Jean-Claude Trichet: Issues related to central counterparty clearing
Speech by Jean-Claude Trichet, President of the European Central Bank, at the joint European
Central Bank - Federal Reserve Bank of Chicago conference, Frankfurt, 4 April 2006.
* * *
Dear Ladies and Gentlemen,
I have the pleasure to conclude a very successful conference, a conference that has been special in
many respects. First, this conference was jointly organised by the European Central Bank (ECB) and
the Federal Reserve Bank of Chicago (FRBC). As such, it marks another fruitful example of
cooperation among central banks across the Atlantic. Second, it has featured research on central
counterparties (CCPs), a topic that has not yet received a great deal of attention from academic
researchers. I hope that this conference has contributed to stimulating more research on this very
important subject. Finally, it has brought together market participants, public authorities and
academics. I am in no doubt that discussions involving people from these very different groups are
beneficial for all of them. However, I am also aware that it is not always easy to initiate such
discussions. This conference has also been very successful in this respect. I wish to thank the
organizers of this conference at the FRBC and the ECB for all their hard work.
Central counterparties play an important role in many financial markets. They interpose themselves
between the buyer and the seller of financial assets, acting as the buyer to every seller and as the
seller to every buyer of a specified set of contracts. This process mitigates counterparty credit risk,
which is the risk that one party of a trade suffers losses because the other party cannot fulfil its
obligations from the trade. Through multilateral netting, central counterparties enhance liquidity and
reduce liquidity costs. Finally, central counterparties ensure post-trade anonymity.
Central banks are interested in the smooth functioning of central counterparties for three reasons:
•
central counterparties can enhance financial stability as long as they function smoothly. The
failure of a central counterparty however can significantly destabilise financial markets. It is
therefore important that central counterparties have appropriate risk management procedures
in place;
•
links between central counterparties operating in different countries can foster financial
integration across those countries, by allowing the participants to trade in a foreign market and
clearing that trade through existing national arrangements. Links between CCPs can take a
variety of forms, ranging from the establishing of direct relations between two CCPs to
arrangements between central counterparties which allow their participants to mitigate the
costs associated with risk control measures (e.g. cross-margining);
•
central counterparties use payment systems and other infrastructures operated by central
banks to carry out their activities.
For these reasons, central banks closely follow and contribute to the discussions related to central
counterparty clearing. This conference is an important element in this respect.
Let me now outline a few central points of this discussion.
Central counterparties must have adequate risk management procedures .
Central counterparties play a systemically important role in many financial markets. The failure of a
central counterparty can severely disrupt financial markets. Central counterparties are highly
specialised in managing risks and failures have been rare. Nevertheless, there is no room for
complacency, and any efforts to improve risk management methods are most welcome. As mentioned
already several times in this conference, in November 2004 the G-10 central banks and the IOSCO
issued a report which set out 15 comprehensive international recommendations for promoting the
safety and efficiency of central counterparties. The ESCB-CESR working group is working in close
cooperation with EU CCPs to adapt these recommendations to the European context. Academic
research can provide additional hints on the specific situations which are targeted by the
recommendations. This has been shown at this conference by Alejandro García and Ramo Gençay or
John Cotter and Kevin Dowd with their approaches to extreme market events, and by Froukelien
Wendt in her survey on intraday margining.
The governance structure of central counterparties should in principle be market driven.
The governance structure may have a significant influence on, for example, risk management and
other strategic decisions of central counterparties, as pointed out by Thorsten Koeppl and Cyril
Monnet. Although the optimal governance structure cannot be defined ex-ante, the markets may in
many cases be in a good position to identify and produce it. Public authorities must, however, step in
whenever market failures become significant. In this respect, the ECB supports the views expressed in
the CPSS-IOSCO recommendations according to which governance arrangements for a CCP should
be clear and transparent in order to fulfil public interest requirements, support the objectives of owners
and participants and, in particular, promote the effectiveness of a CCP's risk management procedures.
The features of post-trading structure should also in principle be market driven.
