Static models of central counterparty risk

Central counterparties (CCPs) have become pillars of the new global financial architecture following the financial crisis of 2008. The key role of CCPs in mitigating counterparty risk and contagion has in turn cast them as systemically important financial institutions whose eventual failure may lead to potentially serious consequences for financial stability, and prompted discussions on CCP risk management standards and safeguards for recovery and resolutions of CCPs in case of failure. We contribute to the debate on CCP default resources by focusing on the incentives generated by the CCP loss allocation rules for the CCP and its members and discussing how the design of loss allocation rules may be used to align these incentives in favour of outcomes which benefit financial stability. After reviewing the ingredients of the CCP loss waterfall and various proposals for loss recovery provisions for CCPs, we examine the risk management incentives created by different ingredients in the loss waterfall and discuss possible approaches for validating the design of the waterfall. We emphasise the importance of CCP stress tests and argue that such stress tests need to account for the interconnectedness of CCPs through common members and cross-margin agreements. A key proposal is that capital charges on assets held against CCP default funds should depend on the quality of the risk management of the CCP, as assessed through independent stress tests.

At the Pittsburgh Summit in 2009, G20 leaders agreed to wide-reaching reforms to over-the-counter (OTC) derivatives markets. One of these reforms required the clearing of standardized OTC derivatives through central counterparties (CCPs). Since then, CCPs have become increasingly important. There has been an extensive programme of regulatory change affecting CCPs, OTC derivatives markets and their participants. As OTC clearing has grown, tension has increased between different classes of market participants over the traditional CCP model of resource provision through loss mutualization. We argue that most of this tension can be explained by a misalignment between the policy goal of enhancing financial stability and the delivery of that goal by mandating clearing through CCPs as they are currently organized. Specifically, the traditional model for resource provision makes most CCPs suitable for managing “club goods”, whereas financial stability is a “public good”. The key differences between these two types of goods, driven by the wedge between those who pay for them and those who derive the benefits, create the observed tensions. Based on this analysis, we propose a framework to analyze the functional elements of a CCP and examine whether an alternative clearing model might be more effective. We conclude that incentives would be better aligned if the functions of CCPs were unbundled and the ownership and funding structures that best suit their individual characteristics were selected. Functions that are critical for the provision of financial stability might suggest some form of public sector involvement, whereas other services might lend themselves to a for-profit or traditional club model.

The global crisis triggered a vast programme of financial markets reform, including a new regime for over-the-counter (OTC) derivatives which requires hitherto private contracts to be cleared through central counterparties (CCPs). This article argues that the interaction between underlying law and this new regulation needs to be addressed in order to advance the objectives of the reforms. The starting point for the argument is the two techniques that underpin CCPs: limited access and posting assets, or margin. Having established that access via intermediated or ‘client’ clearing will become increasingly important with mandatory clearing, the article explores the impact of client clearing on the legal rules governing the margin posted by users of a CCP. The detail of the interaction between European regulations on CCP clearing and the UK rules on client assets is considered as an example. The dilemma identified arises because regulation, designed to improve financial stability by mandating clearing, may potentially undermine certain ways in which CCPs promote that outcome. The article concludes that the interaction between underlying law and new regulation needs to be accounted for and addressed at EU level, in order to safeguard the functions that attracted regulators to clearing in the first place.

Clearing networks

This book provides a perspective on a number of approaches to financial modelling and risk management. It examines both theoretical and practical issues. Theoretically, financial risks models are models of a real and a financial “uncertainty”, based on both common and private information and economic theories defining the rules that financial markets comply to. Financial models are thus challenged by their definitions and by a changing financial system fueled by globalization, technology growth, complexity, regulation and the many factors that contribute to rendering financial processes to be continuously questioned and re-assessed. The underlying mathematical foundations of financial risks models provide future guidelines for risk modeling. The book’s chapters provide selective insights and developments that can contribute to better understand the complexity of financial modelling and its ability to bridge financial theories and their practice. Future Perspectives in Risk Models and Finance begins with an extensive outline by Alain Bensoussan et al. of GLM estimation techniques combined with proofs of fundamental results. Applications to static and dynamic models provide a unified approach to the estimation of nonlinear risk models. A second section is concerned with the definition of risks and their management. In particular, Guegan and Hassani review a number of risk models definition emphasizing the importance of bi-modal distributions for financial regulation. An additional chapter provides a review of stress testing and their implications. Nassim Taleb and Sandis provide an anti-fragility approach based on “skin in the game”. To conclude, Raphael Douady discusses the noncyclical CAR (Capital Adequacy Rule) and their effects of aversion of systemic risks. A third section emphasizes analytic financial modelling approaches and techniques. Tapiero and Vallois provide an overview of mathematical systems and their use in financial modeling. These systems span the fundamental Arrow-Debreu framework underlying financial models of complete markets and subsequently, mathematical systems departing from this framework but yet generalizing their approach to dynamic financial models. Explicitly, models based on fractional calculus, on persistence (short memory) and on entropy-based non-extensiveness. Applications of these models are used to define a modeling approach to incomplete financial models and their potential use as a “measure of incompleteness”. Subsequently Bianchi and Pianese provide an extensive overview of multi-fractional models and their important applications to Asset price modeling. Finally, Tapiero and Jinquyi consider the binomial pricing model by discussing the effects of memory on the pricing of asset prices.

