Central counterparties — New uses for a century-old market mechanism

Central counterparties have been the preferred mechanisms used to share the risk of funding financial instruments between financial institutions and between financial institutions and their customers. With the inevitable next crisis looming, regulators have turned to a century-old concept to do what no government wants to do — guarantee that enough capital will be there the next time markets collapse. To do this regulators and industry members are embedding central counterparty mechanisms into all manner of interconnected risk: securities lending; the repo markets; and the swaps, credit default swap (CDS) and other over-the-counter (OTC) derivatives markets. Will it be a better guarantee than the too-big-to-fail concept of governments? Will it work better than the living will doctrine that regulators are imposing on systemically important financial institutions to assist in their breakup? With more risk now concentrated in central counterparties the inevitable question arises, are those entities now too big to fail? This paper explores this question and suggests that innovations are to be expected in managing the risk of too-big-to-fail central counterparties.