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Why a SIFMU Must Always Manage Liquidity Risk

Traders Magazine Online News, November 12, 2018

John Fennell

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: 

  1. Same-day, and in some cases intraday, funding;
  2. A requirement to consider the failure of its largest participants and related entities, and;
  3. 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.

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