"Following the financial
crisis, worries about failures in over-the-counter (OTC) derivatives trading
causing destabilizing runs and market crashes have led regulators to force most
OTC trades to be cleared through central counterparties (CCPs). CCPs act like
clearing banks, taking on their own books the risk of the seller
defaulting. Sellers clearing OTC trades through a CCP can (in theory) default
on payment without risking the entire system unravelling.
But this creates a problem. What
happens if a CCP fails? Of course, the way CCP-cleared OTC trades are
structured should minimize this risk. CCPs require sellers to post initial
margin in the form of cash or government bonds to cover expected volatility
during the lifetime of the trade, and they also require posting of variation
margin in cash to cover daily price movements. As everything is fully margined
in liquid safe assets, there should in theory be no shortfalls and no defaults.
But…..cash margin requirements
don’t necessarily make the system safer. Firms with largely illiquid balance
sheets, such as large insurance companies, can have difficulty raising the cash
to meet large increases in variation margin. The principal cause of the failure
of AIG in 2008 was cash margin calls on OTC credit default swaps that it
was unable to meet. And this brings me back to the question – what happens if a
CCP fails?"
