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09 October 2015

Bank of England: OTC derivatives, central clearing and financial stability

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The concentration of risk within CCPs highlights specific challenges, including the need for supervisory co-operation internationally. Authorities are working to address them by working together to ensure consistency of approach across jurisdictions based on robust regulatory standards.

The concentration of business in CCPs is increasing the systemic importance of many CCPs and creates the risk that they are perceived to be ‘too big to fail’. International initiatives to address this risk have focused on establishing strong regulatory standards for CCPs, ensuring that they have recovery plans, and ensuring that authorities have resolution powers in the extreme event that a CCP nevertheless experiences distress.

It is clearly critical that CCPs are subject to strong risk management standards. Internationally, the work of authorities to promote CCP resilience is ongoing. For example, a review has been initiated of stress-testing arrangements across CCPs. Stress-testing methodologies are very important for the resilience of CCPs because they determine CCPs’ estimates of the losses they could face in extreme but plausible circumstances, which in turn drive the size of CCPs’ default funds.

CPMI and IOSCO have also issued standards to encourage greater transparency in the approach of CCPs in managing their risks. This highlights the important risk governance role played by clearing members, their clients, and other relevant parties. Increased transparency should allow these stakeholders to monitor the quality of CCP risk management.

While every effort should be made to minimise the risk of CCP failure, it is impossible to remove this risk entirely. Regulators therefore also focus on recovery arrangements, which are intended to help the CCP remain viable even during periods of stress, so as to ensure continuity of critical clearing functions. To this purpose, CPMI and IOSCO have issued guidance on recovery arrangements for financial market infrastructures. Tools identified in the report (and already implemented in the United Kingdom) include CCPs’ use of the right to call for additional funds from clearing members; haircutting (that is, applying a proportionate reduction of value to) a CCP’s obligation to pay its clearing members variation margin; and, if necessary, terminating outstanding centrally cleared contracts to cap the CCP’s exposure.

Full paper

© Bank of England

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