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Counter Party Risk – The Truth

February 12, 2018

Counter Party Risk – The Truth

Counter-Party Risk

Last week (2nd of February, 2018) ESMA (European Securities and Markets Authority) published the results of its second EU wide stress test for CCP’s (Central “Clearing” Counterparties). These tests are conducted under EMIR (European Markets Infrastructure Regulations) and were first published back in April 2016. There are sixteen CCP’s currently under this structure with around 900 clearing members, which includes multiple entries belonging to one group.

The result of this second test, under greater regulatory risk measures, found that using the test samples at different stages throughout 2017, two of the 16 would have problems under the credit stress test. Market volatility always acts as a platform for this kind of scenario so if they failed in 2017, what will they do in 2018! The volatility we forecast for this year should already be making you nervous.

Having years of actual trading experience, it is the fear that just one counterparty is experiencing problems occurs way before the clearing houses are even aware is what will drive volatility! The overnight repo market, collateral management triparty flow, and individual share price action are the early indicators of risk. Once these start to move you can forget about the end of day obligations to clearing counterparties, the money has already gone. There are always going to be problems when the derivative market sizes become multiples of the underlying.

This is how the credit risk is just pushed up the food chain. Initially, a brokerage is pushed up to the bank/exchange members, the exchange to other clearers and the bank pushed up to the central bank, the central bank is the currency. A collection of central banks (possibly the EU and the ECB) and exchanges results in global demand for the reserve currency. What could possibly go wrong!

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