We are witnessing fast developments in the field of financial market infrastructures, especially in
Europe, but also in other parts of the world. With respect to central counterparties, I would like to
mention four major developments:
a) Consolidation of central counterparties
Since the start of EMU, the number of central counterparties for financial instruments has fallen from
14 to 7 in the euro area. This process of consolidation may have a positive impact on financial stability
as larger central counterparties may find it easier to diversify risks. It may also have a positive impact
on the efficiency of post-trading arrangements due to network effects and issues related to
interoperability. However, the failure of large central counterparties could have an even more
disastrous impact on financial markets. Moreover, consolidation may eventually lead to a reduction in
competitive pressures with a negative impact on efficiency. The Eurosystem has formulated this
position in a policy statement on consolidation in central counterparty clearing, which was published as
early as September 2001. As stated in the policy statement, the ECB supports any form of market-led
integration or consolidation process that fulfils the ECB's requirements in terms of financial stability,
open access, price transparency and efficiency.
b) Expansion of activities of central counterparties
While in the past, most European central counterparties only cleared derivatives, many of them also
now clear securities transactions. The effects of such an expanssion have been differently assessed
by different speakers at this conference. On the one hand, John Jackson and Mark Manning found
that central counterparties that diversify their activities across imperfectly correlated assets may often
be able to better manage their risks than single-product clearers. At the same time, securities market
participants benefit as their exposure to counterparty credit risk is reduced. This trend towards
multiproduct central counterparties could therefore be beneficial from a financial stability perspective. On
the other hand, Diana Chan mentioned in the first panel yesterday, that central counterparts that
diversify their activities across imperfectly correlated assets and reduce the collateral requirements for
their participants by offsetting margins related to these different activities could. significantly
underestimate risk exposure and collateralisation requirements, thereby create additional and
unknown risks. These developments need therefore to be carefully observed by market participants
and relevant authorities.
c) Creation and dismantling of vertical "silos"
In Europe, vertical silos encompassing trading, clearing and settlement infrastructures have been
created, while other silos have been dismantled. The discussion on which structure is preferable is
ongoing, and the answer may be different for different markets. While silos may help infrastructure
providers to reduce operating costs and to better coordinate the prices of the different integrated
services (e.g. trading, clearing and settlement), they may reduce competition when they are misused,
for example, to favour a central counterparty in the silo over its competitors outside of the silo. As the
Eurosystem explained in its policy statement of September 2001, the disadvantages of vertical silos
"can be overcome provided that customers can choose between systems along the value chain [...]. It
is therefore crucial that access to essential facilities, whether vertically integrated or not, should not be
unfairly impeded."
d) Growing need for adequate infrastructure in the field of credit derivatives
Volume growth in derivatives - especially OTC derivatives - outpaces the cash markets, spurred on
by increased interest in hedge funds and the ongoing innovation in the types of contract offered. While
interest rates contracts remain the key hedge instrument (187 Tri USD outstanding), credit default
contracts (6.3 Tri USD outstanding) are growing at approximately 90% per year, now reaching 10,000
trades per day. Volume growth is expected to continue over the coming years, causing some concern
among operations managers on the OTC market, given the lack of straight-through-processing and
hence capacity to manage the volumes. This rapid multidimensional growth (i.e. in terms of products,
volumes, market participants and secondary markets) calls for an enhancement of the post-trading
infrastructure that may support more careful risk control by the various participants. As mentioned by
Governor Kroszner, enhancing the post-trading infrastructure does not automatically mean to
introduce telles quelles the same techniques that CCPs use in exchanged-traded derivatives but
rather to identify the solutions which are equally effective and take into account the different features
of OTC markets.
All these developments refer to the market structure that surrounds central counterparties and are
highly relevant for the interests of central banks in the fields of financial stability and financial
integration. As central banks, we believe that the market structure should be market driven as long as
market failures are not observed. Significant market failures however must be identified and in many
cases require appropriate public intervention.
This brings me to my last point.
What is the role of public authorities and, in particular, central banks?
Market forces need a sound legal, regulatory and oversight basis to work efficiently. In the euro area
with its 12 countries, and in the European Union with its 25 countries, the creation of such a sound
basis requires first and foremost a certain degree of harmonisation of public principles and standards
across countries. Efforts in this direction are ongoing and the Eurosystem provides active support.
Here I should mention the joint work by the European System of Central Banks and the Commission of
European Securities Regulators towards establishing standards for securities clearing and settlement
in the European Union. As indicated in the ECB policy statement of 2001, standards are to be carefully
set and then implemented by public authorities with a clear interest and expertise in the respective
field. It appears evident that the Eurosystem, for example, should be involved in the oversight of any
major infrastructure for euro-denominated assets with a view to being able to properly address serious
threatens to financial stability. A paper, authored by a Professor at the Woodrow Wilson School at
Princeton University in 1990, addressing the performance of the derivatives clearing and settlement
systems during the 1987 stock market break, concluded, inter alia, that "the Federal Reserve played a
vital job in protecting the integrity of the clearing and settlement systems." The name of that Professor
is Ben Bernanke.
Finally, it is important that cross-fertilisation of experiences and expertise of market participants,
academics and public authorities in this field continues and, as I said before, this conference has
certainly contributed in this respect.
With this, I thank you very much for your attention, close the conference and wish you a pleasant
journey home.