Central counterparty (CCP) clearing for OTC instruments may not make financial markets any safer, a team of J.P. Morgan analysts contend.
Championed by the G-20 group of nations and pursued by regulators in both Europe and the US via the European market infrastructure regulation (EMIR) and Dodd-Frank respectively, central clearing of OTC derivatives has been considered a key tool to reduce systemic risk in financial markets.
But the J.P. Morgan team, led by Kian Abouhossein, pointed out that bank regulation was likely transferring banking risk to highly-leveraged CCPs, which may lack the resources to survive default events such as sovereign haircuts in EU countries. Using clearer LCH.Clearnet as an example, the research team asserted the clearing house had €333 million equity and assets of €541 billion, against a correlated tail risk of €283 trillion notional in interest rate swap exposures alone.
That equated to a leverage of six basis points in equity versus assets – meaning the clearing house had relatively limited capital resources to withstand a concerted shock.
“Proposed clearing member banks’ capital support is a solution, but makes a potential failure of a CCP a potential circular event directly impacting the banking system,” read the report. “In addition, CCP clearing could trigger event risk, as we witnessed in LCH’s haircut increase on Italian/Portuguese bonds.”
The J.P. Morgan research suggests central clearing would see systemic risk transferred from banks to clearing houses. While the regulatory deficits the firm calculated for central clearing houses were only hypothetical, the paper was keen to stress these could become real deficits in a sovereign crisis, given clearing house concentration risk.
“The defaults of one or two clearing member banks or large corporate clients is absorbable,” said the report. “However, when you take into account sovereign debt collateral yield movements and liquidity changes during crisis events, if these events impact more than one or two names, we believe CCP resources could prove insufficient.”