Central Clearing of Financial Contracts -Part 2

Reasons for systemic risks in non-financial derivatives contracts

The systemic risk of financial derivatives contracts depends on the nature of the counterparty rather than its inherent nature. Therefore, signing non-financial derivatives contracts with systemically important counterparties may also have systemic risks. Almost all contracts will generate counterparty risks which is the result of fulfilling obligations over time.

In fact, most of the counterparty risks of financial institutions that triggered the financial crisis were generated under non-financial derivatives contracts. Although some people consider the bankruptcy of Lehman Brothers as an incentive for the financial crisis, Lehman’s counterparty risk was first generated under non-financial derivatives contracts. The problems with financial derivatives contracts did not appear until Lehman went bankrupt.

To reduce systemic risks, regulators should require central clearing of non-financial derivatives contracts with at least one systemically important counterparty. This theory is valid only when the benefits of financial regulation exceed the costs.