United States: Office Of Financial Research Proposes Central Counterparty Stress Testing Framework

Last Updated: March 6 2017
Article by Robert Zwirb

Most Read Contributor in United States, July 2018

In a recent brief, the Office of Financial Research ("OFR") proposed a framework for stress testing central counterparty ("CCP") resilience in the face of losses due to the defaults of clearing members. In the brief, the OFR recommended that regulators use:

  • a common set of underlying factors, such as interest rates or equity prices, to create stress scenarios;
  • the existing results of individual stress tests against clearing member defaults submitted by CCPs to their respective supervisors in order to calculate the profit-and-loss impact on clearing members; and
  • structural default models that are consistent with stress scenarios.

The brief also highlighted the importance of regulatory cooperation:

"U.S. regulators already have the information needed to build a systemwide stress test. However, carrying it out would require further cooperation among U.S. regulators, including the Commodity Futures Trading Commission. . . , Securities and Exchange Commission, and Federal Reserve Board."

Commentary / Bob Zwirb

The OFR emphasized that a proper evaluation requires testing the resilience of not only individual CCPs, but also "the entire system of CCPs and clearing members." However, two recent stress tests conducted by regulators were limited to evaluating the resilience of individual CCPs and, although the CCPs in the test conducted by the CFTC passed with flying colors, those that were tested by the European Securities and Market Authority did not. In the latter test, defaults by two clearing members with the largest losses at each CCP resulted in the exhaustion of the CCPs' prefunded resources and an additional systemwide shortfall of 10 billion euros. Presumably, stress tests of the "entire system" could result in even more sobering findings.

Currently, global regulators consider CCPs that are able to withstand the default of two of their largest clearing members to be sufficiently resilient. That said, the problem that may confront financial regulators during the next financial crisis may involve other factors: not what to do when one or two prominent clearinghouse members default on their obligations, but what to do when more than two members suffer a liquidity crisis. This problem is only exacerbated by the modest resources that many CCPs carry in order to deal with such events. According to three economists for the Bank of International Settlements:

"[C]apital of CCPs tends to be quite modest compared with their other prefunded resources, their gross exposures and the scale of their potential losses. The size of this capital cushion within the waterfall is typically a percentage of the total capital and is uncorrelated with the risks incurred by the CCP should one or more participants fail to meet their trading obligations. A recent study . . . indicates that the capital held by the five biggest CCPs in swaps is equivalent to just 2.6% of the sum of margin requirements and the default fund."

Dietrich Domanski, Leonardo Gambacorta and Cristina Picillo, "Central Clearing: Trends and Current Issues," BIS Quarterly Review, pp. 71-72 (Dec. 6, 2015).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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