Reforming Over-the-Counter Markets: The role of central counterparts
The opacity, size, and complexity of over-the-counter (OTC) markets are under forensic examination by lawmakers, as they have led to the significant build-up of systemic risks across the global financial system and were at the heart of the 2007-2008 global financial crises.
The rapid expansion and diversity of OTC markets can be largely attributed to the increased innovation and financial engineering that was triggered by the rising demand for speculation and the securitization of debt. Central counterparties (CCPs) are one method to contain systemic risks in the financial market system. This paper comments on their contributions to both reducing and increasing these risks. On the one hand, CCPs can contribute in reducing counterparty credit risk in OTC derivatives contracts. CCPs can indeed increase financial system stability, reduce price volatility, diminish defaults and reduce the procyclicality of the financial system. On the other hand, CCPs can give rise to system risks. For instance, margin requirements may prompt inflated and systemically destabilizing price movements, CCPs insolvencies pose serious systemic risks and systemic complications can furthermore arise from hidden risks when derivative contracts are sold to unregulated counterparties. From a regulation point of view, although derivatives represent only a part of the risk exposures of financial firms, and only a fraction of the linkages between them, CCPs and derivatives data repositories can still provide valuable information to regulators, facilitating the disclosure of positions and respective risks. Furthermore, the increasing importance of CCPs and the related need to control their activities have given rise to regulatory reforms, which develop risk management standards and implement closer oversight of CCPs. The current regulatory efforts are, however, reallocating risk—not reducing it. Upcoming policy guidelines should ensure that CCPs do not become the catalyst for future systemic failures.