CDS sellers pose bigger contagion risk than CCPs

Central counterparty clearing firms do not constitute a major source of systemic risk, a new study from the US Treasury shows, but large counterparties that are heavy net sellers of credit default swaps could pose a threat to the financial system, irrespective of the health of the clearinghouse.
A report on contagion in the CDS market by the Office of Financial Research found that CDS counterparties that are not direct members of CCPs, such as hedge funds, asset managers and insurers, pose the biggest risk to financial contagion, despite regulatory efforts to eliminate systemic risk by mandating vanilla contracts into central clearing.
"More attention should be paid to firms that are very large and have highly unbalanced CDS positions, whose failure can trigger large systemic losses even when the CCP does not fail," say the report authors Mark Paddrik, Sriram Rajan, and H Peyton Young.
Using data from the Depository Trust and Clearing Corporation, covering the 26 members of ICE Clear Credit - primarily dealers - and over 900 non-member firms including hedge funds, asset managers and insurance companies, the study found that the CCP's contribution to contagion under a stress scenario was lower than that of the largest member and non-member firms.
Contagion risk is largest for net sellers of CDS contracts. Under a stress scenario that triggers a sharp spread widening, CDS sellers can quickly find themselves facing a shortfall as the amount of variation margin they are required to pay out - typically within a matter of hours - can dramatically outstrip the amount owed to them, leading to missed or reduced payments that become amplified through the system.
"These payment deficiencies increase the stress on the firms' downstream counterparties, possibly leading them to reduce their payments too," said the report authors. "The upshot is network contagion."
The figures show that the five largest member firms faced an initial shortfall in variation margin of US $16bn under a Federal Reserve stress-test scenario. That is even greater for non-members, with the five largest non-member firms showing a US $9.4bn shortfall.
"A shortfall in payments by these firms can cascade into the network of broker-dealers, causing some of them to suffer payment shortfalls," said the report authors. "Under some scenarios, the contagion could bring down the CCP."
By contrast the CCP's stress position is flat, with margin owed by the clearinghouse equal to the margin owed to it.
The results may help to calm some concerns about the systemic nature of CCPs and their status as a central point of risk following new regulations forcing much of the US $544trn over-the-counter swaps market into clearinghouses.