Publish Date:

Jul 12, 2024

Serial Number:

2017PA1002

Views: 159
Downloads: 2
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Rama Cont

@ramacont

Professor of Mathematics, Chair of Mathematical Finance, University of Oxford

Central Clearing and Risk Transformation

Key Findings


The introduction of central clearing in OTC markets has been effective in reducing counterparty exposures across clearing members. But, rather than removing counterparty risk, central clearing -together with initial and variation margin requirements for non-cleared transactions- transforms it into liquidity risk.


Abstract


The clearing of over-the-counter transactions through central counterparties (CCPs), one of the pillars of financial reform following the crisis of 2007-2008, has promoted CCPs as key elements of the new global financial architecture. Given the cost of implementing central clearing mandates and the associated collateral requirements, it is important to examine how these reforms have affected risks in the financial system and whether central clearing has attained the initial objective of the reform, which is to enhance financial stability and reduce systemic risk. We show that, rather than eliminating counterparty risk, central clearing transforms it into liquidity risk: margin calls transform accounting losses into realised losses which affect the liquidity buffers of clearing members. Accordingly, initial margin and default fund calculations should account for this liquidity risk in a realistic manner, especially for large positions. While recent discussions have centered on the solvency of CCPs, their capital and ‘skin-in-the-game’ and capital requirements for CCP exposures of banks, we argue that these issues are secondary and that the main focus of risk management and financial stability analysis should be on the liquidity of clearing members and the liquidity resources of CCPs. Clearing members should assess their exposure to CCPs in terms of liquidity, rather than counterparty risk. Stress tests involving CCPs should focus on liquidity stress testing and adequacy of liquidity resources.

  • Cont, Rama and Kokholm, Thomas (2014) Central clearing of OTC derivatives: Bilateral vs multilateral netting, Statistics and Risk Modeling, Vol 31, No. 1, pages 3–22. Cont, Rama and Minca, Andreea (2016) Credit default swaps and systemic risk, Annals of Operations Research, Vol 247, No 2, 523-547 Cont, Rama and Lakshithe Wagalath (2013) Running for the exit: distressed selling and endogenous correlation in financial markets, Mathematical Finance, Vol. 23, No. 4 (October 2013), 718–741.

  • #(CCPs)
  • #CCP
  • #central clearing
  • #central counterparty
  • #systemic risk
  • #liquidity risk
  • #counterparty risk
  • #default fund
  • #OTC derivatives
  • #collateral requirement
  • #regulation
  • #stress testing.

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Category

  • Central Clearing

Author Type

  • Academic

Authors

  • Rama Cont