A number of commentators have argued that the move to central clearing will further concentrate risk in the financial system. There is some truth in that assertion. Moving a significant share of the $700 trillion OTC derivatives market to central clearing will concentrate risk at CCPs. But the intent is not simply to concentrate risk, but also to reduce it--through netting of positions, greater transparency, better and more uniform risk-management practices, and more comprehensive regulation. This strategy places a heavy burden on CCPs, market participants, and regulators alike to build a strong market and regulatory infrastructure and to get it right the first time.

It has also been frequently observed that central clearing simplifies and makes the financial system more transparent. That, too, has an element of truth to it, but let's take a closer look [I]n the real world CCPs bring with them their own complexities. As the figure shows, we do not live in a simple world with only one CCP. We do not even live in a world with one CCP per product class, since some products are cleared by multiple, large CCPs. Also, significant clearing members are often members of multiple CCPs in different jurisdictions. The disruption of a single member can have far-reaching effects. Accordingly, while CCPs simplify some aspects of the financial system, in reality, the overall system supporting the OTC derivatives markets remains quite complex.

To say it as plainly as possible, the purpose of all of this new infrastructure and regulation is not to facilitate the orderly bailout of a CCP in the next crisis. Quite to the contrary, CCPs and their members must plan to stand on their own and continue to provide critical services to the financial system, without support from the taxpayer.

CCPs must adopt plans and tools that will help them recover from financial shocks and continue to provide their critical services without government assistance. It has been a challenge for some market participants to confront the fact that risks and losses, however well managed, do not simply disappear within a CCP but are ultimately allocated in some way to the various stakeholders in the organization--even if the risk of loss is quite remote. This realization has generated a healthy debate among CCPs, members, and members' clients and regulators that has provided fertile ground for new thinking about risk design, risk-management tools, and recovery planning. To ensure that CCPs do not themselves become too-big-to-fail entities, we need transparent, actionable, and effective plans for dealing with financial shocks that do not leave either an explicit or implicit role for the government.

Even in light of the significant costs of initial margin, it seems clear that some requirements are needed. The current use and application of initial margin is inconsistent, and a more robust and consistent margin regime for non-centrally-cleared derivatives will not only reduce systemic risk, but will also diminish the incentive to tinker with contract language as a way to evade clearing requirements. Robust and consistent initial margin requirements will help prevent the kind of contagion that was sparked by AIG: They would serve, in effect, to limit the effects of interconnectedness within the financial network.

[T]he challenge facing the Board is to enhance supervision, oversight, and prudential standards of major derivatives market participants in a manner that promotes more-effective risk management and reduces systemic risk, yet retain the significant benefits of derivatives to the businesses and investors who use them to manage financial market risks.

A CCP has the potential to reduce counterparty risks to OTC derivatives market participants and risks to the financial system by achieving multilateral netting of trades and by imposing more-robust risk controls on market participants.  However, a CCP concentrates risks and responsibility for risk management in the CCP.  Consequently, the effectiveness of a CCP's risk controls and the adequacy of its financial resources are critical.  If its controls are weak or it lacks adequate financial resources, introduction of its services to the credit derivatives market could actually increase systemic risk.

A CCP that seeks to offer its services in the United States would need to obtain regulatory approval.  The Commodity Futures Modernization Act of 2000 included provisions that permit CCP clearing of OTC derivatives and require that a CCP be supervised by an appropriate authority, such as a federal banking agency, the Commodity Futures Trading Commission, the SEC, or a foreign financial regulator that one of the U.S. authorities has determined to satisfy appropriate standards.  A CCP for credit derivatives with standardized terms that was not regulated by the SEC might need an exemption from securities clearing agency registration requirements.

The New York Fed and other supervisors are working with market participants to fundamentally change how CDS and other OTC derivatives are processed by applying increasingly stringent targets and performance standards. They are also emphasizing that dealers must demonstrate their capability to adequately manage the failure of a major counterparty, including calculating exposures rapidly, having clear management procedures, and conducting internal stress exercises. Finally, they are encouraging the development of well-regulated and prudently managed central counterparty clearing arrangements for CDS trades.

"Credit default swaps are a good example of a market that has huge potential for helping people manage risks," said Kohn, but he added that those who use the swaps "need to be aware of the risks they're taking."

Kohn said "good progress" has been made in improving the infrastructure of the credit default swaps market, so that "counterparties are not assigned arbitrarily." But he said swaps purchasers still need to "be very careful about where their exposures are in that market."

From Q&A as reported by Market News International

Fortunately, legislative and regulatory changes in the U.S. over the past several decades have allowed banks and other financial firms to diversify their portfolios of assets and their geographic boundaries. Institutions that make mortgage loans no longer are limited to taking deposits within limited geographic areas. They no longer are restricted as to what interest rate they can pay on those deposits. And they no longer are prevented from making other types of loans. In addition, financial innovations, such as asset securitization, have allowed the spreading of risks in the financial system. This means that today banks and many other financial institutions are much better diversified than during previous housing cycles. Thus, both deregulation of the financial system and innovations in financial products have lessened the risk of asset price declines triggering substantial adverse effects in the financial sector. 

