Even though the market has not witnessed a massive meltdown of central counterparties (CCPs) and its paralysing effect, regulators are taking precautions, says Finextra.
In a blog post, the firm discussed the various merits and downfalls of CCPs, stating that benefits such as lower settlement costs and reduced risk offset their vulnerability, so long as they are properly managed and well capitalised.
“CCPs can potentially pose significant systemic risk to the market, with the concentrated risk that they take on. There have been heated discussions about the vulnerability of CCPs in distressed market situations."
"Some even start to apply the term 'too big to fail' to CCPs. How do CCPs usually manage their risk and what is the sequence of events when a participating member defaults?"
“In the event of a member default as defined in the CCP default rules (eg, fail to settle, fail to pay fees), the CCP can claim the member to be in a non-conforming or default status … the CCP may seize the default member’s assets, and then either transfers the assets to another member or auctions the portfolio to other members," said the firm.
"To cover the induced loss from the default member, the CCP’s first recourse is to seize the default member’s resources, including the collateral it pledged for margins and its contribution to the default fund. If the above resources are not sufficient to cover the loss, the CCP will look to its own capital reserved for this purpose and then the remaining default fund contributed by members still in good standing.”
Finextra concluded by predicting that even though the market has not witnessed CCP failure as of yet, regulators will step up their game to avoid a CCP meltdown.
