By John Fennell, OCC Executive Vice President and Chief Risk Officer
Following the global financial crisis in 2008, policy makers identified one of the major risks to the financial system to be contagion with the unregulated over-the-counter (OTC) market. This was caused by the opaqueness associated with the health of one’s counterparties, which ultimately resulted in the freezing up of the OTC market.
At the same time, however, the regulated exchange-listed market functioned in an uninterrupted fashion. This was largely attributable to the performance of central counterparties such as OCC, which is the world’s largest equity derivatives clearing organization. A central counterparty (CCP) interposes itself between counterparties to contracts traded in financial markets, essentially becoming the buyer to every seller and the seller to every buyer and ensuring the performance of open contracts.
These CCPs effectively serve as a systemic risk buffer for the markets and investors by absorbing the risk associated with a disruption in the financial ecosystem, e.g., the failure of a clearing firm, through a mutualized pool of credit and liquidity resources. This pool, funded by market participants, is designed to temporarily allow the CCP to step into the open financial obligations of the failed clearing firm until it can re-establish its matched book of business and transfer the risk of the defaulted clearing firm back into the ecosystem.
Based largely on the performance of CCPs like OCC to absorb market disruptions during the global financial crisis, policy makers, through regulatory rule-making, began to develop incentives to move financial products primarily traded in the OTC markets into the centrally cleared markets. As a result, CCPs like OCC immediately moved into the forefront given their role, which was critical to supporting the infrastructure of financial markets globally.
Due to the markets becoming increasingly more dependent on CCPs, policy makers began to identify which CCPs were critical to the functioning of financial markets, i.e., should be designated as systemically important, and what standards should be applied to ensure these entities operate with the highest level of resilience from a financial and operational perspective.
The Dodd-Frank Act provides the Financial Stability Oversight Council with the authority to designate a financial market utility (FMU) as one that is or is likely to become systemically important. The failure of or a disruption to the functioning of the CCP that has been designated as a systematically important FMU could create or increase the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the U.S. financial system. Currently, there are eight FMUs designated as systemically important in the U.S. and about 100 globally.
Reflecting on the 10-year anniversary of the financial crisis, the regulations implemented since that time have made market participants more informed about risks, especially liquidity risk, and better capitalized. Although as individual institutions we are stronger, if there is an event that consumes a large institution and drives it to default, does today’s financial ecosystem have sufficient capacity to absorb that institution while continuing to comply with enhanced regulatory requirements and minimizing the systemic impact?
As a systemically important financial market utility (SIFMU), OCC evaluates not only whether it has sufficient credit and liquidity resources to absorb such an event, but also whether it is positioned to re-establish its matched book of business in the event of a default by a clearing member. Re-establishing the matched book can be accomplished through various mechanisms, including (in order from least to greatest impact on the financial market), porting, auctions or market transactions. It is critical that the financial institutions in today’s ecosystem not only have sufficient capital to absorb their own exposure, but that there is excess capacity within the ecosystem to absorb the positions of a defaulting member in the ecosystem.
As a SIFMU, it is important that we acknowledge the contributions that enhanced regulations have added to the resilience of our financial markets at an institutional level. However, we also need to consider the unintended consequences to financial markets that are introduced by regulation and look at how we can modify our regulatory framework to further strengthen the financial markets from a systemic perspective.
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This blog was excerpted from remarks delivered by Mr. Fennell on October 23 to the 3rd Annual Liquidity Risk Management Summit in New York.