The OFR released two working papers today that focus on the potential risks of central clearing of over-the-counter derivative transactions:
Systemic Risk: The Dynamics under Central Clearing develops a model for concentration risks that clearing members pose to central counterparties. Over time, larger clearing members crowd out smaller clearing members. Systemic risk is created because high clearing member concentration results in relatively lower lending, higher cost of capital, and increasingly costly hedging. To address this risk, the paper proposes a self-funding systemic risk charge.
Hidden Illiquidity with Multiple Central Counterparties focuses on the systemic risks in markets cleared by multiple central counterparties (CCPs). Each CCP charges margins based on the potential impact from the default of a clearing member and subsequent liquidation of a large position. Swaps dealers can split their positions among multiple CCPs, effectively “hiding” potential liquidation costs. A lack of coordination among CCPs can lead to a “race to the bottom” because CCPs with lower perceived liquidation costs can drive competitors out of the market.
The OFR also released a blog today by the OFR's Acting Deputy Director for Research and Analysis that discusses the two working papers.
The blog is posted at: http://financialresearch.gov/from-the-management-team/
The papers are posted at: http://financialresearch.gov/working-papers/
The OFR home page is at: www.financialresearch.gov