What Are CCPs?
A central counterparty, viewed from an economic perspective, is a “commitment mechanism.” The ultimate function of a CCP is to assure performance of contract obligations between its members. They do so by becoming substituted counterparties to all trades submitted for clearing—becoming, in effect “the buyer to every seller and the seller to every buyer”—thereby ensuring the performance of open contracts.
Understanding that CCPs are institutions structured to assure commitment is critical to recognizing that, unlike banks, they are not in the business of risk-taking. They exist because participants in financial markets need the guarantee provided by clearing to face some of their financial obligations. The primary function of a CCP, mutual or de-mutualized, is to assure that clearing members meet their obligations in accordance with the CCP’s rules. This function is fundamentally different from the risk-taking functions performed by depository or credit institutions.
Why Does This Matter?
Following the financial crisis, regulators have become more focused on the supervision of CCPs. As many come from a banking background, there has been a tendency to rely on the tools and frameworks used in banking regulation. However, a failure to understand the differences between clearing and banking can lead to the application of an inappropriate paradigm for regulating CCPs, one that sees CCPs through the lens of banking regulation and, in particular, capital regulation. CCP capital, while important, plays but a subordinate role in CCP risk management.
CCPs have unique risk profiles as compared to other market infrastructures and banks. CCPs are managers of risk, not takers of risk.
Banks are risk-takers. In their simplest form, they intermediate deposits and short-term funding against longer-term credit provision. As a consequence, they run mismatched books: their assets from credit provision do not match their liabilities to their sources of funding. This inherent mismatch is supported by capital, and much of the regulatory effort to promote resilience in the banking industry is focused on determining the appropriate standards of capital adequacy.
CCPs are risk managers. They serve as a substituted counterparty to both sides of a transaction brought to them by their clearing members. In contrast to the mismatched books of banks, CCPs run matched books. They do not take risk other than counterparty risk in connection with their role as substituted counterparty. They assume position risk only when a member fails to perform its obligations until such time as the position risk is either liquidated or transferred to another member.
1. CCP capital cannot be a significant resource for loss absorption without fundamentally altering the incentive structure embedded in the default waterfall.
Why? Because altering the amount of CCP capital to take a significant role, or altering its placement in the default waterfall structure, would change the incentives of the parties. Were the CCP capital in the waterfall to become significant, it would come at the expense of diluting the mutualized risk characteristic of the CCP, which in turn could provide a disincentive to members to support the necessary process of liquidating a failed member’s positions. This would, in effect, represent a fundamental change in the business model of the CCP.
2. Since CCP capital is not the primary resource for loss absorption, capital analysis alone tells us little or nothing about CCP resilience. Total loss absorbing capacity (TLAC), a concept that has been developed by bank regulators in the wake of the financial crisis, is largely a capital-based requirement. TLAC is different from CCP loss-absorbing capacity. Default loss absorption is relevant to CCP resilience and must be measured by the total of all financial resources available to the CCP.
Commitment to full performance of open trade obligations is the key to understanding CCPs and their default resources.
CCPs have unique risk profiles as compared to other market infrastructures and banks. Importantly, CCPs are managers of risk, not takers of risk. In contrast to banks, CCP capital is not significant in providing for default management resources. Rather, a combination of initial margin and mutualized resources from clearing members is the primary support for the CCP’s loss absorption capacity in the event of a member default.
For public policymakers addressing issues of CCP risk management and resilience, the challenge is to construct a policy framework that accurately incorporates the unique features of CCP risk profiles. It also needs to be focused on incentives, especially those of the members, for whose benefit the CCP operates.
Further discussion of this issue can be found online at: