Spotlight turns to clearing houses on stress tests

A report from the Bank for International Settlement (BIS) and International Organisation of Securities Commissions (IOSCO) concluded that some Central Counterparties (CCPs) have not adequately addressed their potential risk exposures and did not include enough “liquidity-specific exposures” in their stress testing framework.

Following the 2008 financial crisis, many clearing houses provided a critical role in providing market stability and matching counterparty trades at a time of unprecedented market uncertainty. Given the increased role in the derivatives markets, as mandated by the G20, the spotlight has fallen on clearing houses once again, as the industry assesses whether these institutions have sufficient resources to operate in the event of sudden market shocks.

With a growing volume of OTC derivatives trading now handled by regulated electronic venues and settled via CCPs – in line with regulatory initiatives to create greater transparency and oversight – some industry participants have become concerned that clearing houses could become a source of weakness during times of market stress.

The report is likely to renew the debate over the mandated use of clearing houses for a growing portfolio of derivatives instruments and whether these utility providers are becoming huge warehouses of concentrated market risk. Some are already drawing parallels with the infamous ‘too big to fail’ analogy that characterised the plight of some banks during the financial crisis eight years ago.

There are a many ways clearing houses could get into trouble; investment losses, liquidity shortfalls, member defaults or settlement bank failures all pose possible issues – but the industry is already recognising the value of proper contingency planning. For example, LCH.Clearnet recently addressed a number of pitfalls in a recent white paper, entitled ‘‘CCP Risk Management Recovery & Resolution’.

Moreover, a number of initiatives have already been proposed by IOSCO to dilute the potential market impact in the event of a clearing house failing to deliver its funding obligations. These include providing CCPs with the tools to allocate any uncovered losses and liquidity shortfalls to third parties, and the ability for firms to replenish funds quickly following a ’stress event’.

However, with a deadline of the 31 December 2016 set by the BIS Committee on Payments and Market Infrastructures (CPMI) for clearing houses to demonstrate improvement, the market will certainly be watching the results with bated breath.

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