1 Introduction
At the 2009 G20 Pittsburgh Summit, global leaders agreed that over-the-counter (OTC) derivatives should be standardized and routed through central clearing counterparties (CCPs or clearing houses). This move aimed at mitigating the risk that these instruments posed to financial stability (G20 Leaders Statement, 2009; Stafford, Reference Stafford2017, Reference Stafford2018; ISDA, 2021). OTC derivatives – especially credit default swaps – played a major role in the 2008 global financial crisis (FCIC, 2011). Thus, in the period between the bankruptcy of Lehman Brothers on 15 September 2008 and the G20 Pittsburgh Summit that started on 24 September 2009, pressure had mounted on G20 leaders to address the safety and transparency of OTC derivatives markets.
Derivatives are financial instruments (or contracts) whose value derives from the value of underlying assets and variables (Hull, Reference Hull2021, p. 23).1 Professional investors use derivatives for three main reasons: to hedge against potential losses in investment portfolios; to speculate on the future direction of asset prices and variables; and to arbitrage between the values of two or more securities (Hull, Reference Hull2021, pp. 33–39).2 Since the late nineteenth century, derivatives trading has occurred on both organized exchanges and OTC markets (Swan, Reference Swan1999). Organized exchanges are regulated marketplaces where market participants buy and sell standardized contracts. Trades and risk are managed centrally through CCPs. By contrast, before the post-2009 reforms, OTC derivatives markets were self-regulated spaces where investors traded non-standardized derivatives (often complex ones) bilaterally, without channelling them through clearing houses (Hull, Reference Hull2021, pp. 24–27). By the early 2000s, OTC derivatives trading had expanded dramatically more than trading on organized exchanges had (see Figure 21.1).3 OTC derivatives markets had become a vast, opaque, and decentralized network connecting the trading floors of major financial organizations (Schinasi et al., Reference Schinasi, Craig, Drees and Kramer2000, pp. 9–30). Quite tellingly, Frank Partnoy (Reference Partnoy2009, p. 18) referred to OTC derivatives markets as the ‘wild Wild West of trading’, because in these opaque, decentralized, and practically unregulated markets traders benefited from designing a large range of bespoke derivatives contracts that were not available on organized exchanges. However, despite such benefits, OTC derivatives markets entailed a significantly higher level of risk compared to organized markets (Steinherr, Reference Steinherr2000).
Figure 21.1 National amount (US$ billions) of financial derivatives on global OTC markets and organized exchanges, 1998–2011.
In this chapter, we delve into the transformative measures implemented by policymakers and regulators to improve security and transparency in OTC derivatives markets following the 2009 G20 Pittsburgh Summit. We explore how these efforts substantially increased the ‘infrastructural authority’ (Genito, Reference Genito2019) that CCPs traditionally held over exchange-traded derivatives, which represented a smaller segment of global derivatives markets. According to Genito (Reference Genito2019), the concept of infrastructural authority refers to the ability of CCPs, as private organizations, to influence derivatives trading through their clearing and settlement services.4 As policymakers and regulators pushed for the central clearing of OTC derivatives, CCPs expanded their influence beyond exchange-traded derivatives, encompassing the majority of global derivatives trading. Importantly, while this process enhanced the transparency and safety of derivatives markets, it also transformed CCPs into what has been termed ‘the new too-big-to-fail institutions’ (Stafford, Reference Stafford2017) of global finance.
Our chapter is structured as follows. In the next section, we examine the infrastructural authority of CCPs before the 2009 reforms. We then trace the expansion of CCPs’ infrastructural authority resulting from the post-2009 reforms. After that, we study the implications of CCPs’ heightened infrastructural authority for financial stability. Finally, we conclude with an overview of our analysis and a call for regulators and policymakers to take into consideration the ‘infrastructural properties’ (Campbell-Verduyn, Goguen, and Porter, Reference Campbell-Verduyn, Goguen and Porter2019, p. 928) of CCPs.
2 CCPs’ Infrastructural Authority over Exchange-Traded Derivatives before 2009
Derivatives were historically traded on both organized exchanges and OTC markets (Swan, Reference Swan1999). Exchange-traded derivatives have a long history tracing back to commodity futures trading in the United States during the late nineteenth century (Levy, Reference Levy2006). US commodity exchanges such as the Chicago Board of Trade and the Chicago Mercantile Exchange (CME, or Merc) established the foundations of modern-day derivatives trading as a risk management business that included standardized contracts, open outcry trading pits (today almost completely replaced by electronic trading), the possibility to close out trades through cash settlement without commodity delivery, and, most importantly for the purpose of this chapter, the practices and technologies of central clearing (Moser, Reference Moser and Telser2000; Millo et al., Reference Millo, Muniesa, Panourgias and Scott2005; Levy, Reference Levy2006; Pinzur, Reference Pinzur2016). In the early 1970s, organized exchanges expanded their business beyond commodity derivatives to include the trading of futures and options contracts on financial derivatives (Markham, Reference Markham1987).
