Academic journal article Economic Perspectives

Public Policy and Central Counterparty Clearing

Academic journal article Economic Perspectives

Public Policy and Central Counterparty Clearing

Article excerpt

Good afternoon and thank you for joining us today to discuss some important issues related to central counterparty clearing. On behalf of the Federal Reserve Bank of Chicago (Chicago Fed), I want to thank our host and cosponsor of this conference, the European Central Bank (ECB). This has been a wonderful opportunity for us to discuss these issues with experts from around the world, and I hope that the participants here today have found these discussions helpful. The ECB and the Chicago Fed have worked together closely to plan the conference and agenda, and it has been a very good partnership.

Today, I'd like to share with you my thoughts about the important role that clearing and settlement institutions play in supporting financial markets. In particular, my remarks today will revolve around four key questions related to central counterparty clearing. First, what economic functions do central counterparties, or CCPs, perform in the clearing and settlement of financial transactions? Second, what alternative institutions can perform the same or economically equivalent functions? Third, what are the costs and benefits of using CCPs as compared with alternative clearing institutions? And fourth, what do these costs and benefits tell us about public policy decisions that should be made concerning CCPs and alternative institutions?

I do not expect to give definitive answers to these questions today. We just don't know enough to provide such answers. But I think that careful consideration of these issues is essential to formulating good public policy. The wide variation in financial market structures and the fast pace of financial and technical innovation mean there may not be a single, "first-best" clearing solution that meets the needs of all markets. So, as a practical matter, it is not possible to formulate public policy without facing fundamental and unavoidable tradeoffs when comparing alternative structures for the clearing and settlement of financial transactions. I'll elaborate on this theme in the course of my discussion.

Post-trade clearing and settlement are sometimes referred to as the "plumbing" of the financial system. This term may suggest that clearing and settlement systems are of secondary importance. In fact, however, they are more like the "central nervous system" of the financial system. (1) Clearing and settlement systems provide vital linkages among components of the system, enabling them to work together smoothly. As such, clearing and settlement systems are critical for the performance of the economy. A key role then for public policy is to ensure that these systems function well when confronted by a variety of stresses.

Centralized clearing arrangements utilizing CCPs have become more widespread in recent years, both for exchange-traded and over-the-counter (OTC) markets. This is no surprise, since they are extraordinarily good at what they do. As a consequence of this growth in CCP usage, central banks, securities regulators, and other financial market policymakers have cooperated in recent years to establish appropriate standards for the design, operation, and oversight of CCPs. This effort recently culminated in the Group of Ten (G-10) and International Organization of Securities Commissions' Recommendations for Central Counterparties. (2) The Federal Reserve Bank of Chicago actively participated in the consultative process leading to the adoption of the recommendations and related financial stability initiatives. (3)

In the U.S., the regulatory structure has evolved toward supporting a "hybrid" system of clearing and settlement. For securities transactions, Congress has mandated a "national market system," and the Securities and Exchange Commission has favored centralized clearing and settlement arrangements. But there is no such policy mandate for the derivatives industry. The U.S. thus provides a mixed example of the policy approach that I plan to focus on today. …

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