Central clearing

The Urgent Agenda for Financial Reform

Thanks to unprecedented interventions by central banks and fiscal authorities, the pandemic-induced financial strains of March-April 2020 are now well behind us. Unfortunately, as a consequence of the official actions necessary to stabilize the financial system, market participants now count on government backstops to insure them against the fallout from future disturbances.

Naturally, central banks should be prepared to combat extreme shocks that threaten financial stability. However, to limit excessive reliance on central banks, we need to ensure that financial institutions can continue to operate smoothly on their own even in bad times. This means redesigning parts of the financial architecture. While market participants have a major role to play, it is authorities who need to address externalities—spillover effects—and to improve incentives for the private sector to maintain the liquidity of markets and access to short-term funding in times of moderate stress.

With the pandemic-induced disruptions still fresh in memory, this is the perfect time to identify deficiencies and implement reforms aimed at improving the resilience of the financial system. Fortunately, the June 2021 Report of the Hutchins Center-Chicago Booth Task Force on Financial Stability (H-B) addresses all the key challenges, laying out a broad agenda for U.S. financial reform. In addition, we have the July 2021 G-30 Report that provides detailed proposals for reforming the U.S. Treasury market.

In this post, we discuss these reform proposals, highlighting areas where we strongly agree and believe that implementation is urgent. In particular, we emphasize the benefits that would come from changes in the Treasury market (cash and repo), in the central counterparties (CCPs) that have become the most critical links in the global financial system, and in open-end mutual funds holding illiquid assets. We also highlight the governance proposals in the H-B Report. In our view, full implementation of the agendas set out in the these reports would make the U.S. financial system far safer than it is today….

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Stress Testing Financial Networks: The Case of CCPs

Following the crisis of 2007-09, in which AIG’s bilateral derivatives trades played a notable role, the G20 leaders called for central clearing of standardized derivatives. The resulting shift has been dramatic: central counterparties (CCPs) now clear about three-fourths of interest rate contracts, up from less than one-fourth a decade earlier (see Faruqui, Huang and Takáts).

By substituting a CCP as the buyer to every seller and the seller to every buyer, central clearing mutualizes and can—with appropriate margining, trade compression, position liquidation procedures, and reporting—reduce counterparty risk (see Tuckman). CCPs also contribute to financial resilience by promoting uniform margin standards, reducing collateral and liquidity needs, and making risk concentrations (like that of AIG in the run-up to the crisis) more transparent.

At the same time, the shift to central clearing has concentrated risk in the CCPs themselves. Reflecting economies of scale and scope, as well as network externalities, a few CCPs serving global clearing needs have grown enormous. For example, as of the last report at end-September 2018, open interest at LCH Clearnet exceeded $250 trillion. Moreover, the clearing activity of some CCPs lacks any short-run substitute. As a result, to avoid disrupting large swathes of the global financial system, any recovery or resolution plan for these CCPs must ensure continuity of service (see CCP Resolution Working Group presentation to the OFR Financial Research Advisory Committee). Finally, CCPs are the most interconnected intermediaries on the planet, making them channels for transmission and amplification of financial distress within and across jurisdictions. As then-Governor Powell clearly states in the opening quote, the safety of CCPs is central to the resilience of the global financial system.

We and Richard Berner have been studying how regulators use stress tests (see our earlier posts here and here) to assess the resilience of financial networks, including banks and nonbanks. In our joint work, we focus on CCPs due to their centrality, their extreme interconnectedness and their lack of substitutability. This post is based on our research….

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Opportunities in Finance

“We’re really only at 1% of what is possible, and probably even less than that. […] We should be building great things that don’t exist.”     Larry Page, Google I/O 2013 Keynote

With the summer coming to an end, professors everywhere are greeting a new group of students. So, our thoughts turn to the opportunities and challenges that those interested in finance will face over the course of their careers.

Like many important activities, finance is constantly evolving, so the “facts” that students learn in classes today will almost certainly change rapidly. With that in mind, we always strive to find a set of core principles that will endure, so that students can build a career based both on a set of specialized skills and on a broad capacity to imagine where finance and the financial system are heading...

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