Central counterparties (CCPs) are a market infrastructure that is used to provide clearing and settlement services in financial markets. 1 In the past, CCPs were utilized in the derivative market. In recent years, CCPs have received increased attention because of the crucial role they play in the financial market infrastructure. For example, CCPs are currently used in cash securities markets. In addition, CCPs are used to novate contracts, redistribute, and manage counterparty credit risk. There is growing interest in further expanding the use of CCPs. In this paper, the benefits and potential costs and challenges of CCPs will be discussed.
Benefits of CCPs
CCPs are risk minimizers. 2 Despite serving an auxiliary role in transactions, CCPs performs many crucial functions in financial markets. It is vital to note that there are a number of laws and internal regulations governing the use of CCPs. They create uniform access rules for participation in CCPs. 3 In addition, the laws and internal regulations define the clearing rules for handled assets classes. As a result, there is an increase in standardization as well as transparency of the settlements. This is very important for the functioning of the over-the-counter (OTC) derivatives markets. CCPs have a number of key benefits. 4 CCPs are very beneficial in financial markets because they help reduce systematic risks. 5 In addition, CCPs result in greater market transparency in addition to better marking-to-market and standardization. Well-functioning CCPs can significantly improve the “safety, efficiency, and transparency of the financial system.” 6 Another benefit is that CCPs expose clearing members to one counterpart instead of multiple counterparties with different risk profiles. Since it covers its exposures with high-quality collateral, the activities of CCPS have the potential to improve credit risk. Lastly, CCPs allows for anonymous trading and provides centralized administration for both long and short positions of clearing members. 7 The benefits provided by CCPs include the following: higher transparency, improved marking to market, more efficient over-the-counter (OTC) derivates market, standardization, and prevention of uncollateralized positions, among other benefits. 8
Delegate your assignment to our experts and they will do the rest.
One of the critical benefits of CCPs is related to the reduction of financial risks. CCPs help reduces systematic risks because they guarantee the settlement and clearing of transactions irrespective of whether or not the original contractor meets its obligations. 9 This is because the clearing house, which acts as a backstop, takes over the counterparty’s credit risk. Simply put, CCPs acts as a counterparty credit risk neutralizer. In addition to reducing financial risks, CCPs also help limit coordination problems. This minimization is essential in a crisis situation. By providing clearing and settlement services in financial markets as well as by managing the posted collateral, CCPs turn into crisis managers because they are smooth burden-sharing. 10 As a result, CCPs stabilize the markets. In addition, they significantly contribute to the reduction of their volatility.
CCPs also simplify the relationships between various market players in financial markets. The transactions with CCP has largely displaced bilateral transactions, especially the one that is characterized by multiple counterparties. 11 This entails the utilization of multilateral netting for all cleared transactions, which very important as it significantly minimizes the exposure of the given market participant. This, in turn, entails the cost reduction of the CCP participant. This is because the use of multilateral netting requires fewer securities as collateral and significantly reduces the number of cleared transactions. 12 This, in turn, reduces transaction costs. As such, CCPs can help curtail clearing members’ management costs. This is because they have the ability to limit resources devoted to monitoring the financial condition of the various contractors. Thus, the net benefit of clearing transactions in CCPs is the increased market efficiency that results from the enhanced counterparty credit risk management.
Because of the benefits associated with it, the use of CCPs in facilitating the clearing of transactions has increased the capacity of clearing members to enter into further deals. This helps improve liquidity in financial markets. Also, the use of multilateral netting helps reduce the operational risks of CCPs. Moreover, DnB states that CCPs are generally safer. Overall, the arguments and research studies cited above indicate that CCPs provide a number of benefits in financial markets. However, the model for delivering this good is unusual. This is because CCPs are often private entities. As such, the activities of CCPs are highly likely to be associated with certain costs and challenges or risks.
Potential Costs and Challenges of CCPs
Membership in a CCP carries a number of costs. Some of these costs include membership costs, operational costs, and collateral costs. 13 However, it is important to note that operational costs may be compensated by the operational benefits of participating in a CCP. Of all the three costs, collateral costs are substantial. Clearing members of CCPs incur collateral costs. These costs relate to margin and default fund contribution to clearing members to CCPs. Table 1 outlines the benefits and costs of CCPs.
The activities of CCPs are associated with a number of challenges or risks. First, this market infrastructure is associated with regulatory reforms. These reforms change the structure of the financial market. 14 As such, the diversity of the instrument is reduced. This limits the ability of the institutions to manage their risk. In addition, these institutions are tunnelled into one of the standardized areas of financial markets. As the number of institutions being assigned to one of the standardized areas of financial markets increases, the whole system becomes vulnerable to shocks.
CCPs give rise to systematic risk through risk accumulation. The default of a CCP negatively impacts clearing participants or entities. 15 This, in turn, can negatively impact national or global financial stability. Another risk associated with CCPs is the spread of credit and liquid losses to other financial markets. 16 CCPs, as a market infrastructure that facilitates the clearing and settlement process in the financial market, takes over credit risk of entities clear or settle transactions in the clearinghouse. As such, credit risk is nevertheless concentrated in CCPs. This suggests that the activities of CCPs do no reduce credit risk. Instead, CCPs shift credit risks to them. This contributes to the increase in their systematic risk.
In addition, it is vital to note that the participation of clearing members in CCPs is not automatic. Members are often assessed using assessment criteria outlined by CCPs themselves. Members or entities are accepted based on the outcome of the assessment. However, it is important to note that CCPs are not professionals in the management credit risk. As such, there is a challenge or danger that CCPs may not properly assess the credit risk of potential clients and diversify them. 17 As such, this may lead to asymmetry because the clearing participants have the ability to minimize their exposure to credit risk in financial markets, whereas CCPs cannot reduce their credit risk.
Bibliography
Books
De Nederlandsche Bank (DnB). “All the Ins & Outs of CCPs.” De Nederlandsche Bank. (2013)
McPartland, K. “Systematic risk and the impacts of central clearing.” Greenwich Associates. (2015)
Wendt, F. (2015). Central counterparties: addressing their too important to fail nature (No. 15-21). I nternational Monetary Fund .
Journal Articles
Kozińska, Magdalena. “Central counterparties–risk minimizers?” Central European Review of Economics and Management 2.4 (2018): 87-109.
Nabilou, H., & Asimakopoulos, I. “ In CCP we trust… or do we? Assessing the regulation of central clearing counterparties in Europe.” Capital Markets Law Journal , 15 (1), 70-97. (2020).
