Central Clearing Parties: What they are and why we need them - Part 3

The CCP Advantage: Incentive and Means to Control Counterparty Risks

The case of the insurance giant, AIG, highlights the information and incentives problems that CCPs can address. In the run-up to the financial crisis, AIG’s London-based Financial Products Group managed to sell enormous amounts of credit risk insurance without the liquid resources necessary to cover potential cash calls. By end-June 2008, AIG had taken on $446 billion in notional credit risk exposure as a seller of credit risk protection via credit default swaps (CDS).

AIG’s unhedged, under-reserved and largely uncollateralized sales of nearly half a trillion dollars of insurance represented a significant concentration of credit risk in a financial institution that ultimately did not have the cash to meet crisis-related calls. This concentration threw into stark relief the risks to both individual institutions and the global financial system arising from the vast amount of CDS trading – and showed that those risks were larger and more severe than anyone had realized. Neither AIG’s counterparties nor its regulators could see how much risk it was taking, so no one sought adequate compensation for the risk of trading with AIG.

The lesson from the AIG example is less about one firm’s poor risk management than it is about information and the ability to manage counterparty risk. Would AIG have been able to write nearly half a trillion dollars face-value of insurance if the people it was trading with had been aware of AIG’s behavior and, in response, required it to post sufficient collateral? People think not. A CCP that witnessed all of AIG’s trades (rather than the sliver of trades than a typical counterparty saw) would know that the insurer had taken huge one-sided risks. The CCP would then have an incentive to charge AIG a commensurate fee for such risk taking. And the CCP would have the means to do so by raising AIG’s collateral and margin requirements or, if that proved insufficient, by cutting AIG off from trading all together.

So, by moving derivatives transactions to central clearing parties, governments expect to improve the resilience of the financial system in three important ways.  The first is to put a shock absorber between firms trading derivatives to limit the impact of one’s default on others.  The second is to ensure easy access to information that helps everyone monitor concentrations of risk. And the third is to promote effective market discipline through the imposition of fees that reduce the incentives such risk-taking in the first place.

Are there potential hazards with CCPs, too? Undoubtedly. For example, competition among CCPs can lead to a “race to the bottom” as they bid for clients by slashing margin and collateral requirements. Doing so would make the CCPs themselves a threat to the financial system because they would no longer perform the role of shock absorbers. Instead, they might link all the major financial players even more closely with one another. From a regulator’s perspective, encouraging the use of a CCP is like putting all your eggs in one basket: if you do so, you better watch that basket closely!

Fortunately, history shows clearinghouses and exchanges can be (and have been) operated safely: Since the first futures exchange was established in the United States in 1925, none have failed. That’s an admirable safety record, far better than the recent experience with bilateral over-the-counter derivatives trading.