Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

The Baselization of CCPs

There was a time when central counter parties (CCPs) used robust and coherent risk measures. Way back in 1999, Artzner et al. could write that “We do not know of organized exchanges using value at risk as the basis of risk measurement for margin requirements” (Artzner, Delbaen, Eber and Heath (1999), “Coherent measures of risk”, Mathematical Finance, 9(3), 203-228, Remark 3.9 on page 217). During the global financial crisis, while Basel style risk management failed spectacularly, exchanges and their CCPs coped with the risks quite well. (I wrote about that here and here).

But things are changing as CCPs gear up to clear OTC derivatives. The robust risk management of CCPs is not percolating to the OTC world; instead, the model-risk infested risk measures of the OTC dealers are spreading to the CCPs. The OTC Space has a nice discussion of how the systems that CCP use to margin OTC derivatives are different from the systems that they use for exchange traded derivatives. No, the CCPs are sticking to expected shortfall and are not jumping into value at risk. But their systems are becoming more model dependent, more dynamic (and therefore procyclical) and more sensitive to recent market conditions. These are the characteristics of Basel (even with Basel’s proposed shift to expected shortfall), and these characteristics are gradually spreading to the CCP world.

I am not convinced that this is going to end well, but then CCPs are also rapidly becoming CDO-like (see my post here) and therefore their failure in some segments might not matter anymore.


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