Presentation Assessment

Subject: Securities Regulation

Topic Question
Will a central counterparty (CCP) clearing system, for certain classes of over-the-counter (OTC) derivatives, reduce systemic risk in the financial system?

Thesis Statement
A CCP clearing system for certain classes of OTC derivative
will provide certain benefits. However, in isolation, a CCP will not reduce the overall level of systemic risk in the financial

system.

What are OTC Derivatives?

A derivative is a contract whose value is derived from something else such as the price of a share or

commodity, a certain benchmark interest rate, or even

the occurrence of a specified event such as a default. OTC Derivatives are not traded on exchanges, instead

they

are

negotiated

privately

between

financial

institutions on behalf of their clients and for themselves.

What is a CCP?
Currently most OTC derivative trades are bilateral. This is the plate of spaghetti model that can create an

extremely complex web of interconnected counterparty

relations. The idea behind a CCP is to reduce complexity by creating a hub and spoke structure whereby an entity sits in between the counterparties and assumes their obligations. When trades are cleared through a CCP

each party is liable only to the CCP.

(Source: Council of Financial Regulators Discussion Paper, Central Clearing of OTC Derivatives in Australia, figure 2)

(Source: Council of Financial Regulators Discussion Paper, Central Clearing of OTC Derivatives in Australia, figure 2)

What is Systemic Risk?

The possibility that one financial institution becomes unable to to meet its contractual obligations triggering a domino effect of failures as one financial institution after another goes bust. In such a scenario the continuing viability of the current financial system comes under question.

Legal Context
Pittsburgh 2009 - G20 Group of Nations commitments Intention of preventing a repeat of the GFC Moving towards a system of CCP clearing for OTC derivatives was one of these commitments, based on the belief that it would reduce systemic risk. In response to G20 commitments Australia amends Corporations Act 2001 (Cth) in 2012 ASIC given the power to make derivative transaction rules that require certain classes of derivatives to meet stipulated clearing

requirements (s 901A)

CCP Inability to Clear all OTC Derivatives

Only standardised OTC derivatives will require CCP clearing.
However, many are complex and individualised and thus likely to fall outside any clearing requirements Market participants may avoid CCP clearing requirements via the alteration of standard contracts or regulatory arbitrage. Consequently, risk management benefits of a CCP will not extend to those contracts it does not clear even though they pose similar or possibly greater risks of loss to financial institutions and contribute significantly to systemic risk.

Duplication of Industry Practice

A CCP will implement collateralisation requirements

Such requirements are already in place and would largely

be a duplication of current industry practice as set out by the International Swaps and Derivatives Association (ISDA) Thus the impact on reducing systemic risk would likely be minimal

Concentration of Risk
A CCP will not reduce overall risk it will only alter its form.

Risk will be centralised into the CCP instead of it being

dispersed among a network of institutions To reduce systemic risk institutions must be able to fail without bringing down others with them, however a CCP would itself be the ultimate Too Big to Fail (TBF) institution

Risk Management Issues

The nature of a CCPs role in assuming counterparty obligations means it could fail during market disturbances. OTC derivative contracts can be illiquid and difficult to price and this is especially so during stressed market conditions The use of quantitative models based on historical data to used to measure risk and thus set margin and collateral requirements can be misleading as was demonstrated during the GFC.

Risk Management Issues

Using mark-to-market margin calls can fuel market

crashes as participants are forced to liquidate positions. This creates a negative feedback loop and increases the risk of a financial institution defaulting

Inability to Address Other factors

Regulation of securities of OTC derivatives through a mechanism such as a CCP cannot address the other factors which play a role in creating systemic Risk. Such factors include leverage in the banking system and incentive structures within the financial sector which encourage risk taking.

Conclusion
A CCP clearing system for certain classes of OTC derivative trades will provide certain benefits. However, in relation to systemic risk in the financial system it will not reduce its overall

level.