Jerome H Powell: Central clearing in an interdependent world
Speech by Mr Jerome H Powell, Member of the Board of Governors of the Federal Reserve
System, at the Clearing House Annual Conference, New York City, 17 November 2015.
* * *
Thank you for inviting me to speak today.1 I attended The Clearing House annual meeting in
2013 and spoke about financial market infrastructure reform. Two years have passed, and
this is a good opportunity to take stock. I'll start by reviewing the progress made in
strengthening central counterparty (or CCP) clearing, and then offer some thoughts on
expanded central clearing for repurchase agreement (or repo) markets - an area of
significant current interest.
In the years leading up to the financial crisis, the over-the-counter (OTC) derivatives market
experienced rapid growth and an underappreciated buildup of risk. The huge losses suffered
by the American International Group (AIG) on its derivatives positions and the lack of
transparency about the exposures of AIG's counterparties were major accelerants to the
financial panic that reached its acute phase in September 2008. In response, in 2009 the
Group of Twenty nations committed to moving standardized derivatives to central clearing,
and to requiring posting of margin for derivatives that are not centrally cleared.2
I am a believer in the potential benefits of central clearing under the right circumstances. But
central clearing is not a panacea. Charts similar to that in Figure 1 are often used to illustrate
the netting of exposures and simplification that central clearing can bring to an OTC market.
The tangled and highly opaque picture of a purely bilateral market is replaced by the neat
hub-and-spoke network in which a CCP is buyer to every seller, and seller to every buyer,
allowing netting and greater transparency for participants and regulators alike. Of course,
reality is not so elegant, as Figure 2 illustrates. There are multiple CCPs, even within product
classes, and major dealers act as clearing members across a broad network of CCPs.
Clearing members also perform a range of services for CCPs, including custody, liquidity
provision, and settlement. By design, increased central clearing will concentrate risks in
CCPs; it is essential that, as these risks accumulate, the CCPs build up their ability to
manage them. It is often noted that CCPs made it through the recent financial crisis without
direct government assistance. But many of their major clearing members did receive such
assistance. CCPs must now plan for a world in which these large firms will fail and be
resolved without government support.
Recognizing the importance of strengthening our financial market infrastructure, the
regulatory community has clarified and significantly raised expectations for CCPs and all key
financial market infrastructures (FMIs or market infrastructures). These heightened
expectations are set forth in the Principles for Financial Market Infrastructures (or PFMIs),
which were adopted in 2012 by the Committee on Payment and Market Infrastructures
(CPMI) and the International Organization of Securities Commissions (IOSCO).3 The PFMIs
lay out comprehensive requirements for financial market infrastructures, including CCPs.
Clearing and settlement activities are cross-border and indeed global in nature. Major U.S.
financial institutions interact with market infrastructures around the world. The PFMIs have
established a rigorous set of internationally agreed upon standards for the quality and
quantity of loss-absorbing resources and liquidity, governance, risk management, stress
testing, recovery and orderly wind-down, and other key areas.
I believe that there has been reasonably good progress in implementing these reforms here
in the United States. For example, according to the Financial Stability Board, over 70 percent
of new U.S. interest rate and credit derivatives are now centrally cleared.4 And the Federal
Reserve and other U.S. regulatory agencies have recently announced final margin rules for
uncleared derivatives as well, which should enhance the resilience of trading that still occurs
outside of central clearing.5
But there is still plenty of work left to do. CCPs are implementing the PFMIs under the
oversight of national regulators; clearing members have been vocal commentators on this
process. To assure that the standards are consistently implemented across jurisdictions and
across FMIs, CPMI and IOSCO are conducting joint reviews of the risk-management
practices of a range of global derivatives-clearing CCPs. Working in conjunction with the
Basel Committee on Banking Supervision and the Financial Stability Board (FSB), they have
also set out a detailed work plan for further enhancing the resilience, recovery planning and
resolvability of CCPs.
Earlier this year, CPMI-IOSCO conducted surveys of more than 30 of the most systemically
important CCPs regarding their stress testing, margin, recovery planning, and loss allocation
frameworks. The survey responses have now been received and are being analyzed. I
expect that these exercises will result in more granular guidance to CCPs covering a wide
set of operational areas, further helping to ensure consistency of implementation of the
PFMIs and market infrastructure resilience.
Further work on resolution is also necessary. The FSB has conducted a survey on CCP
resolution regimes and resolution planning within its membership, and found that many
jurisdictions are still in the process of developing resolution regimes. As the reform process
moves forward, this will be an important area of focus.
All of these efforts are directly aimed at strengthening FMIs. But the strength and resilience
of a CCP ultimately depends on the strength and resilience of its clearing members. I'd now
like to shift focus to the relationship between these market utilities and the institutions that
use them.
