Central counterparty clearing (CCP) firms are integral to market structure – mitigating and centralizing counterparty credit risk, meeting margin requirements and much more. Without these organisations managing risk between counterparties, the failure of a single firm could create a domino effect that could rip through markets, pushing the global financial system to the brink.

So far, thankfully, we have broadly avoided this scenario. Yes, there have been crises and near misses, but we have so far avoided a meltdown scenario in which CCPs buckle as risk management infrastructure crumbles under the weight of market stress. The problem is, markets are entering an extraordinary period. At the end of 3rd April, the markets gave their verdict on ‘Liberation Day’ and $2.5tn was wiped off global stock markets, pushing investors into uncharted territory. This is putting CCP’s risk models – the safety net for CCPs and the counterparties they serve – to the test.

The risk models on which many CCPs rely are typically built on the assumption of much calmer market conditions. Historic Value-at-Risk (HVAR), Expected Shortfall (ES), or Monte Carlo models are widely used, using historical precedent to quantify and mitigate against the maximum expected losses over a given period, based on past scenarios and crises. But as escalating tariffs whip up volatility and ratchet market stress, CCPs – the centre of the global financial system – must be bulletproof. Any weakness threatens not only the integrity of individual CCPs but the system itself.

Shaky guardrails

Just because the dam hasn’t breached yet, doesn’t mean that it won’t in future. As I write this, it does not look like the US or its trading partners intend to back down in the escalating trade war. The question for global participants is: as the intensity and frequency of risk events increase, how can historic models mitigate against unprecedented market conditions, and what can CCPs do to enhance their models?

Other participants have recognised the shortcomings of HVAR, spurred by the increasing frequency of crisis events in recent years – from Covid to Archegos, SVB and persistent inflation. One particular aspect where HVAR falls short is its inability to capture tail risk – the extreme but plausible market moves that lie beyond the confidence threshold. While HVAR tells you the maximum expected loss under normal conditions, it says nothing about the magnitude of losses once that threshold is breached.

The Trump administration’s sweeping imposition of large and unpredictable tariffs presents another level of magnitude. They have ripped up supply chains and uprooted business models on which multinational firms have been built, rattling markets as investors raced to liquidate billions in assets.

For CCPs, the primary concern in extremely volatile markets is the simultaneous impact on liquidity and the increased risk of margin calls – putting market structure firms on the front line in the fight against contagion. Miscalculating this volatility and default risk can lead to under-collateralised CCPs, substantially increasing counterparty risk. Worst case, outright failure of a CCP could trigger a wave of defaults across the financial system leading to failure at a systemic scale.

The tools, data and capabilities to enhance the risk practices exist. However, in the current environment, there is no external pressure at a regulatory or industry level for these organisations to adopt more robust risk models. It is incumbent on CCPs to self-regulate to protect their own future and safeguard the financial system.

Fail to prepare, prepare to fail

The recent tariffs mark the biggest change to global trade in 100 years, but the system it has been imposed on is far more complex than that of the 1930s protectionism era. Their impact will take weeks, months or even years to fully materialise. With so many unknown unknowns and the prospect of long-term uncertainty, participants must be prepared for the worst.

CCPs must examine the risk practices to ensure that they can withstand the most extreme market conditions. Historical scenario stresses – even those based on the most consequential crises in modern history, like the GFC – are unlikely to prepare CCPs for the worst impacts of a global trade war. As the world braces for a tumultuous new era, the use of historical data in sophisticated risk models should be consigned to history. Instead, CCPs need to adopt real-time risk modelling as a matter of urgency – for their future and the long-term stability of capital markets.

Blue Riband Group Selects TS Imagine’s TS One for Portfolio Risk Management

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