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A blog on financial markets and their regulation
Regulators of central counterparties (CCPs) seem to have learned a very tiny lesson from the crisis – their standards for CCPs has moved from the laughable to the incredibly lax. The old standard (CPSS-IOSCO Recommendations for Central Counterparties, November 2004) said:
If a CCP relies on margin requirements to limit its credit exposures to participants, those requirements should be sufficient to cover potential exposures in normal market conditions. (Recommendation 4)
In a paper last year, I wrote:
This is like telling a car manufacturer that if a car has brakes, then the brakes should be sufficient to stop the car under normal driving conditions. The implication being that a car need not have brakes and even if they do, the brakes need not be designed to work on a slippery road.
The new standard (CPSS IOSCO Principles for financial market infrastructures: Consultative report, March 2011 ) is a tiny improvement:
A CCP should cover its credit exposures to its participants for all products through an effective margin system that is risk-based and regularly reviewed. … Initial margin should meet an established single-tailed confidence level of at least 99 percent … (Principle 6)
So, now the regulators have gotten around to accepting that the car should have brakes, but the regulation on the effectiveness of the brakes is still incredibly lax.
A confidence level of 99% implies that there would be a margin shortfall every six months. Even if we take into account other resources of the CCP, this is an unacceptably high failure rate for an institution as systemically important as a CCP. In banking regulation, 99% was the accepted level in 1996 (Market Risk Amendment), but this increased to 99.9% in Basel II (2004). For derivative exchanges, I have argued that the margin coverage should be set at 99.95%, so that margins coupled with other CCP resources would allow the CCP to reach an acceptable level of safety.