. In addition, margining and risk-sharing mechanisms of OTC CCPs make them particularly vulnerable to wrong-way risk (WWR), thus contributing further instability.

• A typical OTC CCP’s default waterfall resembles the loss allocation structure of a collateralized debt obligation (CDO) as the various levels in an OTC CCP’s default waterfall are typically accessed in sequence, much like the tranches of a CDO. As a result, the risk characteristics of the two structures may be very similar. In particular, much like senior and super-senior tranches in a CDO, the risk exposure of CMs via an OTC CCP’s default fund is heavily concentrated in terms of systemic risk and WWR and it may increase significantly during periods of large market-wide shocks, high volatility and liquidity shortage.

By building on the findings of the described risk/benefit analysis of OTC CCPs, the present works examines a new approach to systemic risk-related financial regulation, which has emerged in the aftermaths of the GFC and has been inspired by chaos theory, and applies this new approach onto the OTC derivatives clearing context through a two-step analysis. First, the present work focuses on the OTC CCP’s coordinated default management process and discusses how to improve it by considering behavior aspects in the pricing and structuring of an OTC CCP’s default waterfall. In particular, the present work examines innovative designs of OTC CCPs’ pre-funded mutualized default fund(s), which can create the necessary incentives for CMs to cooperate and help the OTC CCP during the coordinated default management process by participating actively in the hedging and auctioning of the defaulted CM's positions. Second, the present work identifies and discusses additional resources and stabilizing mechanisms that could be activated in the remote (but still possible) scenario in which an OTC CCP’s coordinated default management process backfires, including contingent capital, central bank’s liquidity resources, private systemic risk insurance fund(s), third-party systemic risk insurance, and systemic risk catastrophe bonds.