Central Clearing and Risk Transformation

Forthcoming in Financial Stability Review (Banque de France), 2017

16 Pages Posted: 21 Feb 2017 Last revised: 1 Mar 2017

See all articles by Rama Cont

Rama Cont

University of Oxford; CNRS

Date Written: February 1, 2017


The clearing of over-the-counter transactions through central counterparties (CCPs), one of the pillars of financial reform following the crisis of 2007-2008, has promoted CCPs as key elements of the new global financial architecture. Given the cost of implementing central clearing mandates and the associated collateral requirements, it is important to examine how these reforms have affected risks in the financial system and whether central clearing has attained the initial objective of the reform, which is to enhance financial stability and reduce systemic risk. We show that, rather than eliminating counterparty risk, central clearing transforms it into liquidity risk: margin calls transform accounting losses into realised losses which affect the liquidity buffers of clearing members. Accordingly, initial margin and default fund calculations should account for this liquidity risk in a realistic manner, especially for large positions. While recent discussions have centered on the solvency of CCPs, their capital and ‘skin-in-the-game’ and capital requirements for CCP exposures of banks, we argue that these issues are secondary and that the main focus of risk management and financial stability analysis should be on the liquidity of clearing members and the liquidity resources of CCPs. Clearing members should assess their exposure to CCPs in terms of liquidity, rather than counterparty risk. Stress tests involving CCPs should focus on liquidity stress testing and adequacy of liquidity resources .

Keywords: CCP, central clearing, central counterparty, systemic risk, liquidity risk, counterparty risk, default fund, OTC derivatives, collateral requirement, regulation, stress testing

JEL Classification: G18, G24, G28

Suggested Citation

Cont, Rama, Central Clearing and Risk Transformation (February 1, 2017). Forthcoming in Financial Stability Review (Banque de France), 2017. Available at SSRN: https://ssrn.com/abstract=2919260

Rama Cont (Contact Author)

University of Oxford ( email )

Mathematical Institute
Oxford, OX2 6GG
United Kingdom

HOME PAGE: http://https://www.maths.ox.ac.uk/people/rama.cont

CNRS ( email )

Sorbonne University

HOME PAGE: http://rama.cont.perso.math.cnrs.fr/

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