LO 76.2: Assess whether central clearing has enhanced financial stability and

LO 76.2: Assess whether central clearing has enhanced financial stability and reduced systemic risk.
With central clearing, OTC exposures net of collateral between key banks have fallen to a small percentage of bank equity. The initial conclusion is that there is reduced insolvency and contagion risk, because CCPs have removed counterparty risk.
However, there needs to be a consideration of unrealized (non-cash) losses impacting solvency versus realized (cash) losses impacting liquidity. Liquid assets would consist of cash or securities that are easily converted to cash. In short, there are some situations whereby a firm may be solvent but illiquid or insolvent but liquid. A solvent (insolvent) firm simply has total asset values that are higher (lower) than total liability values. A liquid (illiquid) firm has total liquid asset values that are higher (lower) than total short-term liability values.
A firm may become insolvent due to a default by a large counterparty, whereby the decline in asset value is greater than the equity value. However, if that firm has sufficient liquid assets to cover its short-term liabilities, then the insolvency will not immediately impact the firms ability to continue operating. In contrast, if a firm is in default on any payment required in the short-term (i.e., one day for a margin call), then there is a liquidity problem.
In practice, capital requirements to protect against declines in asset values are used to protect against insolvency. The use of short-term repurchase agreements (repos) and borrowing against the value of assets is used to protect against illiquidity. Unfortunately, it is still possible for lenders to call existing loans or abstain from future lending (resulting in a liquidity problem known as a bank run) even if the firm has excess capital and is considered solvent.
In short, central clearing has certainly enhanced financial stability and reduced systemic risk, but it has not completely eliminated systemic risk.
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2018 Kaplan, Inc.
Topic 76 Cross Reference to GARP Assigned Reading – Cont
Tr a n s f o r m in g C o u n t e r pa r t y Ris k t o Liq u id it y Ris k

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