Central counterparty not the “silver bullet” for OTC credit derivatives market

The Senate Banking, Housing and Urban Affairs Committee held a hearing on “Reducing Risks and Improving Oversight in the Over-The-Counter (OTC) Credit Derivatives Market.” Chairman Jack Reed (D-R.I.) and Ranking Member Wayne Allard (R-Colo.) oversaw the hearing. Both senators agreed that the OTC credit derivatives market poses many risks to different sectors of the U.S. economy, including the financial system. Reed said that regulators have been coordinating efforts since 2002 to reduce these risks, but have not made enough progress and have become “too complacent” in their efforts.

Patrick Parkinson, the Deputy Director of the Federal Reserve Board’s Division of Research and Statistics, said that the use of credit derivatives entails risks as well as benefits. He explained that a central counterparty (CCP) is an entity that offers to interpose itself between counterparties to financial contracts, becoming the buyer to the seller and the seller to the buyer. Parkinson said that a CCP has the potential to reduce counterparty risks to OTC derivatives market participants and risk to the financial system by achieving multilateral netting of trades and by imposing “more-robust” risk controls on market participants. Parkinson also said that supervisors and other policymakers should encourage the introduction and use of well-designed CCP clearing services for credit derivatives and should encourage greater standardization of contracts, which would facilitate more trading on exchanges.

James Overdahl, the Senior Economist at the Securities and Exchange Commission, explained the Securities and Exchange Commission’s efforts to encourage sound risk management practice and enhance the infrastructure in the OTC credit derivatives market. Overdahl said that establishing a CCP for credit default swaps is an important step in reducing systemic risk and achieving greater operational efficiency in the market. However, Overdahl also said that while it provides a number of potential benefits, a CCP for credit derivatives or any OTC derivatives contracts is subject o substantial challenges and should not be viewed as a “silver bullet.”