Hedging Against the Next Financial Crisis : Proposals for Managing Systemic Risk in Centrally Cleared Derivatives Transactions

In response to criticisms regarding the accumulation of systemic risk and lack of transparency in over-the-counter [“OTC”] derivatives markets, regulators have introduced new central clearing and reporting requirements for OTC derivatives transactions. However, the capacity of a central counter-party clearinghouse [“CCP”] to limit the short-term contagion risk of a systemic market event is contingent on a clear distinction between systemic risk and ordinary counter-party risk. This article explores the role of CCPs in providing short term liquidity designed to limit the contagion risk associated with a counter-party's default. In doing so, it recommends that regulators should consider the use of ex ante counter-cyclical regulatory capital requirements, impose buyer-side margins to buffer against contagion risk, limit the extent to which credit risk can be fractioned, and introduce behavioral regulations for central clearing participants to address the moral hazard that may result from market participants relying on the CCP guarantee to offset remote exposures