Journal of Financial Market Infrastructures

Special Issue: Central Counterparty Default Management and Stress Testing

Since the 2008-9 financial crisis, regulators and market participants around the world have been engaged in unprecedented efforts to strengthen the financial system and enhance financial stability. A key element of these reforms is the role played by financial market infrastructures, particularly central counterparties (CCPs). Reforms mandating the use of central clearing have promoted the growth of CCPs, the scope and complexity of cleared products, and the critical role of CCPs in the financial system. As CCPs enter new markets and take on larger roles, the effects on CCP risk profiles and risk management practices are being closely assessed and  actively debated by market participants and regulators.

The six papers in this special issue of The Journal of Financial Market Infrastructures offer a number of new insights into topical and actively debated issues around CCP risk management, including governance, incentives, default management and stress testing. The papers make important contributions to the ongoing debate surrounding CCP risk management, and point to further important research that is needed to inform risk management design and prudential policy.

The first two papers critique some of the unique differences and challenges surrounding CCP risk management governance and the implications for risk management incentives and regulatory policy. In the first paper, Mark Manning and David Hughes highlight the key differences between CCPs and banks in terms of roles, risk profiles, balance sheets and systemic characteristics, and the implications of these differences for CCP risk management and regulation. They conclude that, while experiences from bank regulation may be useful inputs, it is important that regulatory standards for CCPs continue to reflect the fundamental differences between banks and CCPs.

Our second paper, by Robert Cox and Robert Steigerwald, examines risk management governance challenges of the demutualized CCP ownership model and the incentives faced by "incomplete demutualization", where clearing members remain the ultimate underwriters of CCP default risk. The paper concludes that governance conflicts engendered by such a model may make it impossible for a CCP in crisis to recover and may hinder resolution efforts. Policy responses to this conflict should focus on the incentives of both CCPs and clearing members to participate collaboratively in CCP default management.

The next three papers discuss the challenges and incentives of CCP default management, including the structure of CCP default waterfalls, CCP "skin-in-the-game" contributions, loss allocation, and CCP stress testing. Louise Carter and Megan Garner discuss the incentives created by the structure of CCPs' default waterfalls, drawing out the role of transparency and governance in ensuring effective incentives. They conclude that, while no single optimal default waterfall structure would apply in all circumstances, waterfall design must ensure an alignment of incentives between those with control over risk management and those who are exposed to losses. The paper views CCP contributions to the default waterfall, risk management transparency and clearing member input to risk management governance as key mechanisms to align incentives.

The issue's fourth paper, by Vijay Albuquerque, Chris Perkins and Mariam Rafi, further explores the issue of CCP contributions to default resources: so-called skin in the game. The paper makes an important contribution to this ongoing dialogue by proposing a set of principles and an analytical framework for calibrating skin-in-the-game contributions. The authors conclude that "an analytical approach achieves a reasonable risk-based starting point for a framework that will incentivize both CCPs and clearing members to thoughtfully manage risk", and identifies several areas for further work.

The fifth paper, by Edwin Budding, Robert Cox and David Murphy, provides an interesting case study of a clearing crisis involving concentrated positions and default management through a "partial tear up" of open contracts. The paper highlights the vulnerability of CCPs to large concentrated positions that may be difficult or impossible to close out, and it points out that while many CCPs are better protected today, positions that cannot be auctioned may still arise. This risk has important implications for CCP default management design and supervisory tools and its discussion is timely with increasing attention being focused on the potential for auction failures and the use of contract tear-ups as a default management tool.

Stress testing is recognized both as an important tool for gauging the sufficiency and robustness of CCP default resources and as an area of active assessment by regulators. In the issue's sixth paper, David Murphy and David Macdonald focus on the selection and use of historical scenarios in CCP stress testing. The paper shows that scenarios covering both systemic and idiosyncratic stresses are important and that the choice of the stress period can significantly affect the calculated stressed value-atrisk. It concludes by suggesting that enhanced prudential standards for the selection of stressed historical periods would be beneficial and that CCP-specific scenarios should be supplemented by a requirement to conduct standardized stress testing using data from broad market disruptions.

We hope you find these papers illuminating and stimulating.

Jeff Stehm
Promontory Financial Group LLC