Central Counterparty Risk Management - No Silver Bullet

The credit crisis has pushed OTC derivatives and securities financing across the world to move to a centralized counterparty (CCP) approach where a single counterparty assumes the settlement and pre-settlement risks of its members. Recent changes to the Basel II accord, namely capital reductions for transactions with CCPs, are fueling this trend. But beware – there is a catch. Moving to a CCP only makes sense if the CCP has a higher credit rating and superior risk management capabilities than the counterparties it is servicing.

But what does it mean for a CCP to perform effective risk management? I think it boils down to a few basic things that the CCP say an exchange, must get right.

These summarize many of the recommendations of the BIS/IOSCO committee back in 2004. It starts with ensuring that clearing members have adequate financial resources to back up the CCP in the event of crisis -- Credit worthiness criteria for new members is crucial as is the ability of the exchange to monitor clearing member positions and prices in real time The primary tools that the exchange uses are margins, initial margins and variation margins. These function on the principle that the defaulter pays by providing margin periodically usually based on some measure of the pre-settlement risk of their exposure. This might be measured by a VaR calculation over the settlement period. The variation margins are typically dynamically adjusted to capture changing market conditions and positions. Daily margin adjustments to a large extent prevent individual clearing members’ defaults having knock-on effects to the other exchange members. Then Back testing can be used to check just how effective the margin measures are in capturing actual members losses over time. Stress testing can determine the default fund, essentially a capital fund used to protect the exchange in the event of extreme shocks beyond the margins, for example by looking at the impact of the two largest members exposures defaulting simultaneously. Of course there are many other risks faced by a CCP, investment risk (of all those margin payments), custodian risks, operational risks, legal risks and so on.

The question it seems to me is whether there are scale economies in managing the counterparty credit risks (probably true), and whether existing CCPs are able to show competence in managing the residual risks (this is less clear, particularly in the light of potential systemic risk and the potential cost to taxpayers of having to pick up the pieces). What do others think?