Central clearing is the major benefit of trading derivatives on organized exchanges. It mitigates counterparty risk and provides a transparent platform for clearing, settlement, and reporting trades. Crucially, central clearing is the socio-technical construct through which CCPs historically exerted their infrastructural authority over exchange-traded derivatives (Genito, Reference Genito2019). Central clearing is legally based on counterparty substitution through ‘novation’, which means that a CCP becomes the counterpart in each trade, selling derivatives contracts to buyers and buying them from sellers, while also clearing and settling such contracts (Loader, Reference Loader2020). CCPs have several firewalls to protect against possible defaults of participating members. The margin system is the first and most important firewall (Norman, Reference Norman2011).
In the margin system, the clearing house collects liquid collateral – for example, sovereign bonds and cash-like instruments – from traders, and such collateral is used in case of default to make up for financial losses (Genito, Reference Genito2019, pp. 945–946). In derivatives markets, the margin system includes the initial margin paid into the investor’s account to enter the market; the variation margin, which reflects the daily gains and losses between traders; and the maintenance margin as the lowest amount an account can reach before a margin call is issued asking a trader to bring the margin back to the initial amount (Hull, Reference Hull2021, pp. 51–52). Should the margin requirements be exhausted, CCPs can also resort to other firewalls such as default funds and, in the last instance, their own capital (LCH, 2024).
The key point is that, contrary to bilateral trading, CCPs allow investors to be individually exposed only to the clearing house, which uses multilateral netting to sum up investors’ multiple transactions (Genito, Reference Genito2019, pp. 944–945). CCPs use the ‘matched book’ to offset a position taken on with one counterparty with an opposite position taken on with another counterparty (Rehlon and Nixon, Reference Rehlon and Nixon2013, p. 2). In a word, central counterparty clearing replaces multiple risk exposures among investors with a centralized network in which clearing participants are only individually exposed to the CCP (Domanski, Gambacorta, and Picillo, Reference Domanski, Gambacorta and Picillo2015, p. 60). Thus, clearing houses can reduce market risk by matching all positions and offsetting losses against the buyer with gains from the seller. However, as we show later in this chapter, CCPs are themselves vulnerable to the risk of counterparty default.
Thus, CCPs traditionally exerted infrastructural authority over exchange-traded derivatives through the practices and technologies of central clearing. CCPs replace by means of novation the buyers and the sellers of derivatives contracts in organized exchanges. In so doing, CCPs become legally responsible for all contractual obligations. Furthermore, CCPs both enable the trading of derivatives instruments and constrain it through the imposition of margins and the posting of collateral (Genito, Reference Genito2019, p. 950).
Unlike organized exchanges, OTC markets before 2009 were decentralized networks of financial organizations tailoring derivatives instruments to fit certain requirements of their clients (Schinasi et al., Reference Schinasi, Craig, Drees and Kramer2000). Derivatives were privately negotiated between two parties without using CCPs – for example, a bank selling an interest rate swap to a local authority that wants to optimize liability costs (Hendrikse and Sidaway, Reference Hendrikse and Sidaway2013; Lagna, Reference Lagna2015). Just like derivatives trading on organized exchanges, OTC derivatives markets have a long history. For example, during the 1950s options dealers advertised premiums for equity options in the Wall Street Journal and the New York Times (Options Institute, 1995, pp. 6–7). A turning point in the history of OTC derivatives markets occurred in the 1980s when the growing use of swaps contracts marked the expansion of OTC markets (Bryan and Rafferty, Reference Bryan and Rafferty2006).
One of the first swaps was introduced in 1981 with a famous agreement between IBM (International Business Machines Corporation) and the International Bank for Reconstruction and Development (World Bank Group) (Kapur, Lewis, and Webb, Reference Kapur, Lewis and Webb1997, p. 1035). Initially, a group of big banks structured bilateral swap deals, but soon these banks realized the fee-earning potential and started acting as market makers (Geisst, Reference Geisst2002, p. 250). In 1985, they established the International Swaps and Derivatives Association (ISDA) to represent the swaps industry (ISDA, 2024). From this point onwards, swaps became the fastest growing derivatives sector, with companies using them to hedge the risk exposures to interest rates and exchange rates (Markham, Reference Markham2002, p. 192). Moreover, customized swaps became the perfect unregulated instruments that corporations ‘could use […] to avoid regulation or to hide risks’ (Partnoy, Reference Partnoy2009, p. 47). Governments and local authorities also joined the swaps market for their debt management activities, becoming important clients of major investment banks that were packaging and selling swaps (Hendrikse and Sidaway, Reference Hendrikse and Sidaway2013; Lagna, Reference Lagna2015, Reference Lagna2016).
