TORONTO – Speaking at Sibos this week, Tim Lane, Deputy Governor of the Bank of Canada, emphasized that “sufficiently robust” central counterparties (CCPs) for the Canadian OTC derivatives market would strengthen Canada’s financial system and reduce the counterparty credit exposures of major participants. The question now for Canada, Lane wondered, is whether to go domestic or international.
Canada held up well following the financial crisis of 2008-09, but Lane noted that Canadians must be mindful of the country’s C$9 trillion OTC derivatives market. “OTC derivatives, especially interest rate swaps are closely connected via arbitrage and financing relationships with other markets in Canada, including other derivative, bond and money markets,” he said. “So that’s big enough and connected enough that any disruptions would likely result in significant reverberations through our markets.”
Moving to a CCP likely would reduce the complexity of the network, according to Lane. “Since CCPs, which interpose themselves between buyers and sellers in financial markets, concentrate risk by becoming the counterparty to all transactions, they must have stringent risk management standards and clear procedures for dealing with the eventuality of a member’s default,” he said.
To be safely cleared, OTC derivative contracts must be sufficiently standardized. Standardization also provides additional benefits, such as helping to create more liquid and transparent markets for the contracts, as well as setting the stage for shifting trading onto exchanges or electronic trading platforms.
Canada has appointed the Canadian Derivatives Clearing Corp. as its central counterparty in repo and fixed income transactions. But for OTC derivatives transactions, Canada is debating whether to employ a domestic or international provider of CCP services. “The solution we choose must come to grips with the systemic importance of OTC derivatives to Canada and the globalized nature of the market,” Lane said.
Clearing through large offshore CCPs can provide greater opportunities for netting and risk mutualization, but local Canadian brokers might only be able to obtain access through a direct clearing member, Lane explained. Although access is broadening, it was formerly limited to the world’s largest financial institutions, and these organizations still have considerable advantages and present their own share of risk. If any of the direct clearing members fail, it would pose risk to the other direct members as well as any organizations that clear indirectly through them. “It is essential to ensure that we do not unduly further concentrate risk in a relatively small number of institutions that are direct clearing members of global CCPs,” Lane said. “These were the very institutions that spread and amplified contagion through the global financial system in 2008.”
Conversely, a Canadian CCP would make it easier for Canadian authorities, such as the Bank of Canada, to intervene in the event of a financial crisis. A domestic CCP also could reduce the impact of international financial shocks on Canadian markets, and would be tailored to the Canadian financial system. “The key questions are whether a domestic CCP would be economically viable, and whether it would support financial stability and efficiency,” Lane said. “We know that much of the OTC market is global in nature and for a Canadian clearing service for OTC derivatives to be a success, wide participation of both Canadian and most likely global firms would be necessary. Without that, the risk is that the market would become fragmented. Market liquidity could decline, and a domestic CCP’s risk controls could be undermined.