One of the systemic risks that has drawn the attention of monetary authorities that we have covered is over-the-counter derivatives. This area of investment/speculation has grown very large over time. Much of it also operates in what is sometimes called the "Shadow Banking" arena which is often not very transparent. Because these speculative OTC derivative contracts can lead to a situation where a major so called "too big to fail" entity gets in trouble, monetary authorities like the BIS have recognized the potential systemic risk. 

The Bank for International Settlements(BIS) has taken a leading role in trying to implement various counter measures to systemic risks that it can identify. In this case, they are issuing guidance for doing stress tests on key "central counterparties" (CCPs) who act as clearinghouses for derivatives trading. Below is the  latest press release from BIS on this issue and then a few added comments.

Draft guidance for supervisory stress testing of central counterparties released
28 June 2017
Press release

Draft guidance for authorities on how to design and run supervisory stress tests for central counterparties (CCPs) was released today by the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO).

As a result of the Group of 20 (G20) derivatives reforms, and in particular the move towards central clearing of standardised over-the-counter derivative contracts, the role of CCPs in the financial system has gained in importance.

The consultative report, Framework for supervisory stress testing of central counterparties (CCPs), provides a framework for authorities to evaluate the collective response of a set of CCPs to one or more financial stresses. In particular, conducting stress tests of this type could help authorities better understand the impact on the broader economy of a common stress event affecting multiple CCPs, as well as the implications of interdependencies between markets, CCPs, and other entities, such as liquidity providers and custodians.

"Having a common basis for supervisory stress testing will help build confidence that these crucial parts of the financial system have enough resources to withstand shocks," said CPMI Chairman Benoît Cœuré.

"This framework will enable authorities to better understand the magnitude of the interdependencies between CCPs and other entities, and the impact that a stress event affecting various CCPs could have on the wider economy. The framework is also flexible enough to allow authorities to design a stress test that is best suited to their circumstances," said IOSCO Board Chairman Ashley Alder.    

The framework covers six components of a stress-testing exercise: (i) setting the purpose and exercise specifications; (ii) establishing governance arrangements; (iii) developing stress scenarios; (iv) collecting and protecting data; (v) aggregating results and developing analytical metrics; and (vi) determining the use of results and disclosure. The components are intentionally broad and flexible to allow authorities to develop the most suitable approach for their circumstances. Authorities are encouraged, but not required, to use the framework as they deem appropriate.

Comments on the framework proposed in the report should be submitted by Friday, 22 September 2017. A cover note to the consultative report is available at http://www.bis.org/cpmi/publ/d161_covernote.pdf.

Click here for a more detailed note on this issue

Note: I added the bold emphasis above

My added comments: Just a couple of points on this. First, as we can see from the text I put in bold type above, the BIS does view OTC derivatives as something that can "impact the broader economy". The say the stress tests are designed to "help build confidence that these crucial parts of the financial system have enough resources to withstand shocks." 

I think that institutions like the IMF and BIS want to have as much information on these risks as they can because it is my understanding that if a risk is known it is much easier to get central banks to take whatever actions may be needed to "ring fence" a problem before it can spill over into the broader financial system.

Secondly, we can see from this press release that there is not any kind of sense of urgency that some kind of derivatives problem that could threaten systemic stability exists right now. This is just the early stage of this program to issue guidance on stress tests and they are just getting early feedback at this time (initial feedback comments not due until September 2017). This suggests that they believe they have plenty of time to work on this project.