By the time of the 2008 global financial crisis, OTC derivatives markets had expanded dramatically compared to organized exchanges (see Figure 21.1). Importantly, such expansion was built upon the self-regulation of derivatives dealers (Group of Thirty, 1993; Pagliari, Reference Pagliari2012; Tsingou, Reference Tsingou2015). To be sure, several self-regulatory initiatives were developed to minimize risk. Notably, derivatives contracts were subject to the ISDA Master Agreement, which outlines the terms and conditions for parties engaging in OTC derivatives transactions. The ISDA Master Agreement reduced investors’ concerns with counterparty risk concentration in large financial organizations (Lockwood, Reference Lockwood, Helleiner, Pagliari and Spagna2018). However, despite the ISDA Master Agreement, OTC derivatives markets ultimately functioned in a decentralized manner without CCPs mitigating risk and ensuring transparency. As Schinasi et al. (Reference Schinasi, Craig, Drees and Kramer2000, p. 19) aptly explained:
OTC derivatives markets exist on the collective trading floors of the major financial institutions. There is no central mechanism to limit individual or aggregate risk taking, leverage, and credit extension, and risk management is completely decentralized […] There is no centralized trading, clearing, or settlement mechanism in OTC markets. Transparency is generally limited as well […] Information about market concentration and who owns which risks is generally unavailable; at best, a trading desk might know that some institutions are building up positions.
Eventually, the collapse of Lehman Brothers on 15 September 2008, and the ensuing global financial crisis, dealt a major blow to OTC derivatives markets. Credit derivatives – and OTC derivatives more broadly – were at the root of the crisis and necessitated radical reforms (G20 Leaders Statement, 2008, p. 7). It was clear that the decentralized practices of risk management and the ISDA Master Agreement failed to prevent the accumulation of counterparty risk in large financial organizations like Lehman (Parker and McGarry, Reference Parker and McGarry2009). Soon enough, the attention of policymakers and regulators turned to central clearing as useful to make OTC derivatives markets safer and more transparent. In Section 3, we turn to these regulatory actions and how they augmented the infrastructural authority of CCPs.
3 Augmenting the Infrastructural Authority of CCPs
Following the 2009 G20 Pittsburgh Summit, several crucial reforms were implemented, including: (1) the central clearing of standardized OTC derivatives; (2) organized trading of standardized OTC derivatives (where possible); (3) reporting of OTC derivatives trades to data repositories; and (4) higher capital and minimum margin requirements for non-cleared OTC derivatives (ISDA, 2021, p. 3). In a word, such reforms rethought the historical distinction between organized derivatives markets and OTC derivatives.
CCPs rose to prominence in the aftermath of the 2008 global financial crisis when LCH.Clearnet, which in 2016 renamed itself LCH, successfully handled the default of Lehman Brothers. Lehman Brothers used LCH.Clearnet to clear trades. Lehman’s collapse on 15 September 2008 left a multitrillion-dollar exposure on LCH.Clearnet’s books (De Teran, Reference De Teran2008; Norman, Reference Norman2011, p. 26). By October 2009, LCH.Clearnet settled Lehman’s positions without having to rely on its default fund (Gregory, Reference Gregory2014, p. 43). In other words, LCH.Clearnet prevented any of its clearing members from incurring financial losses stemming from Lehman’s defaulting positions. This specific event helped consolidate the regulatory and policy-making consensus on leveraging the practices and technologies of CCP to make the central clearing of OTC derivatives mandatory – in so doing, improving the transparency and stability of these complex financial markets (Lee, Reference Lee2010; Wendt, Reference Wendt2015).
Mandatory clearing of OTC derivatives was introduced in the USA with the 2010 Dodd-Frank Act and in the European Union (EU) with the 2012 European Market Infrastructure Regulation. The Committee on Payments and Settlements Systems – later renamed the Committee on Payments and Market Infrastructures – and the International Organization for Securities Commission were mandated to establish international standards to supervise and regulate CCPs (Helleiner, Reference Helleiner, Best and Gheciu2014, p. 80; Thiemann, Reference Thiemann, Braun and Koddenbrock2023, p. 139). Following these regulatory actions, by the second quarter of 2017, the portion of interest rate swaps cleared through CCPs represented 88.5% of the traded notional amount for such instruments. Cleared credit default swaps accounted for 79% of the notional amount (ISDA, 2017). As of the first quarter of 2023, cleared interest rate swap transactions comprised 78.4% of the total traded notional amount, while cleared credit derivatives transactions accounted for 87.4% of the traded notional total (ISDA, 2023).
