Use of global clearing houses to reduce counterparty risk in the financial markets could be undermined if membership is not broadened, according to Tim Lane, deputy governor of the Bank of Canada.
Speaking at the Sibos banking conference in Toronto on 19 September, Lane said that central counterparties (CCPs) had been shown to be more effective in minimising counterparty risk in the OTC derivatives markets in the aftermath of the collapse of Lehman Brothers in 2008. But he warned that risk would be shared among a handful number of large broker-dealers, if smaller counterparties were forced to access CCPs indirectly.
“It is essential to ensure we do not unduly further concentrate risk in a relatively small number of institutions that are direct clearing members of global CCPs,” he said, adding, “If we are going to rely on central clearing through large global CCPs, direct access has to be broadened in a manner compatible with ensuring these CCPs have robust risk controls.”
The Group of 20 political leaders and central bankers have demanded that systemic risk in the OTC derivatives markets is reduced by standardising OTC derivative instruments, trading them on exchange and clearing them via CCPs rather than bilaterally. A number of countries have developed national CCP solutions to reduce risk in their OTC derivatives markets. A number of cross-border CCPs such as LCH.Clearnet offer clearing services in both national and global equities and derivatives markets. These CCPs are often user owned by larger broker-dealers or require high collateral levels for direct membership.
Canada has appointed the Canadian Derivatives Clearing Corporation to act as central counterparty in repo and fixed income markets, but it is still weighing up the pros and cons of opting for a national or offshore provider of CCP services for OTC derivatives transactions, including Canadian dollar-denominated interest rate swaps, the market for which includes both global and Canadian market participants.
“The solution we choose must come to grips with the systemic importance of OTC derivatives to Canada and the globalised nature of the market,” said Lane.
While use of an international CCP would in theory offer more opportunities for netting and mutualisation of risk, local Canadian brokers might not meet the membership criteria and as such might have to access the offshore CCP via a larger clearing member.
Use of a domestic CCP would in theory enable the Bank of Canada to intervene more effectively in the event of a crisis, but it might not be able to support the needs of both local and international market participants as effectively as a global CCP, potentially leading to market fragmentation. For the time being, the Canadian central bank has resolved both to work with domestic and international partners to ensure global CCPs are able to deliver the intended financial stability benefits while actively exploring the potential for a local solution with Canadian market participants. “We are in the midst of the most sweeping reforms of the last 70 years. Not only are the issues complex, they present cross-border challenges that must be addressed both at the global level and in Canada,” he said.