Isda paper tackles the economics of central clearing

Source: Isda

The International Swaps and Derivatives Association, Inc. (ISDA) today announced the publication of an in-depth discussion and analysis of the purposes, function and issues associated with central clearing of over-the-counter (OTC) derivatives.

The paper, "The Economics of Central Clearing: Theory and Practice" is authored by Craig Pirrong, Professor of Finance at the Bauer College of Business at the University of Houston. It is the first in a series of discussion papers covering key topics in OTC derivatives, public policy and financial regulation that will be written by acknowledged experts in their fields of study. The new paper is particularly timely given the current regulatory proposals to expand the role of central clearing, and the active debate about the rules that should apply to it.

Central clearing can provide significant benefits to the stability of the financial system. Current statistics indicate that approximately 50 percent of the interest rate swaps volume outstanding has been cleared, and over $17 trillion of credit default swaps has been cleared.

The paper points out both the benefits and potential issues related to central counterparty clearing facilities (CCPs). Several of its more important conclusions include:

* CCPs can successfully reduce and reallocate counterparty risk through rigorous preparation for, and management of, member defaults;
* CCPs can also create systemic risk, and it is imperative they have strong and conservative risk management and sufficient financial resources to withstand stressed markets. They also require close supervision by regulators;
* The margin policies of CCPs can pose risks to the efficient functioning of the financial system. Mandatory clearing of OTC derivatives will lead to a large amount of liquidity being tied up as margin at CCPs. Increases in margin requirements by CCPs during a crisis could be destabilizing;
* CCPs should generally align control, governance and membership requirements with the interests of participants that absorb their risks and share their losses.

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