BIS: Clearing risks in OTC derivatives markets: the CCP-bank nexus

Systemically important banks and central counterparties (CCPs) interact in highly concentrated over-the-counter (OTC) derivatives markets. We outline the CCP-bank nexus to think about the endogenous interactions between banks and CCPs in periods of stress. As these interactions could potentially lead to destabilising feedback loops, the risks of banks and CCPs should be considered jointly, rather than in isolation.

Central clearing is a key feature of global derivatives markets. Almost two thirds of over-the-counter (OTC) interest rate derivative contracts, as measured by outstanding notional amounts, are now cleared via central counterparties (CCPs) – up from around one fifth in 2009. The share of central clearing has also grown in other product markets, such as credit derivatives. The increasing use of CCPs is by design. Notably, the G20 leaders agreed in 2009 that standardised OTC derivative transactions should be centrally cleared (G20 (2009)), in recognition of the risk management benefits offered by CCPs.

Increased regulatory attention to CCPs’ risk management has accompanied the G20 central clearing mandate. Global standards for the resilience and recovery of CCPs have been strengthened since the crisis, guidance has been set out for resolution planning and a framework developed for supervisory stress testing of CCPs (CPMI-IOSCO (2018)). These standards buttress the systemic stability benefits of central clearing by strengthening the resilience of the CCPs themselves. But risks in cleared markets remain. In September 2018, a single trader’s default wiped out roughly two thirds of the commodities default fund at Nasdaq Clearing AB, a Swedish CCP.

OTC derivatives markets are closely knit. Two recent reports by international standard setters map the interlinkages between CCPs and clearing members, the most important of which tend to be systemically important banks. These interlinkages give rise to questions on interactions, as risks can be generated endogenously. For instance, how does risk management at CCPs affect banks’ risk-taking? Conversely, how does banks’ risk-taking behaviour affect CCP resilience? Could these interactions lead to a self-reinforcing feedback loop under stress?

The full paper is available at https://www.bis.org/publ/qtrpdf/r_qt1812h.htm

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