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Optimizing risk allocation for CCPs under the European market infrastructure regulation

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Abstract
Events such as the recent global financial crisis, the failure of Lehman Brothers, and the bailout of American International Group, have called increased attention to the opaque workings of the over-the-counter (OTC) derivatives markets which have remained unregulated until now. Nevertheless, the 2009 commitments of the Group of 20 (G20) economies towards the standardization and central clearing of OTC derivatives, have led to new regulatory initiatives which have culminated in the recent promulgation of the European Market Infrastructure Regulation (EMIR) within the European Union (EU). This paper provides an overview of the OTC derivatives market and the EMIR provisions, as well as undertaking a cost-benefit analysis of the clearing of OTC derivatives by a central clearing counterparty (CCP). It suggests that in theory, centralized OTC derivatives clearing offers significant benefits such as reduced systemic risk, more effective default management, and mitigation of counterparty risk, reduced complexity, and increased efficiency and transparency. However, these benefits must be weighed against potential structural weaknesses in centralized clearing which correlate with either current or potential costs, such as financial failure of a CCP, moral hazard, adverse selection, increased regulatory arbitrage, and increased trading and regulatory costs. Consequently, the paper suggests that in order to successfully achieve its overall objectives, the EMIR must ensure the optimization of risk allocation for CCPs. Most importantly this will require the correct determination and balancing of clearing eligibility for OTC derivatives. It will also require ensuring strict adherence to CCP risk governance and harmonization practices, and greater efforts made towards achieving interoperability of CCPs in the near future.

Suggested Citation

  • Zepeda, Rodrigo, 2013. "Optimizing risk allocation for CCPs under the European market infrastructure regulation," Journal of Financial Transformation, Capco Institute, vol. 37, pages 39-52.
    • Handle: RePEc:ris:jofitr:1555
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    More about this item

    Keywords

    risk allocation; risk management; CCP; European Market Infrastructure Regulation; EMIR; OTC derivatives; OTC;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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