Before the 2008 financial crisis, the emphasis of risk management leaned more toward credit risk, with liquidity being a secondary concern. However, during the crisis it became clear that liquidity, and the velocity with which it can evaporate, could render an entity unable to meet its contractual obligations. The events surrounding the crisis, in other words, pointed to liquidity risk as being an accelerant toward the ultimate default of a market participant.
The need to address this worrisome reality became a crucial goal for policy makers globally and a particular focus for the Bank for International Settlements and the International Organization of Securities Commissions (IOSCO). In 2012, IOSCO published a set of 24 principles, also referred to as the PFMIs, or Principles for Financial Market Infrastructures. These principles set standards spanning a wide range of risks relevant to central counterparties, such as OCC, including credit, operational, general business and liquidity risks.
The context was obvious: To the extent that a Systemically Important Financial Market Utility (SIFMU) like OCC is critical to the continuous functioning of our financial markets, it needs to be not only solvent from a credit perspective, but it also must have sufficient liquid resources to satisfy the funding commitments of its clearing firms.
Given the interconnectedness of financial markets, the failure of a CCP to fund its settlement obligations on time likely would have a ripple effect on the liquidity resources of its clearing members. This in turn would impact the clearing firms' ability to satisfy their obligations to other CCPs or counterparties. Because of the novation process and netting of settlements that occurs within a CCP, a single funding failure could impact all other clearing firms, creating the potential for a rapid escalation in to a systemic event.
Knowing this, policy makers established stringent expectations to drive the level of resiliency CCPs must maintain from a liquidity risk perspective. These expectations include:
- Same-day, and in some cases intraday, funding;
- A requirement to consider the failure of its largest participants and related entities, and;
- Plans for how to respond and operate under extreme, but plausible, market conditions.
In order to meet these obligations, CCPs began developing sophisticated risk management frameworks designed to identify, measure, monitor and manage the liquidity risk that could occur under a wide range of circumstances, including those that might otherwise be considered extreme tail events. Owing to an industrywide effort, CCPs are now using forecasting and stress testing as key tools to understand and estimate their liquidity risks under a variety of scenarios.
The most obvious risk event is the failure of a counterparty, but the varying ways in which defaults could occur does present challenges. Defaults can happen within a single legal entity, across related entities or even simultaneously with multiple counterparties. However, it cannot be assumed that more defaults are necessarily worse, as these scenarios can have both positive and negative impacts on the CCP's liquidity risk profile, so all combinations and correlations must be considered. For instance, failures can occur with clearing firms or with a bank where liquidity resources are in custody, preventing access to them.
Ultimately, it is a collection of multiple risk events that drive a CCP's aggregate liquidity risk. But with today's internal stress testing frameworks, a CCP can have a deep understanding of its risk, establish proper policies, drive incentives to mitigate the risks and demonstrate to key stakeholders that it has sufficient resources and controls.
For OCC, our new Financial Safeguards Framework builds on the previous enhancements to our financial resources and resiliency as a SIFMU. Indeed, over the last several years, we have significantly expanded and diversified our access to liquidity.
OCC has maintained and renewed our $2 billion committed credit facility from a consortium of banks, while reducing clearing member participation in such facilities to reduce concentration risk. OCC enhanced the availability of pre-funded financial resources by requiring a minimum of $3 billion in cash in the Clearing Fund, which is held at the Chicago Federal Reserve Bank. OCC also became the first and only SIFMU to add a new $1 billion non-bank committed credit facility with CalPERS, the largest U.S. pension fund.
Still, are we more prepared to withstand the next crisis when it happens? As the foundation for secure markets, we at OCC always have to consider extreme events.
To continue improving risk management in the markets, including liquidity risk management, we must support a principled approach to reduce regulatory arbitrage on an international level by evaluating the consistency with which international regulations have been adopted at a national level. Additionally, we should work with regulators on the importance of aligning central bank access for SIFMUs in the U.S. with that of their European counterparts. Finally, we should identify opportunities to align policy with risk reduction at a systemic level and promote incentives to support commercial or utility-based alternatives to enhance all SIFMUs' access to high quality liquidity alternatives.
At least some degree of liquidity risk will be with us for as long as there are financial markets. That's why OCC is always striving to improve our resiliency and be prepared for the what-if events - no matter how unlikely they may seem.
To learn more about OCC's thought leadership on industry issues, visit OCC's blog.
This blog was excerpted from remarks delivered by Mr. Fennell on October 23 to the 3rd Annual Liquidity Risk Management Summit in New York.