The role of CCPs in evolving market structures
20 April 2019
Eurex Clearing’s Erik Müller discusses why CCPs, in particular, are attractive as additional risk-mitigating mechanisms
Image: Shutterstock
The financial crisis revealed that the concentration and interconnectedness of banks could prove problematic if these leveraged businesses add outsized incremental leverage. It is particularly difficult to manage where such risk transfer or acquisition occurs outside organised and regulated markets or financial market infrastructures. While even some of the larger players needed support from investors, governments or taxpayers, the same was not true for market infrastructure providers.
Post-crisis measures have made banks much safer by stepping up equity capital requirements and introducing new rules on liquidity management, with rather crude backstop measures such as leverage ratio. Even though banks are much more stable today, it is interesting to give some thought to what makes central counterparties (CCPs) in particular so attractive as additional risk-mitigating mechanisms.
1. Placing the CCP between two counterparties reduces interconnectedness and allows for netting the exposures across different counterparties. Typical CCP netting figures range from 95 to 99 percent.
2. The concept of variation margin prevents credit exposure build-up by levelling “marking to market” the exposures every day. This concept is increasingly applied in uncleared markets as well.
3. Initial margin essentially restricts the leverage to what a market participant can collateralise. Total initial margin across major global CCPs exceeds $500 billion on any given day. Applied thoughtfully, these mechanisms go a long way to ensure trade size reflects capital.
4. A mechanism called default fund that backstops initial margin modelled for extreme but plausible events to the best of the collective imagination and judgement. All participants in the clearing ecosystem, including the CCPs themselves, resource it. The prefunded collateral currently held at CCPs globally is around $75 billion—true mutual resources committed jointly by market participants.
5. Mechanisms embedded in the rulebooks of CCPs that allow CCPs to rebalance themselves in case all other lines of defence fail.
6. The last two elements create an incentive structure and ongoing interest of participants in risk management that is virtually impossible to archive in bilateral markets.
Much has been done by regulators to reduce the likelihood of bank failure and their implications. CCPs address both these aspects, enabling a shift from firm-based financed to market-based financed, which fosters competition and transparency in the markets. Most importantly, they ensure very strong and structured risk management between financial companies.
Post-crisis measures have made banks much safer by stepping up equity capital requirements and introducing new rules on liquidity management, with rather crude backstop measures such as leverage ratio. Even though banks are much more stable today, it is interesting to give some thought to what makes central counterparties (CCPs) in particular so attractive as additional risk-mitigating mechanisms.
1. Placing the CCP between two counterparties reduces interconnectedness and allows for netting the exposures across different counterparties. Typical CCP netting figures range from 95 to 99 percent.
2. The concept of variation margin prevents credit exposure build-up by levelling “marking to market” the exposures every day. This concept is increasingly applied in uncleared markets as well.
3. Initial margin essentially restricts the leverage to what a market participant can collateralise. Total initial margin across major global CCPs exceeds $500 billion on any given day. Applied thoughtfully, these mechanisms go a long way to ensure trade size reflects capital.
4. A mechanism called default fund that backstops initial margin modelled for extreme but plausible events to the best of the collective imagination and judgement. All participants in the clearing ecosystem, including the CCPs themselves, resource it. The prefunded collateral currently held at CCPs globally is around $75 billion—true mutual resources committed jointly by market participants.
5. Mechanisms embedded in the rulebooks of CCPs that allow CCPs to rebalance themselves in case all other lines of defence fail.
6. The last two elements create an incentive structure and ongoing interest of participants in risk management that is virtually impossible to archive in bilateral markets.
Much has been done by regulators to reduce the likelihood of bank failure and their implications. CCPs address both these aspects, enabling a shift from firm-based financed to market-based financed, which fosters competition and transparency in the markets. Most importantly, they ensure very strong and structured risk management between financial companies.
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