Originally appeared in MiFID Monitor
The market may be overestimating the impact that the introduction of a central clearing counterparty (CCP) will have on systemic risk, according to London-based consultancy Adsatis. The firm’s recent white paper, entitled “A central counterparty for OTC credit derivatives – are we over estimating the importance?”, examines the benefits and possible disadvantages of clearing OTC credit derivatives via a CCP.
Bill Hodgson, Adsatis consultant and author of the paper, explains: “The benefits of a CCP for OTC credit products have been widely advertised as reducing ‘systemic’ risk in the capital markets. Our contention is that changing the processing of one high volume product makes no difference to the entire capital markets system, leaving the wider system unaffected. The inability of any CCP to take on the risk mitigation of complex structured credit products, means the CDOs and SIVs at the centre of the current crisis remain untouched by this initiative.”
The white paper examines the characteristics of a CCP and how these will affect industry participants in the CDS market. Hodgson identifies three main benefits to a member of a CCP: the release of credit line usage, the release of regulatory capital and more efficient back office processing.
But he also identifies what he sees as a negative impact: “One downside of having OTC contracts via a CCP is the exclusion of these trades from the existing ISDA based margin agreement between a pair of firms. With a large number of trades being novated to the CCP, this can potentially reduce the effect of exposure netting, and increase the amount of margin required in the bilateral relationship.”
The CCP will also provide benefits to regulators such as a single window into the risk exposures of its members, says Hodgson.
However, he is sceptical that the initiatives will benefit the industry significantly in terms of reducing systemic risk. “If your definition of systemic means the whole capital market, then given the narrow scope of the OTC credit CCP, this benefit doesn’t seem justified given the wide range of other business transacted by the major firms,” he says.
Hodgson puts the introduction of the CCP into this market down to two primary factors: public image that something is being done and the desire of regulators to more closely monitor the sector. He believes the existence of a credit CCP won’t prevent a future crisis and will be a footnote to any history of this period. “If anything this is a tactical step which will be forgotten once launched as we continue to see the after effects of the crisis. And a final note, given the scale of losses in the market so far, can a single CCP absorb such losses bringing concentration of risk into a single entity?”