How Can Stress Testing Be Improved to Better Account for the Interconnectedness of Ccps?

Concept

The global financial architecture underwent a fundamental redesign following the 2008 crisis. A core tenet of the reforms, mandated by the G20, was the expansion of central clearing for standardized over-the-counter (OTC) derivatives. This initiative successfully simplified the previously opaque and convoluted web of bilateral exposures, concentrating counterparty credit risk within a specialized set of institutions ▴ Central Counterparties (CCPs). In doing so, however, the nature of systemic risk evolved.

It shifted from a diffuse, tangled network to a concentrated, hub-and-spoke model where CCPs form the critical nodes. The safety of the entire financial system has become inextricably linked to the resilience of these key infrastructures.

Improving stress testing is therefore a matter of adapting our analytical frameworks to this new topology. The challenge lies in moving beyond the assessment of a single CCP’s resilience in isolation. The very structure of modern clearing creates deep and complex interconnections that traditional stress tests were not designed to measure.

A shock to the system does not impact CCPs as discrete entities; it propagates through a network of shared dependencies. Understanding this interconnectedness is the foundational step toward building a more robust testing regime.

The shift to central clearing has concentrated risk in the CCPs themselves, making them critical hubs in the global financial network.

The Fabric of Interconnection

To enhance stress testing, one must first deconstruct the channels through which risk can spread across the CCP ecosystem. These are not theoretical pathways; they are the operational realities of the global clearing system. The primary vectors of contagion include:

• Common Clearing Members ▴ A small number of large, global financial institutions act as clearing members across numerous CCPs. The FSB has noted that the largest clearing members are connected to between 16 and 25 CCPs. The default of one such member would not be an isolated event for a single CCP. It would trigger simultaneous, correlated stress events across every CCP to which that member belongs, creating a system-wide shockwave.
• Shared Service Providers ▴ CCPs do not operate in a vacuum. They rely on a concentrated group of other financial institutions to function. These include liquidity providers for cash needs, custodians for holding collateral, and settlement banks for the movement of funds. The failure of a key service provider, or even a significant operational disruption, could simultaneously impair the functioning of multiple CCPs that depend on it.
• Correlated Asset Holdings ▴ During a default, a CCP must liquidate the defaulter’s portfolio and collateral. When multiple CCPs are managing defaults triggered by a common market event, they may be forced to liquidate similar or identical assets into a stressed market. This coordinated selling pressure can amplify initial price shocks, creating a destructive feedback loop that exacerbates losses for all involved.

A stress test that fails to model these interdependencies examines a component without understanding the machine. It can confirm the strength of a single link while remaining blind to the fragility of the entire chain. The imperative, therefore, is to evolve our testing philosophy from a microprudential assessment of individual CCPs to a macroprudential analysis of the system as a whole.

Strategy

The strategic evolution of CCP stress testing requires a fundamental shift in perspective. The objective is no longer simply to answer, “Is this individual CCP resilient enough?” Instead, the critical question becomes, “How does the network of CCPs and their members respond to a system-wide shock?” This transition from a siloed to a systemic view necessitates a new strategic framework, one built on the dual pillars of comprehensive network analysis and coordinated, multi-CCP supervisory stress tests (SSTs). This approach acknowledges that the default of a major clearing member is not a localized problem but a contagion event that ripples across the global financial system.

The goal is to develop a macroprudential toolkit that allows authorities to see the financial system as it truly operates ▴ an intricate network of exposures and dependencies. By mapping these connections and then subjecting the entire map to a common, severe shock, regulators can identify hidden concentrations and potential amplification mechanisms that are invisible at the level of a single institution. This strategy moves beyond a simple pass/fail assessment of individual CCPs and toward a more sophisticated understanding of collective vulnerabilities.

A New Testing Doctrine

The transition to an interconnected stress testing strategy involves rethinking the core parameters of the exercise. The traditional approach, while valuable for assessing individual CCP risk management, is insufficient for the current market structure. A new doctrine is required, focused on systemic resilience.

The Core Strategic Pillars

System-Wide Network Analysis

Before a system can be stressed, it must be mapped. The foundational pillar of this advanced strategy is the rigorous analysis of the global clearing network. This involves collecting and aggregating data to create a comprehensive picture of all critical linkages. Key data points include:

• CCP-Member Links ▴ Identifying which members clear through which CCPs.
• Inter-Member Exposures ▴ Understanding the relationships between clearing members themselves.
• Service Provider Dependencies ▴ Mapping which CCPs rely on which settlement banks, custodians, and liquidity providers.

This mapping exercise, such as the analysis conducted by the FSB and other committees, provides the essential blueprint of the system. It reveals the most critical nodes ▴ both CCPs and clearing members ▴ whose failure would have the most widespread consequences. This analysis is not merely a data collection exercise; it is the intelligence that informs the entire stress testing process, allowing for the design of targeted, relevant scenarios.

