Incredibly lax regulation of central counterparties

Regulators of central counterparties (CCPs) seem to have learned a very tiny lesson from the crisis – their standards for CCPs has moved from the laughable to the incredibly lax. The old standard (CPSS-IOSCO Recommendations for Central Counterparties, November 2004) said:

If a CCP relies on margin requirements to limit its credit exposures to participants, those requirements should be sufficient to cover potential exposures in normal market conditions. (Recommendation 4)

In a paper last year, I wrote:

This is like telling a car manufacturer that if a car has brakes, then the brakes should be sufficient to stop the car under normal driving conditions. The implication being that a car need not have brakes and even if they do, the brakes need not be designed to work on a slippery road.

The new standard (CPSS IOSCO Principles for financial market infrastructures: Consultative report, March 2011 ) is a tiny improvement:

A CCP should cover its credit exposures to its participants for all products through an effective margin system that is risk-based and regularly reviewed. ... Initial margin should meet an established single-tailed confidence level of at least 99 percent ... (Principle 6)

So, now the regulators have gotten around to accepting that the car should have brakes, but the regulation on the effectiveness of the brakes is still incredibly lax.

A confidence level of 99% implies that there would be a margin shortfall every six months. Even if we take into account other resources of the CCP, this is an unacceptably high failure rate for an institution as systemically important as a CCP. In banking regulation, 99% was the accepted level in 1996 (Market Risk Amendment), but this increased to 99.9% in Basel II (2004). For derivative exchanges, I have argued that the margin coverage should be set at 99.95%, so that margins coupled with other CCP resources would allow the CCP to reach an acceptable level of safety.

Posted at 9:37 pm IST on Thu, 10 Mar 2011         permanent link

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