Thus, prompted by G20 leaders and their objective to reduce the risk that OTC derivatives trading posed to financial stability leading up to the 2008 financial crash, policymakers and regulators profoundly reshaped OTC derivatives markets by introducing the system of central clearing (BIS, 2016, p. 5). As a result, CCPs – and particularly the world’s largest clearing houses such as LCH, CME Clearing, and Eurex Clearing – have increased their infrastructural authority considerably, superintending a broad swathe of global derivatives trading through counterparty substitution and margin requirements. Whereas during the self-regulatory era, OTC derivatives users were relatively free to negotiate and customize the terms of contracts, now they must accept standard practices imposed by CCPs – above all, the collateral-based margins (Genito, Reference Genito2019, p. 950).
4 Central Counterparty Clearing and Financial Stability
What are the implications of CCPs’ infrastructural authority for financial stability? Let us focus on two dimensions: risk concentration in CCPs and the impact of CCPs’ margins on market liquidity. Both dimensions have the potential to render the infrastructural authority of CCPs more visible to the wider financial system and economy, in the sense that market participants would become fully aware of CCPs’ operations in the event of a financial meltdown caused by those clearing practices and technologies that are usually hidden in the background (Genito, Reference Genito2019, p. 942). Such CCP-led crises could result in state actors reining in the infrastructural authority of clearing houses.
4.1 CCPs and Risk Concentration
Mandatory clearing shifted exposure to derivatives risk from large banks to CCPs (Banque de France, 2010, p. 34). This shift transformed CCPs into too-big-to-fail institutions (Stafford, Reference Stafford2017). CCPs became central to OTC derivatives markets due to their ability to reduce counterparty risk by means of a matched book, multilateral netting, and collateral-based margin requirements. However, CCPs still suffer from risk concentration, namely an exposure to counterparty risk that is significant enough to impact financial stability negatively (Moscow, Reference Moscow2007, p. 44; Domanski, Gambacorta, and Picillo, Reference Domanski, Gambacorta and Picillo2015; Gracie, Reference Gracie2015, p. 2; Wendt, Reference Wendt2015).
Concentrating a large amount of exposure to OTC derivatives in a few clearing houses increases the possibility that the clearing members are unable to meet margin calls and ultimately default. If the CCP were to go bust, such defaults could cause problems for one or more CCPs and the entire financial system (Domanski, Gambacorta, and Picillo, Reference Domanski, Gambacorta and Picillo2015, pp. 60–68). Such risk exposure is also heightened by the interconnected nature of central counterparty clearing. CCPs have contractual relationships with the same clearing members – that is, systemically important financial organizations and major contributors to CCPs’ financial resources. Because of this interconnectedness, if a large clearing member defaulted, such an event is likely to affect multiple CCPs (FSB, 2017; Genito, Reference Genito2019, p. 953). In addition, so-called interoperability agreements between two CCPs – which entail a cross-system execution of transactions – further expose different CCPs to one another and to each other’s clearing members (ESMA, 2016; Genito, Reference Genito2019, p. 954).
As we explained, clearing houses have built several firewalls to protect themselves against counterparty risk. Collateral-based margin requirements are the most important line of defence. Despite these protections, there are three well-documented cases of CCPs that shut down in the past: Caisse de Liquidation des Affaires en Marchandises à Paris in 1974, the Kuala Lumpur Commodity Clearing House in 1983, and the Hong Kong Futures Exchange Clearing Corporation in 1987. All three cases occurred because clearing members failed to meet margin calls in a context of market distress, while clearing houses had insufficient default funds (Hills et al., Reference Hills, Rule, Parkinson and Young1999; Gregory, Reference Gregory2014, p. 267; Bignon and Vuillemey, Reference Bignon and Vuillemey2017). Now that CCPs have become too-big-to-fail institutions (Stafford, Reference Stafford2017), regulators and policymakers are addressing key questions concerning the vulnerabilities of CCPs, many of which were raised already in the aftermath of the 1987 US stock market crash, an event in which clearing houses – notably, the Chicago-based Options Clearing Corporation – weathered the storm rather well. That event also laid bare the structural problem of central clearing. In 1990, Ben Bernanke (Reference Bernanke1990, pp. 143–144) explained the structural problem in the following words:
In general, insurance arrangements are not able to cope completely with systematic [sic] risk. It is not possible, for example, to insure property against damage caused by a major war. For the same reason, while a conservative clearing house might try to prepare itself for even a very large shock, there must be some eventualities for which, ex ante, insurance is just too costly. The issue then becomes, what if a shock so large as to be judged nearly impossible ex ante actually occurs? What are the mechanisms to minimize the damage to the functioning of the market ex post? Let us put aside the possibility of government intervention for the moment. Then there seems to be a potential structural problem with the clearing house arrangement.5
Almost forty years later, that structural problem has yet to be solved, leaving policymakers and regulators in search of solutions that do not exist once the possibility of direct state intervention is removed (Thiemann, Reference Thiemann, Braun and Koddenbrock2023, pp. 138–140).