Multi-CCP Supervisory Stress Tests

With a map of the network in hand, the second pillar is the execution of coordinated stress tests by supervisory authorities. A multi-CCP SST is designed to simulate a single, severe but plausible shock and observe its propagation through the entire ecosystem. Unlike a CCP’s internal stress test, which uses a “Cover 2” standard (surviving the default of its two largest members), a multi-CCP SST might simulate the default of a single, highly interconnected member and trace its impact across the 15 or 20 CCPs it belongs to. This provides insight into how risk diversifies or concentrates across the system and whether the collective resources of all affected CCPs are sufficient to absorb the shock without broader contagion.

Execution

Executing a stress test that properly accounts for interconnectedness is a complex, multi-stage process that requires deep coordination among supervisory authorities. The framework developed by the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) provides a detailed operational guide. The execution phase translates the strategy of systemic analysis into a concrete set of actions, moving from high-level objectives to granular data analysis and the generation of actionable risk metrics.

A multi-CCP SST could be designed to analyse concentrations of exposures to common participants, common risk factors or common dependencies on particular liquidity providers or other service providers.

A Playbook for Systemic Stress Testing

An effective multi-CCP supervisory stress test can be broken down into a sequence of deliberate components, each building on the last. This process ensures that the test is well-defined, the scenarios are robust, and the results are meaningful.

1. Purpose, Scope, and Governance ▴ The initial step is for authorities to clearly define the test’s objective. Is it designed to assess credit risk (loss allocation) or liquidity risk (payment shortfalls)? The scope must then be set, identifying the in-scope CCPs, which may span multiple jurisdictions. Crucially, robust governance and information-sharing agreements must be established to allow for the secure exchange of highly sensitive position and exposure data among the participating authorities.
2. Scenario Development and Calibration ▴ This is the analytical core of the exercise. It involves designing an extreme but plausible market event. This process includes several sub-steps:
   • Framing the Scenario ▴ A narrative is developed, such as a major geopolitical event or a sudden, sharp economic downturn that triggers the stress.
   • Identifying Core Risk Factors ▴ Authorities identify the key market indices, interest rates, or currency pairs that are central to the scenario.
   • Calibrating Shocks ▴ Shocks to these core factors are calibrated using historical data or forward-looking models to ensure they are both severe and internally consistent.
   • Specifying Defaults ▴ Based on the scenario, the test specifies the default of one or more entities. The most powerful tests for interconnectedness simulate the default of a large, global clearing member that is active across many of the in-scope CCPs.
3. Data Collection and Aggregation ▴ Authorities collect granular position data from all in-scope CCPs as of a specific reference date. The calibrated stress scenario is then applied to these positions to calculate profits and losses for every clearing member at every CCP. This data is meticulously aggregated, respecting each CCP’s specific netting rules, to determine the total loss that would be caused by the specified defaulter(s) at each CCP.
4. Analysis and Risk Metrics ▴ The final stage moves beyond a simple pass/fail. The analysis focuses on systemic metrics, such as the total drawdown of the global default fund pool, the number of CCPs that would exhaust their own capital, and the scale of losses that would be mutualized among surviving clearing members. This provides a clear picture of the system’s ability to withstand the shock collectively.

Illustrative Simulation the Default of a Global Systemically Important Member

To make this tangible, consider a hypothetical stress test simulating the sudden default of “Global Member A,” a clearing member at five major international CCPs. The analysis would quantify the cascading impact on each CCP’s loss-absorbing waterfall.

This type of analysis provides authorities with a holistic view. While each individual CCP might withstand the default by using its mutualized default fund, the test reveals the significant, simultaneous drain on the resources of surviving members across the entire system. It quantifies the interconnectedness and allows supervisors to assess whether the collective impact could trigger secondary defaults or broader market instability, a question that siloed stress tests cannot answer.

Reflection

From Component Resilience to Systemic Integrity

The evolution of stress testing from an individual to a systemic focus represents a maturation in our understanding of financial stability. The frameworks and methodologies now exist to model the complex web of interdependencies that define modern clearing. This capability moves the analysis beyond a simple verification of regulatory compliance for individual entities. It equips authorities with a dynamic model of the financial ecosystem, allowing them to probe for weaknesses and understand how shocks are transmitted and amplified.

The knowledge gained from these advanced tests is not merely an academic exercise. It is a critical input for constructing a more resilient financial architecture, one where the strength of the system as a whole is understood with the same rigor as the strength of its individual components. The ultimate objective is to ensure the continuity of critical market functions, even in the face of severe, system-wide distress.