There are good reasons to think that financial innovation over the past few decades, including the emergence and growth of the credit derivatives markets, has made the financial system and the economy more resilient. But it would be foolish to think that these innovations have eliminated systemic risk.

There are good reasons to think that these developments have made the financial system more resilient to shocks originating in the real economy and have made the economy less vulnerable to shocks that start in the financial system. Borrowers have a greater variety of credit sources and are less vulnerable to the disruption of any one credit channel; risk is dispersed more broadly to people who are most willing to hold and manage it. One can see the effects of these changes in the reduced incidence of financial crises in recent years. From the 1970s through the early 1990s, we seemed to be in almost continuous crisis mode. These crises were centered on depository institutions, and because borrowers were so dependent on depository institutions for credit availability, problems at depository institutions meant problems for the financial system and for the economy more generally.

...

But we certainly should not read this experience as meaning that we are free of systemic risk--the risk of financial-sector problems spilling into the real sector or aggravating already difficult economic circumstances. Indeed, I see several reasons for carefully considering the potential for such problems to emerge.

New players and new instruments have become important since 2002, when the last adverse credit cycle peaked. New and already existing market participants are maneuvering for greater shares in a rapidly evolving market structure. Although leverage has declined in the nonfinancial businesses whose credit is being priced and traded, it may well have increased in the structure of intermediary finance. In any event, the growth of tranched CDOs and other structured credit products with substantial embedded leverage has made it more difficult to assess the degree of leverage of individual institutions or of the financial system as a whole.

In addition, the extraordinarily rapid growth of credit derivatives markets in the past few years has occurred against the backdrop of relatively benign macroeconomic performance--good global growth, low inflation, historically high corporate profits and low business failures, and reasonably predictable monetary policies. Partly as a consequence, the prices of financial assets seem to embody relatively low expected volatilities and relatively little reward for taking credit risk or for extending the duration of investor portfolios.

Credit derivatives can be useful instruments aiding the cause of financial stability.  In the midst of surging growth in the number of credit derivative products and their value, and the growing diversity of market users, there has been progress in strengthening the underlying infrastructure around the instruments to make them more resilient in times of stress.  Despite this, and of primary importance, they have yet to be tested in a real environment of financial shock.  To me, that suggests that concerns about how their underlying risks will play out in such circumstances are warranted.

As reported by Bloomberg News

Of course, in some respects financial innovation makes risk management easier. Risk can now be sliced and diced, moved off the balance sheet, and hedged by derivative instruments. Indeed, the need for better risk sharing and risk management has been a primary driving force behind the recent wave of innovation. But in some respects, new instruments and trading strategies make risk measurement and management more difficult. Notably, risk-management challenges are associated with the complexity of contemporary instruments and trading strategies; the potential for market illiquidity to magnify the riskiness of those instruments and strategies; and the greater leverage that their use can entail.

[S]yndicated loans are not a new instrument.  They have been around since the 1970s.  But recently, the secondary-market liquidity of syndicated loans has improved dramatically, in part because of the demand for loans by CLOs.  This improved liquidity has transformed loans from buy-and-hold investments into traded assets.

In this context, we are working to put in place a stronger regulatory capital regime and to strengthen the capacity of firms to absorb losses in stress conditions. We are encouraging more sophisticated and more conservative management of credit exposures in over-the-counter (OTC) derivatives and structured financial products, as well as of exposures to hedge funds. And we are encouraging a range of efforts to modernize the operational infrastructure that underpins the OTC derivatives markets, and to improve the capacity of market participants to manage adversity.

The collaborative process that produced this progress {on credit derivatives clearing} has much to recommend it. What principles led to this outcome?

First, regulators and supervisors -recognised that they were more likely to achieve their goals if they worked with the private sector in the development of solutions to complex problems. In this case, supervisors laid out broad objectives but let the market design the solution. Working with the market may be necessary to keep pace with changes at the frontier of innovation.

Second, to fix the credit derivatives problem it was necessary to involve a large and diverse pool of financial institutions. No firm or national authority had the capacity to make progress on its own. To correct this collective action problem, firms needed confidence that competitors would be held to similar standards. Having firms set common metrics and insisting on sharing aggregate reporting data with the entire group ensured that each firm could measure its progress against the group, discouraging individual firms from free-riding or circumventing the group's effort.

Finally, in a more integrated global market, we will increasingly find ourselves compelled to pursue borderless solutions. In the case of derivatives, a local or national solution would have been insufficient to protect domestic financial markets from the risks posed by market practices.

FT article co-authored with Callum McCarthy and Annette Nazareth.