How should CCP risk be evaluated? (Premium Content)

Moody’s announced last week that it will be working to create ratings for CCPs. Thomas Murray has a CCP rating program as well. We’ve seen some of these methodologies and have to ask, what’s the risk that really needs evaluating? It would be great for centralized services to outsource this work for individual market participants, but with the information available, what purpose does this serve?

According to their press release, “Moody’s proposes a new Clearing Counterparty Rating (CCR), which will reflect Moody’s opinion of a CCP’s ability to meet its clearing and settlement obligations to its clearing members (probability of default) and the financial loss that would result if a CCP were unable to meet such obligations (severity of loss). The CCR will reflect a bottom-up analysis of each clearing service in a rated legal entity.” Moody’s notes that it already evaluates four CCPs and would just convert those ratings to the new methodology with no changes.

Thomas Murray Data Services currently rates 29 CCPs across 21 countries. From their website, “The CCP Risk Assessments service is a global program that defines key criteria and related data against which each CCP is assessed. The output provides participants with an assessment, supporting validated data and on-going surveillance as to a CCP’s effectiveness in eliminating risks associated with transactions processed by it.”

These ratings services propose to evaluate all sorts of CCP activities including operations, technology and default risk management practices. In practice, while we don’t necessarily agree with all parts of the methodology, there is a genuine acceptance of the largest ratings agencies’ determinations. The fact that the Options Clearing Corp carries a rating of AA+ from Standard & Poor’s is popular shorthand for saying that they are a good bet. It may also mean that the same ratings agency may assign a high credit quality to a structured product backed by underlyings that are centrally cleared on the Options Clearing Corp. For investment funds that are legally or organizationally tied to ratings for their investment choices, these numbers matter.

In addition to private ratings, individual CCPs already conduct all sorts of risk management exercises including Cover 1, Cover 2 and Cover All analyses (can the CCP survive one default, two defaults or all member defaults) to ensure that they themselves are adhering to the best possible standard of risk management. For a witty summary of the main CCP default risk management conversation see “The Bank of England on CCP default funds: is “cover 2″ enough?” from October 2014. Finadium research subscribers can also access “CCP Recovery and Resolution Plans: Players, Regulations and Ideas.”

On a practical basis, we’re not sure that the ratings agencies will ever get to the bottom of two major elements of CCP risk: how risk models function and what happens in the event of a large member default that threatens more than one CCP at the same time. Of the CCP risk models that we have seen, Eurex comes closest to providing transparency with their Prisma margin calculator. CME or LCH.Clearnet? Its really hard to say how the wheels turn on the inside. If the ratings agencies can get inside the risk engines of these CCPs, that would really help the market. Market participants already have or will soon have CCP Cover 1/2/All data; they won’t need the ratings agencies to provide the same information twice.

On the question of multiple CCP defaults, we don’t think that the ratings agencies will get there soon. This would entail a highly complex systems dynamics or operations research type of model about how financial markets work. Its a great academic project but unlikely to be accomplished soon. In fact, if someone built this model, it would probably be best used for macro investing instead of measuring cross-contamination of CCP risk. All the same, multiple default risk is what concerns us most about CCPs, not whether they have the competency to manage their technology.

We end with a great quote from John McPartland of the Federal Reserve Bank of Chicago on CCP risk: “Five years from now, someone besides me will realise the default management process for cleared OTC derivatives begins to fall down as the number of OTC CCPs derivatives increases. The concept that 15 CCPs worldwide are all going to borrow human capital from the dealer community – all on the same day, for a week – to think this will somehow work is fantasy.”

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