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July 8, 2014

Eurex / Deutsche Borse Whitepaper | How CCPs Reduce Risk

Eurex are proud to publish our latest (37 page) whitepaper on "How central counter-parties strengthen the safety and integrity of financial markets". The full paper is attached below, and via a link, here is the executive summary to whet your appetite:

The financial crisis in 2008 unearthed three root causes of systemic risk: excessive risk taking, inter- connectedness of market participants, and insuffi- cient collateralisation. Following the financial crisis, regulators, policy makers and market participants have put tremendous efforts in addressing systemic risk in order to prevent future crisis and the associated high costs for the public. The primary tool for doing this is central clearing via central counterparties (CCPs), focusing on a clearing obligation for over-the-counter (OTC) derivatives, which will increase the importance of CCPs.

 

In light of these developments, the time is right for a fact-based review on CCPs and how they contrib- ute to the safety and integrity of financial markets, particularly with respect to reducing systemic risk. Essentially, a CCP is a mechanism to handle coun- terparty credit risk. By making the default manage- ment and loss allocation explicit, a CCP creates the system through which contagion and uncertainty can be mitigated. Central clearing thus brings a market together, and establishes both individual and mutual incentives for its users to safeguard the market. If one wants to address systemic risks, one needs CCPs. CCPs are not risk takers or investors in the sense of their members, but they do concentrate risk man- agement. While it is highly desirable to do so in a neutral party, it requires strenuous CCP governance and prudent risk standards.

 

This white paper finds that central clearing significantly reduces systemic risks and their amplifying factors in financial markets in several ways: CCPs serve the financial system in a unique way as transparent independent risk managers. They prevent the build-up of excessive risk. A centrally cleared market structure reduces interconnectedness of market par- ticipants. Because CCPs’ multiple lines of defence are available to serve as loss absorbers, they miti- gate defaults and protect the market against shocks that would otherwise have devastating effects in an un-cleared market with insufficient collateralisation.

 

This white paper also stresses the pre-requisites for CCPs to perform their important function. CCPs must adhere to the highest quality standards, as, for ex- ample, set out by EMIR. These include governance and incentive structures, prudent risk management standards, high quality operational capabilities and liquidity arrangements. Last but not least, CCPs must continue to serve as trusted, stable counterparties by providing transparency to their users and stakeholders.

 

To ensure that CCPs can respond appropriately if confronted with unprecedented and unforeseen events, mechanisms and tools shall be in place that enable the recovery of viable CCPs and the resolution of un- viable ones. These recovery and resolution plans will ensure that in scenarios that overwhelm expectations, CCPs are a mechanism to manage their impact and mitigate uncertainty, as well as ensure positive ex ante incentives for the CCP and its participants.

CCPs have proven their capabilities in the past financial crisis, and the extension of their use for previ- ously lightly regulated and under-collateralised markets is underway. In anticipation of this, CCPs have been refined and improved through various regula- tions to enshrine their best features, and work is underway to establish robust back-stop measures. To conclude, the use of well-designed CCPs will create a resilient financial market structure, suited to handle crises in a controlled and effective manner.

 

You download a fresh copy from this link: http://www.eurexclearing.com/clearing-en/resources/publications/997338/ or click the attachment below.

 


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