Central Counterparty Clearing - Systemic Risk

[pic 1]

DERIVATIVES

Systemic Risk

[pic 2][pic 3]

[pic 4]

Table des matières

Introduction        2

How does a central clearing counterparty work?  What are the actors?  Does it reduce systemic risk?        4

Does it reduce systemic risk?        6

What are the EU proposals regarding bail-out and bail-in?        6

What are the obligations in the EMIR regulation?        8

In particular, explain the clearing obligation and the trade reporting obligation        8

Discuss the concept of separation of Investment and Commercial Banks, with a focus on a dealing room.        9

Introduction        9

Reasons why we talk about separation        10

Ways to install and regulate the separation        11

Is separation the miracle solution ?        12

Recent Regulations        12

Conclusion        13

References        14

Introduction

How does a central clearing counterparty work?  What are the actors?  Does it reduce systemic risk?

   A big risk during the contract on the financial market is that one of the party cannot honor their agreement, obligation.  This would lead to a loss for the counterparty on the other side of the contract.  If the loss is large enough it could have a knock-on effect for their.  The counterparty credit risk is an important channel for contagion and can be a potential source of systemic risk.[pic 5]

  Central Counterparty Clearing (CCP) are financial market infrastructures that can reduce and share between their members counterparty credit risk in the markets in which they operate.

  CCPs can reduce counterparty credit risk by netting exposures across their members.  They balance an amount due from a member on one transaction against an amount owed to that member on another, to reach a single, smaller net exposure.  We call ‘novation’ when the single contract between the two initial counterparties is replaced by two new contracts between the CCP and each of the two parties. The CCP becomes the buyer to the original seller, and the seller to the original buyer.

  On the figure, we see a simple example of this system.  On the first picture it is the existing contracts between three different banks, they trade without any interlocutor.  In the second one, contracts are centralized by the Central Counterparty Clearing.  It will netting the amount   between parties and so reduces exposures.  As we see on the last picture, this system allows also to reduce need of liquidity by the contracting.

  If one member defaults, le CCP still have to ensure the contract rescinded. It might seek to find new counterparties to take on the positions of the defaulting member and return the CCP to a matched book of contracts.  The CCP also holds collateral, known as ‘initial margin’, to mitigate against the risk of default.

Does it reduce systemic risk?

 However the default of one or more members can lead to CCP failures if all available financial resources have been exhausted.  This failure will act like a channel of contagion. CCP may fail also because of losses on investment of collateral.  So it reduces risk in case of small default of payment.  But the CCP may fail and in that case the failure will touch every member of the system.  So risks are not gone.

To reduce risks linked to a CCP, they must place certain requirements to members:

• Solvency
• Liquidity
• Operational reliability

Following the big financial crisis, the market of off-exchange trading (OTC) has been regulated in the European Union by the “European Market Infrastructure Regulation” (EMIR-2012).  EMIR includes the obligation to centrally clear certain classes of over-the-counter (OTC) derivative contracts through Central Counterparty Clearing (CCPs) that have been authorized (for European CCPs) or recognized (for non-EU CCPs) under the EMIR framework (esma.eu).

What are the EU proposals regarding bail-out and bail-in?

  During the financial crisis of 2008, some governments intervened on the financial system in order to restore and assure the viability of their largest banks, by bailing them-out with the use of public funds.

  “A bail-out is when outside investors rescue a borrower by injecting money to help service a debt. Bail-outs of failing banks in Greece, Portugal and Iceland were primarily financed by taxpayers.”1

  This was necessary because households, businesses and governments rely on the services that banks provide. This government support may be successful in avoiding financial contagion within closely interconnected banking system. But bailing out large banks is undesirable; indeed this resolution mechanism is often costly, complex and time-consuming, in particular for large institutions. Moreover, the expectation of assistance via publicly funded bailouts amplifies moral hazard, leading to excessive risk-taking.

  Following the financial crisis, the Financial Stability Board developed a set of principles for managing the failure of systemically important financial institutions. These ‘Key Attributes’ of effective resolution regimes sought to ensure that firms could fail without disrupting the financial system, without interrupting the critical services they provide and, importantly, without requiring public sector support.

One of the tools included in the Key Attributes was bail-in.

  “[…] a bail-in forces the borrower's creditors to bear some of the burden by having part of the debt they are owed written off”2.

  In a bail-in, the claims of shareholders and unsecured creditors of the failed firm are written down and/or converted into equity in order to absorb the losses and recapitalize the firm or its successor. The aim is that the firm, or its successor, is able to operate without public support.

  In Europe, a new regulatory framework regarding bail-in and bail-out, the Bank Recovery and Resolution Directive (BRRD) have been designed the 1st January 2014 and incorporated in national laws by 1st January 2016. The BRRD will set harmonized standards for national resolution regimes across Europe in compliance with the FSB Key Attributes.