Risks Faced By Central Counterparties
CCPs face five major risks: default risk, model risk, liquidity risk, operational risk, and legal risk. Other risks they may face include investment risk, settlement and payment risk, foreign exchange risk, custody risk, concentration risk, sovereign risk, and wrong-way risk.
The default of a clearing member and its flow through effects is the most significant risk for a CCP. Because of a default, there may be the default or distress of other clearing members given that default correlation is likely to be high among OTC derivatives market participants.
Risks to Clearing Members and Non-Members
Non-members face exposure from CCPs, clearing members, and other non-members.
If a CCP fails, a non-member may be able to avoid losses so long as its counterparty is solvent. Non-members are not required to contribute to default funds so they are not exposed to losses that result from CCP failures. The extent of non-members’ losses lies with the initial margins and whether they are segregated, guaranteed, or both. Non-members face the risk of not being able to port their trades should the counterparty member default.
Lessons Learned From CCP Failures
Lessons learned from prior CCP failures include:
- Operational risk must be controlled to the maximum extent possible.
- Variation margins should be recalculated often and collected quickly.
- CCPs should have an information system that allows for automated payments.
- There should be cross-margining linkage arrangements between CCPs.
- Initial margins and default funds should be sufficiently large.
- CCPs must actively monitor positions.
- CCPs must have one or more external sources of liquidity.