4.2 CCPs and Market Liquidity
Besides raising important questions concerning systemic risk, CCPs can also negatively impact market liquidity in times of crisis. The 1987 stock market crash already exposed this problem. As CCPs of future markets in Chicago asked for over US$4 billion in variation margins during two days, they were criticized for reducing liquidity during the crisis (Bernanke, Reference Bernanke1990, p. 147; Genito, Reference Genito2019, pp. 954–955).
The risk of CCPs impacting market liquidity is clearly shown in the case of the Eurozone debt crisis, particularly during the 2010–2012 period. Such events did not concern derivatives markets, but rather the market for repurchase agreements (repo), which are short-term funding tools for banks and non-bank financial actors using sovereign bonds as collateral (Gabor, Reference Gabor2016). As a major clearing house operating in the European repo market, LCH.Clearnet destabilized European sovereign-debt markets by increasing margins on Irish, Portuguese, Spanish, and Italian government bonds as repo collateral. LCH.Clearnet issued margin calls that forced banks to sell the sovereign bonds. These sell-offs resulted in bond yield hikes and widening bond yield spreads (Gabor and Ban, Reference Gabor and Ban2016, p. 631; Genito, Reference Genito2018, pp. 214–271; 2019, p. 955; Genito and Lagna, Reference Genito and Lagna2024).
5 Conclusion
In this chapter, we showed how the regulatory actions following the 2009 G20 Pittsburgh Summit bestowed considerable infrastructural authority on CCPs. First, we analysed how, before 2009, CCPs had limited infrastructural authority on global derivatives trading because they oversaw only exchange-traded derivatives. We then examined how policymakers and regulators enabled the expansion of CCPs’ infrastructural authority following the post-2009 reforms. Such authority hinges on the mandatory clearing of OTC derivatives, counterparty substitution by means of novation, and CCPs’ use of collateral-based margins. Finally, we delved into the implications of CCPs’ increased infrastructural authority for financial stability, specifically regarding the concentration of systemic risk in a limited group of CCPs and the potential impact of CCPs’ margin calls on market liquidity.
The post-2009 reforms of OTC derivatives markets were a double-edged sword. On one hand, they placated political pressure to reform global finance after the 2008 great crash by increasing the infrastructural authority of CCPs in global derivatives markets. On the other hand, such reforms concentrated risk in CCPs and did not consider the negative impact that CCPs’ margins may have on market liquidity. Policymakers and regulators have tried to address the structural problem of CCPs’ risk concentration – for example, through the recovery and resolution of failing CCPs (Regulation (EU) 2021/23, 2020). However, these regulatory actions ‘stand in for a solution which de facto cannot be found’ (Thiemann, Reference Thiemann, Braun and Koddenbrock2023, p. 141). In case of a low-probability/high-impact market event, CCPs would require state intervention in the form of liquidity injection by central banks (Thiemann, Reference Thiemann, Braun and Koddenbrock2023, p. 141). Furthermore, while the systemic risk of a failing CCP has been at least considered, policymakers and regulators have not significantly explored the negative impact that CCPs’ margins can have on market liquidity (Genito, Reference Genito2019, p. 955; Genito and Lagna, Reference Genito and Lagna2024).
The debate on CCPs’ growing centrality in global finance and their impact on financial stability continues. We can only hope that viable solutions will be found before we are confronted with another tail event in global financial markets. Finding viable solutions requires thinking carefully about the ‘infrastructural properties’ (Campbell-Verduyn, Goguen, and Porter, Reference Campbell-Verduyn, Goguen and Porter2019, p. 928) of CCPs to avoid ending up in a game of Whac-A-Mole, in which regulatory actions unintentionally create new systemic risks.
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