On January 27, 2016, the Office of Financial Research (OFR), an arm of the Treasury Department created under the Dodd-Frank Act, issued its fourth annual report to Congress. The report highlights the results of OFR research, risks to financial markets, and OFR priorities for the coming year. Notable among its findings, the report suggests that reforms mandating central counterparties in the formerly OTC swaps market could unintentionally increase systemic risk in the long run rather than reducing it.
While inserting central counterparties (CCPs) into swaps markets has a number of very important benefits like improving counterparty risk management, increasing transparency, and allowing for multilateral netting of exposures and payments, according to the OFR, adding CCPs to the mix may also result in several serious unintended consequences. OFR notes that individual CCPs can be new points of vulnerability for failure. In addition, because of the global nature of the swaps market, CCPs could increase the risk that a catastrophic failure in one market could be transmitted to others.
"Central clearing can reduce the risk of counterparty default — as long as the CCP has the resources to meet payment obligations. However, a CCP is a single point of vulnerability for failure and creates the potential for propagation of risks, potentially offsetting the advantage."
The OFR's concerns demonstrate something that regulators and standard-setters are beginning to discover. A solution for one set of problems may create new and unforeseen risks and problems. Reforms like adding CCPs to the swaps markets that may seem obvious or appear to be a panacea for the risks associated with a particular segment can change behaviors in ways that end up working against the intended regulatory objective . For example, OFR is concerned that over time, larger CCPs could crowd out smaller clearing members and result in greater concentration of risk among the big CCPs. In addition to concentrating risks in a small number of CCPs, because high clearing member concentration tends to result in relatively lower lending, a higher cost of capital, and increasingly costly hedging, mandating CCPs in the swaps market could, in the long run, unintentionally drive up both costs and systemic risk rather than reducing them.
Going forward, OFR plans to keep an eye on the effect of CCPs in the swaps markets, watching for signs of harmful risk concentration. They plan to do so by continuing to assess and improve the quality of data available to evaluate US central clearing of swaps and also by collecting data about CCP operations.