Barring an operational event, CCPs only face credit or liquidity risk when one of their
members fails to make a payment when due. Thus, one effective way to make a CCP safer
is to make its members safer. In that sense, the post-crisis reforms that have greatly
strengthened our largest and most systemically important banking institutions have directly
benefitted CCPs and other FMIs.
While requiring bank holding companies and their associated broker-dealers to be better
capitalized and hold more liquid assets has unquestionably made them safer, it has also
raised their balance sheet costs and thereby created incentives to scale back on less
profitable business lines. Clearing has traditionally been a low margin business, and
brokerdealers have often offered these services to clients in the belief that doing so may lead to
more profitable business. In the new environment, broker dealers are reconsidering this
model, and may reduce services to smaller clients or move to an agency model with higher
fees.
Banks and broker-dealers serve not only as clearing members of CCPs, but also as liquidity
providers and as custodians of their cash and securities. CCPs typically have lines of credit
with banks and other arrangements for secured credit to meet their potential liquidity needs.
The higher cost of funding for large financial institutions has made these liquidity
arrangements substantially more expensive and more difficult to obtain. Given the balance
sheet costs involved, financial institutions may also be less willing to hold cash deposits on
behalf of their CCP clients.
These considerations suggest that there will be a period of adjustment as firms and market
infrastructures adapt their business models to the new regulatory landscape. This is not
necessarily a cause for alarm. To some extent, these adjustments are desirable. Liquidity
risk seems to have been systematically underpriced before the crisis. Firms are now much
more focused on both managing and more accurately pricing this risk. It is also appropriate
that the pricing of a bank's services accurately reflect the costs and profitability of different
business lines, which should lead to a more efficient allocation of resources.
One area where market participants are actively searching for new business models is the
repo market, where there are currently several private initiatives for greater central clearing.
Expanded repo clearing could potentially bring a range of benefits, including greater
opportunities for netting and related reductions in balance sheet costs for dealers affiliated
with a bank holding company. The evolution of repo markets and central clearing can serve
to illustrate both the potential benefits and the complexities that arise as the market seeks
new infrastructure models.
Repo clearing
The U.S. repo market is composed of several segments, as illustrated in Figure 3. Dealers
are at the center of the figure and operate in all five of the segments shown. In the bilateral
market (segments 1 through 3), participants often impose narrow restrictions on the specific
securities eligible for collateral. In this portion of the market, cash providers tend to be
professional investors such as asset managers (segment 1), or the securities dealers
themselves. Cash borrowers include prime brokerage clients (segment 3). Securities dealers
may also borrow cash in this market, or may borrow it and then redistribute it to other dealers
(segment 2).
The tri-party repo market (segments 4 and 5) is used to finance general collateral pools
rather than specific securities, and trades in this portion of the market are settled on the
books of the two clearing banks, Bank of New York Mellon and JP Morgan Chase.6 Money
market mutual funds and securities lenders are among the most prominent cash providers in
segment 4, while securities dealers are the primary borrowers of cash. Dealers may use this
cash to fund their own portfolios; they may also lend it to other dealers in the general
collateral finance (GCF) repo market (segment 5). This segment is cleared through the Fixed
Income Clearing Corporation, and is currently the only segment of the market that is centrally
cleared.
Based on figures from September 2015, the size of the tri-party repo market, segment 4, was
approximately $1.5 trillion and the GCF market (segment 5) was approximately $300 billion.
The general lack of data on bilateral repo activity makes it difficult to know the precise size of
each individual segment of that market, but bilateral repo and securities lending taken
together accounted for approximately $1.7 trillion in outstanding activity.7
Given its vast scale and position at the center of the wholesale finance markets, repo is
without doubt a critical activity. Repo is a key source of financing for a wide range of firms,
and an important "safe asset" for investors. The GCF segment, although modest in size
compared to the overall market, is a key source of financing for smaller dealers, particularly
in times of financial stress. The availability of repo funding for a diverse range of participants
supports market liquidity by enabling them to make markets in Treasury and agency
securities. CCPs themselves also rely on these markets, often using repo to earn interest on
cash collateral and counting on access to repo markets in their liquidity planning.
The FSB has called on authorities to "consider the pros and cons of broadening participation
in repo clearing arrangements."8 What are the potential benefits of greater clearing in this
market? In addition to the potential netting benefits I mentioned earlier, a CCP typically
performs three other beneficial economic functions: 1) a reduction in the potential cost of
counterparty default coming from the orderly liquidation of a defaulting member's positions,
2) greater transparency and a reduction in operational risk from enhanced reporting
requirements and standardization of data, and 3) the sharing of risk among members of the
CCP through some mutualization of the costs of a counterparty's default. I'll discuss each of
these in turn.