This chapter illustrates the new legal framework for the regulation of non-European Union (EU) central counterparties (CCPs) operating in the EU, which came into force in 2020. The new legal framework divides recognized non-EU CCPs into categories according to systemic importance. Additionally, it is possible for the European Securities and Markets Authority (ESMA) to recommend relocation of systemically important CCPs to the EU. Brexit has also created a mirror-image framework of systemic classification by the UK authorities in respect of non-UK CCPs. The chapter attempts to trace a pathway through the new legal and regulatory environment. Along the way, various strategic landmarks stand out: the extent to which geography is relevant to the regulation of clearing of financial products which have no obvious geographical roots, the meaning of ‘systemic importance’ as applied to CCPs, the impact of Brexit on the industry’s most important CCPs for clearing of over-the-counter (OTC) derivatives, and the policy of the EU and the European Central Bank (ECB) with regard to the location of CCPs.

The over-the-counter (OTC) derivatives market has captured the attention of regulators after the Global Financial Crisis due to the risk it poses to financial stability. Under the post-crisis regulatory reform the concentration of business, and risks, among a few major players is changed by the concentration of a large portion of transactions in the new market infrastructures, the Central Counterparties (CCPs). This book, for the first time, analyses the regulatory response of the United Kingdom and the United States, the two largest centres of OTC derivatives transactions, and highlights their shortcomings. The book uses a normative risk-based approach to regulation as a methodological lens to analyse the UK regime of CCPs in the OTC derivatives market. It specifically focuses on prudential supervision and conduct of business rules governing OTC derivatives transactions and the move towards enhancing the use of central clearing. The resulting analysis, from a normative risk based approach, suggests that the UK regime for CCPs does not fulfil what would be expected if a coherent risk based approach was taken. Our comments on the Dodd-Frank Act highlight that the incoherent adoption of risk-based approach to regulation affects the effectiveness of the US regime for CCPs. Such a regime does not follow the pace of events of 'innovation risk'; in particular, the foreseeable changes FinTech will bring to the OTCDM and central clearing services. The second inadequacy of the US regime concerns the dual regulatory structure of the CFTC and the SEC, and the inadequate adoption of different and not well-coordinated regulatory strategies. We also analyse the cross-border implications of the US regime for non-US CCPs that provide clearing services to US market participants. Finally, we study the negative effects of the absence of a clearly defined resolution regime for CCPs.

CCPs and network stability in OTC derivatives markets

The dispute over ractopamine in the Codex Alimenta-rius Commission (CAC) exemplifi es changes in Codex proceedings. In its early days, the CAC resembled to an honourable Club of senior food safety offi cials aim-ing at setting food standards in a consensual manner. However, with the WTO connexion established in 1995, CAC proceedings are overshadowed by looming trade disputes and increasingly decided by majority voting. The tendency towards majority voting in the CAC may ultimately undermine the universality of food safety standards and the legitimacy of the CAC as an inter-national standard setting body.

An international initiative to increase the use of central clearing for over-the counter (OTC) derivatives emerged as one of the reactions to the 2008 financial crisis. The move to central clearing is a fundamental change in the structure of the market. Central clearing will help control counterparty credit risk, but it also has potential implications for market liquidity. We analyze the relationship between liquidity and central clearing using information on credit default swap clearing at ICE Trust and ICE Clear Europe.We find that the central counterparty chooses the most liquid contracts for central clearing, consistent with liquidity characteristics being important in determining the safety and efficiency of clearing.We further find that the introduction of central clearing is associated with a slight increase in the liquidity of a contract. This is consistent with two countervailing effects. On the one hand, central clearing will likely increase collateral requirements relative to the prereform bilaterally cleared market, thereby increasing clearing costs and possibly reducing the liquidity of the market. On the other hand, improved management of counterparty credit risk, increased transparency and operational efficiencies at central counterparties could bring more competition into OTC derivative markets and serve to increase liquidity.

•Most recently valued at $648 trillion, the over-the-counter (OTC) derivatives markets are vast, global and systemically important. About 90 per cent of these transactions are agreed on International Swaps and Derivatives Association’s (ISDA’s) standard terms, which provide for disputes to be resolved by the courts of England and Wales, or New York (though some parties amend this drafting). •This article presents research into all the available decisions of the English courts involving the ISDA standard terms. Analysis of this data demonstrates the courts’ capacity to provide a remedy for derivatives market participants in a very wide range of circumstances. It also shows how adjudication by the courts sustains the common law and increases transparency in the markets. •Triggered by the G20’s statements in the immediate aftermath of the crisis, regulators are now engaged in sweeping projects of reform in this sector. However, the impact of new rules on the courts has been overlooked. •The article argues that reforms targeting the OTC sector threaten to disrupt the role currently played by the courts in these markets. More specifically, a detailed examination of the internal rules of central counterparties (CCPs) suggests that requiring the bulk of OTC business to be cleared is very likely to reduce the numbers of OTC derivatives related cases coming before the national courts. Especially given regulators’ concern with transparency, the article concludes that these effects need to be considered urgently, and in detail, as part of the impact assessments accompanying regulatory reform.

Chapter 46 - Exposure-driven risk management strategies for chemicals in food

Auf dem G20-Gipfel wurde 2009 beschlossen, dass insbesondere OTC-Derivate-Transaktionen künftig überwiegend über Zentrale Gegenparteien (Central Counterparties) abgewickelt werden sollten. Weltweit beträgt das pro Jahr abgewickelte Volumen von Zins-, Währungs- und Aktienderivaten mehr als 400 Billionen US-$. Nach dem Brexit stellt sich die Frage, ob das derzeit überwiegend in London abgewickelte Clearing von Euro-OTC-Derivaten auf eine Zentrale Gegenpartei in der EU verlagert werden sollte. Gegner einer solchen Relokation befürchten hohe Kosten für die Marktteilnehmer. Die bislang vorliegenden Kostenschätzungen sind jedoch viel zu hoch.

The evolution of the G4 + 1 and its impact on international harmonization of accounting standards

An equilibrium model for the OTC derivatives market with a collateral agreement