Examining the Causes of Historical Failures of Central Counterparties

Sean Dowling and Sebastien Printant in this RBA Bulletin Article:

Although historically rare, the failure of a central counterparty (CCP) could severely disrupt and destabilise the financial system. This has driven a global push to implement resolution regimes so that authorities can support the continuity of critical functions of a distressed CCP. This article examines 3 CCP failures to identify common causes of failure that could help authorities prevent or prepare for a resolution. It finds that while there are some common causes of failure in the episodes considered, they have largely been addressed by improvements in CCP financial risk management in recent years.

The 3 CCP that failed were:

• Caisse de Liquidation des Affaires en Marchandises (1974)
• Kuala Lumpur Commodities Clearing House (1984)
• Hong Kong Futures Exchange (1987)

The three common causes for failure are:

This article identified 3 factors that were highlighted by the failures of the 3 CCPs examined. First, the CCP had a particular make-up of participants and clients which left them vulnerable to the consequences of major price movements. Second, perverse incentives for the CCPs led them to behave in ways that departed from appropriate financial risk management. Third, the CCPs had inadequate regulatory supervision and oversight. These factors, combined with a rapid unwinding of a large price increase, resulted in the CCPs’ failure.

These factors have, to a large extent, been mitigated by modern CCP risk management frameworks and stronger supervision, including through the implementation of the PFMI. However, CCPs are often systemically important and their failures could be sudden. It is therefore important for CCP supervisors and resolution authorities to remain vigilant to these factors, as well as emerging factors, which could cause a CCP failure. It will continue to be important that CCP supervisors and resolution authorities explore possible factors that could lead to a CCP failure, how to mitigate these factors, and how these factors might influence a possible CCP resolution.