Central clearing and credit default swaps

Abstract

My interest in this research topic was inspired by the apparently global consensus on the mandate for central clearing in the credit default swaps market. At the first glance, the central clearing mechanism with its central counterparties is the hero who saved many market participants from substantial losses following Lehman Brother’s collapse. It was heralded for debunking the complex interconnection among financial counterparties and resolving Lehman Brother’s positions in a timely and orderly manner.

Nonetheless, after coming into the spotlight, central counterparties raise significant concern about their potential to concentrate systemic risk and grown into ‘too important to fail’ institutions. Any collapse of a ‘too important to fail’ institution is undoubtedly disastrous and likely results in a cascade of defaults by other market participants. Therefore, it is highly questionable whether central clearing can ultimately maintain and protect the market robustness and sustainability. It is even criticised as the Maginot Line of the financial market for being a costly but inefficient bulwark and creating a “false sense of security”.

Therefore, this research paper aims to address the aforementioned concern, whether the central clearing regime should be promoted to mitigate the counterparty risk even when it simultaneously propagates another type of systemic risk to the financial market.

As the legal framework and the risk management practices of CCP have not been battle test, it is impossible to reach any final and ex post conclusion on the ultimate efficiency of CCP. Nevertheless, historically CCP managed to withstand severe market distress whereas currently policymakers and regulators are spending increasing efforts on addressing and mitigating the systemic risk concentrated through CCP. Compared to other alternative clearing infrastructures, it is evident that central clearing is the optimal approach to address the counterparty risk and to enhance the market stability. Further, the research demonstrates that despite central counterparties’ potential to concentrate and re-distribute systemic risk, their shortcomings and contagious fallouts are not insurmountable. They can be efficiently controlled and mitigated through the implementation of adequate regulations and supervision.