Risk & Return Canada: CCPs won’t stop future crises, says academic

Legislators have put too much faith in central counterparties (CCPs), but they are not certain to prevent future crises, an academic has warned.

Speaking at the Risk & Return Canada conference in Toronto, Thorsten Koeppl, associate professor at Queen’s University at Kingston, compared CCPs to the Maginot line – a line of concrete fortifications built by the French in the 1930s to protect the country against an invasion by Germany.

“CCPs seem like a strong bulwark of the financial system that can save us from the next crisis or prevent it altogether, but it’s a Maginot line that creates a false sense of security,” he said.

To back up his argument, Koeppl cited the failure of the Paris-based Caisse de Liquidation in 1974, as well as the 1987 blow-up of the Hong Kong Futures Exchange. Both the Chicago Mercantile Exchange and the Options Clearing Corporation also came close to failure in 1987, he said – a topic that was researched by Federal Reserve chairman Ben Bernanke during his academic career. “People think CCPs are risk-proof. There’s nothing in the financial world that’s risk-proof. And history has shown us examples of where CCPs can fail.”

If a CCP did fail, supervisors would have no choice but to bail it out. “By their very nature, CCPs are the epitome of too-large-to-fail. What they do is concentrate all counterparty risk in a single entity,” he said.

There are other potential downsides, too. The push to central clearing would require huge amounts of high-quality, liquid collateral to be posted to CCPs in the form of initial and variation margin – and Koeppl questioned the extent to which this additional expense would make the financial system safer.

“The regulators have a view about the requirement for more collateral, and the market thinks it is overkill that you have to go to a CCP to begin with. We don’t know where this debate is going to go, but we do know it’s going to be very expensive and it might not be that safe,” he said.

Meanwhile, like the Maginot line, market participants would find ways of circumventing the new safeguards – for example, by using CCPs with lower margin requirements, or developing bespoke transactions that are not required to be centrally cleared.

Koeppl urged participants to take a step back from the debate on CCPs and instead look at the costs and benefits through the prism of economics. Supervisors need to ask how much risk they want the financial industry to take, and any debate on CCPs needs to include a frank discussion of liquidity support, he added.

He also drew attention to the speed with which Group of 20 (G-20) leaders agreed that over-the-counter derivatives must be cleared through central counterparties by the end of 2012. The G-20 made the decision in September 2009, also announcing that standardised OTC derivatives contracts should be traded on exchanges or electronic platforms, where appropriate.

“I call it the infamous Pittsburgh G-20 summit. If you ever open the newspapers and look the G-20 up, they never agree on anything. The only time they agreed on something was Pittsburgh, and they agreed on something very funny: that all standardised OTC derivatives should be cleared centrally.”

Although some regulators have focused on the need to provide greater protection to end-users of OTC derivatives, Koeppl said most Canadian users of the products were sophisticated financial institutions. “For me, that’s not really the issue,” he said.

The same was true of arguments to promote greater pre- and post-trade transparency. “Do OTC derivatives lack transparency? Probably. But on competitiveness, if you flip through a copy of Risk, there are surveys saying end-users generally talk to three or four dealers,” he said.


This article was first published on Risk

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