Markets for CCPs and Regulation: Considering Unintended Consequences

Central clearing counterparties (CCPs) have become a cru- cial element of the financial architecture and as such they have lately attracted the attention of prudential authorities at the highest level emphasising their crucial, if not too well understood, role in the financial system, while also reflecting anxiety at imagining the possibility of a main clearing house failing during times of stress. Post Lehman directives and legislation, both in Europe and the U.S., have placed more emphasis on CCPs within the global financial system as a possible “fix” to derivatives related banking system risk. Many papers have argued for mutualisation of counter party risk, at various degrees, to better stave off another financial crisis, which may be driven, in particular, by derivatives trad- ing. In this paper issues related to regulation of this already heavily regulated industry are discussed in light of the in- surance industry literature, focusing on potential issues that may arise from various efforts to “solve counterparty prob- lems” with greater regulation or legislative directive. Raising concerns about the unintended consequences of particular forms of socialization or regulation of CCPs, the work intends to highlight possible side effects of centralized or monopoly (either from regulation or fiat) systems for counterparty clear- ing that may (will likely) lead to greater, not less, systematic risk in ways not foreseen in any potential legislation. To do so, the authors build several simple conceptual structures of markets for CCPs and discuss various profit maximiz- ing structures that may be taken by a CCP under different conditions with allusion to the insurance industry. What becomes clear from the discussion is that the various busi- ness models will lead to complexities not easily anticipated and understood due to the interactions of many different economic agents. Regulation, both existing and potential, quickly complicates the various business relationships that allow markets to function and various products and agents to interact at all levels. Simple solutions to the systematic is- sues raised by the financial crisis via regulation or legislation can have far from simple implications for the stability of the system as a whole.