securities regulation - powerpoint presentation

7/28/2019 Securities Regulation - Powerpoint Presentation

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Presentation Assessment

Subject: Securities Regulation


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Topic Question

Will a central counterparty (CCP) clearing system, for

certain classes of over-the-counter (OTC) derivatives,

reduce systemic risk in the financial system?


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Thesis Statement

A CCP clearing system for certain classes of OTC derivative

will provide certain benefits. However, in isolation, a CCP will

not reduce the overall level of systemic risk in the financial

system.


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What are OTC Derivatives?

A derivative is a contract whose value is derived from

something else such as the price of a share or

commodity, a certain benchmark interest rate, or even

the occurrence of a specified event such as a default.

OTC Derivatives are not traded on exchanges, instead

they are negotiated privately between financial

institutions on behalf of their clients and for themselves.


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What is a CCP?

Currently most OTC derivative trades are bilateral. This is

the plate of spaghetti model that can create an

extremely complex web of interconnected counterparty

relations.

The idea behind a CCP is to reduce complexity by

creating a hub and spoke structure whereby an entity

sits in between the counterparties and assumes their

obligations. When trades are cleared through a CCP

each party is liable only to the CCP.


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(Source: Council of Financial Regulators Discussion Paper, Central Clearing of OTC Derivatives in Australia, figure 2)


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(Source: Council of Financial Regulators Discussion Paper, Central Clearing of OTC Derivatives in Australia, figure 2)


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What is Systemic Risk?

The possibility that one financial institution becomes unable

to to meet its contractual obligations triggering a domino

effect of failures as one financial institution after another

goes bust. In such a scenario the continuing viability of the

current financial system comes under question.


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Legal Context

Pittsburgh 2009 - G20 Group of Nations commitments

Intention of preventing a repeat of the GFC

Moving towards a system of CCP clearing for OTC derivatives wasone of these commitments, based on the belief that it would

reduce systemic risk.

In response to G20 commitments Australia amends Corporations

Act 2001 (Cth) in 2012

ASIC given the power to make derivative transaction rules that

require certain classes of derivatives to meet stipulated clearing

requirements (s 901A)


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CCP Inability to Clear all OTC Derivatives

Only standardised OTC derivatives will require CCP clearing.

However, many are complex and individualised and thus

likely to fall outside any clearing requirements

Market participants may avoid CCP clearing requirements

via the alteration of standard contracts or regulatory

arbitrage.

Consequently, risk management benefits of a CCP will not

extend to those contracts it does not clear even though

they pose similar or possibly greater risks of loss to financial

institutions and contribute significantly to systemic risk.


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Duplication of Industry Practice

A CCP will implement collateralisation requirements

Such requirements are already in place and would largely

be a duplication of current industry practice as set out by

the International Swaps and Derivatives Association (ISDA)

Thus the impact on reducing systemic risk would likely be

minimal


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Concentration of Risk

A CCP will not reduce overall risk it will only alter its form.

Risk will be centralised into the CCP instead of it being

dispersed among a network of institutions

To reduce systemic risk institutions must be able to fail

without bringing down others with them, however a CCP

would itself be the ultimate Too Big to Fail (TBF) institution


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Risk Management Issues

The nature of a CCPs role in assuming counterparty

obligations means it could fail during market

disturbances.

OTC derivative contracts can be illiquid and difficult toprice and this is especially so during stressed market

conditions

The use of quantitative models based on historical data

to used to measure risk and thus set margin and

collateral requirements can be misleading as was

demonstrated during the GFC.


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Risk Management Issues

Using mark-to-market margin calls can fuel market

crashes as participants are forced to liquidate positions.

This creates a negative feedback loop and increases the

risk of a financial institution defaulting


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Inability to Address Other factors

Regulation of securities of OTC derivatives through a

mechanism such as a CCP cannot address the other

factors which play a role in creating systemic Risk.

Such factors include leverage in the banking system and

incentive structures within the financial sector which

encourage risk taking.


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Conclusion

A CCP clearing system for certain classes of OTC derivative

trades will provide certain benefits. However, in relation to

systemic risk in the financial system it will not reduce its overall

level.

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