Orderly liquidation
While repos are generally a low risk, low margin business, they proved to be vulnerable to
runs during the financial crisis, when concerns of possible defaults by large financial firms led
to a sudden withdrawal of funding from repo markets. As a result, a reform project led by my
colleagues at the Federal Reserve Bank of New York produced a set of measures that have
sharply reduced the amount of intraday credit and improved risk management practices in
the tri-party repo market. These reforms have made the overall structure of that market much
safer, and significantly reduced the likelihood of a borrower default. But if a default were to
take place, some counterparties, particularly those unwilling or unable to hold sizable
positions, would retain strong incentives to sell assets quickly regardless of the price
received.
A repo CCP could help to address this "fire sale" risk. CCPs have rule-based processes to
dispose of the portfolio of a defaulted member. CCPs can transfer positions to solvent
broker-dealers, or hedge positions and auction them off over time.
Greater transparency and reduction in operational risk
Central clearing could also improve transparency and bring a reduction in operational risks.
CCPs are in position to aggregate trade information from all clearing members, and thus to
monitor and manage counterparty and market-risk exposure better than individual members.
As I noted earlier, we have relatively little information on bilateral repo activity, so greater
clearing in this segment could have significant benefits in helping to aggregate market
information. CCPs also provide participants with central confirmation of trades and netting of
positions, allowing their members to reduce operational risk of post-trade processing.
Risk sharing
In terms of risk sharing, when a CCP clearing member defaults, any resulting losses are
shared among the surviving members and the CCP itself according to pre-agreed rules.
Members of a CCP contribute to a default fund that can be used to absorb these losses. The
degree of risk sharing depends on the design of the CCP, but transparent rules help to
create an orderly, predictable process for managing a default.9
Finding a way forward
The potential benefits of proposals for expanded central clearing of repo in U.S. markets are
undergoing a period of evaluation by regulatory authorities and market participants alike. For
these proposals, it will not be a simple matter to find a way forward while meeting the
heightened regulatory expectations I mentioned earlier. The liquidity requirement of the
PFMIs will present a particular challenge - a CCP must have sufficient liquid resources to
meet its payment obligations on time in extreme but plausible market conditions, including in
the event of a default of that participant whose default would generate the largest
obligations.10 In repo trading, unlike in swaps, the full notional principal amount is exchanged
at the beginning and end of the trade. As a result, the liquidity requirements for repo clearing
will be quite high.
Another key question is how great the opportunities for netting actually are, in light of the
dominance of "one-way flows" in U.S. repo markets. Netting for balance sheet purposes is
only permitted for offsetting trades with the same maturity and counterparty.11 The many repo
market participants who act as either lenders or borrowers - but not both - have little
opportunity for netting. Netting opportunities are therefore more likely to occur in the
interdealer market, so it is not surprising that the current repo CCP operates in this segment
of the market.12 Further gains in netting could arise if clearing expanded to the bilateral
market or if some of the larger end users in the tri-party market, for example money market
mutual funds or hedge funds, were able to gain access to the CCP. This could pose its own
complications, however, as some of these institutions may be unwilling or legally unable to
engage in the risk mutualization that exists in most clearing models.
Conclusion
Despite these challenges, it is worth noting that, in the right setting, central clearing can
produce significant benefits, including reduced credit and liquidity risks; improved default
management and reduced risk of fire sales; greater transparency; and improved risk
management. Of course, this does not mean that every product should be cleared, or that
every type of repo trading would benefit from clearing. In my view, clearing should be limited
to those assets that are highly liquid and expected to remain so even in severely stressed
market conditions. While any model for expanded repo clearing will have to satisfy stringent
regulatory requirements, regulators should be open to emerging clearing solutions where
they provide substantial benefits and can meet these standards. This may be particularly true
for repo trading in government and agency securities, since new regulations require financial
institutions to hold such high-quality collateral under the assumption that it can be quickly
9
While details vary, in a waterfall, to cover losses resulting from a defaulting member, a CCP typically first uses
the financial resources of the defaulting member, including margin and default fund contributions. If losses still
exist, then the CCP uses its capital (skin in the game), followed by the default fund contributions of surviving
members. Further losses could be absorbed by additional assessments on surviving members.
10
Principle 7 in the Principles for Financial Market Infrastructures, April 2012 (PDF) . Committee on Payment
and Settlement Systems and Technical Committee of the International Organization of Securities
Commissions.
11
See Financial Accounting Standards Board Interpretation No. 41, "Offsetting of Amounts Related to Certain
Repurchase and Reverse Purchase Agreements."
12
Repo CCPs mainly exist in markets where the underlying flows provide large-scale opportunities for
multilateral netting. For example, CCPs play a large role in the European and the Canadian repo markets,
which are primarily interbank markets.
converted to cash. It is therefore important to consider ways to support their continued
liquidity where possible.