May 3, 2011 – The recent financial crisis has driven many plans for improving the stability and resilience of the global financial system. One concept, managing the risk of default in securities or financial derivatives markets through central counterparties, receives scrutiny in a report released today by the C.D. Howe Institute.
In “Time for Stability in Derivatives Markets – a New Look at Central Counterparty Clearing for Securities Markets,” Thorsten V. Koeppl of Queen’s University examines the role centralized clearing parties could play in improving system resilience.
These centralized clearing parties, Professor Koeppl explains, are institutions that interpose themselves between counterparties in financial transactions. Professor Koeppl offers a new look at what these institutions could achieve in over-the-counter derivatives trading and short-term funding markets. He places the emphasis on the core services they could provide: the diversification of counterparty risk and the redistribution of default losses among its members.
For derivatives markets, says Koeppl, this perspective opens an avenue for also including customized derivative products in centralized clearing, which is crucial to avoiding future episodes of instability in the financial system. Clearing needs to concentrate more on insuring against counterparty default, he says, not merely on ensuring proper risk management and valuation of contracts, because the latter presumes a high degree of standardization of financial derivatives. He argues such a shift would put more emphasis on how the design of a centralized derivatives clearing market could avoid adverse effects on market discipline, once insurance against counterparty risk has been introduced.
For short-term financing markets, the author points out that the case for a new clearing house is less clear, because most transactions are already backed by high-quality collateral that markets readily can deal in. Nonetheless, the current move to centralized clearing in Canada, he says, could be seen as a market-based solution that would prevent a collapse in short-term funding for financial institutions in times of a crisis. This potential solution is not foolproof: clearing houses themselves can fail, in which case governments may feel compelled to bail them out because of their systemic importance. This raises the challenge of how to balance their financial stability benefits with the risks a central bank or government is willing to bear in backing up the clearing house's liquidity needs or losses.
Click here for the full report.
For more information contact:
Thorsten V. Koeppl,
Associate Professor and RBC Fellow,
Department of Economics,
Queen’s University;
or
Philippe Bergevin, Policy Analyst,
C.D. Howe Institute,
416-865-1904, email: cdhowe@cdhowe.org