OFR_2016_Financial-Stability-Report

2.4 Central Counterparties as Contagion
Channels
The growing role of central counterparties (CCPs) in financial markets
will improve market efficiency, transparency, and financial stability,
but will also concentrate risks. Distress at a CCP could impose losses
on its clearing members, which include the largest and most interconnected
financial institutions. New public data releases and stress
test results in 2016 shed light on the potential for a distressed CCP to
transmit financial instability.
Since the financial crisis, regulators across the world have worked to move
derivatives from bilateral transactions to central clearing through CCPs. The
use of CCPs promotes product standardization and greater transparency.
The role of CCPs in clearing derivatives transactions has grown greatly
since the crisis. About 75 percent of transactions in swap markets supervised
by the CFTC are now centrally cleared. That is up from about 15 percent in
2007 (see Massad, 2016). Swaps markets now clear 97 percent of new trans -
actions in forward rate agreements and 89 percent in fixed-float interest rate
swaps (see CFTC, 2016b).
Derivatives CCPs reduce counterparty credit risk in over-the-counter
(OTC) derivatives markets, reducing some of the financial stability risks of
bilateral trading. CCPs could lower trading costs, improve price discovery,
and reduce counterparty exposures through multilateral netting.
However, in the process, CCPs will also concentrate counterparty
default risk. For this reason, if not well managed, they may pose systemic
risks. To address these risks, supervisors have coordinated and introduced
international risk management standards for CCPs and other financial
market infrastructures. As reliance on central clearing grows, the risk management
practices and regulation of CCPs become more important. A CCP
is vulnerable to the default of its clearing members. Clearing members
are typically large and interconnected banks acting as dealers and clearing
agents for many clients.
CCPs manage risks through collateral requirements, membership standards,
close surveillance of members, and legal procedures to address any
default by clearing members. If CCP risk management proves inadequate, a
distressed CCP may impose losses directly on remaining clearing members.
A distressed CCP could also affect markets indirectly. Unwinding of portfolios
as part of default management, either through auctions or liquidation,
may aggravate price volatility.
New data that CCPs across the world began disclosing this year provide
insights about CCP risks. The data are useful for sizing up the effects of
CCPs on financial stability. Still, gaps remain. European supervisors also
Distress at a CCP could
impose losses on its
clearing members,
which include the
largest and most
interconnected financial
institutions. New public
data releases and stress
test results in 2016 shed
light on the potential
for a distressed CCP
to transmit financial
instability.
Key Threats to Financial Stability 49