Confused about just how the Dodd-Frank Act would actually change derivatives markets? Happily, Barclays Capital’s Rajiv Setia and team have tried an answer.
Not so happily, the answer is a bit disconcerting.
In a paper exploring the proposed reforms, BarCap focused on the future of interest rate derivatives in particular. However, the Act’s targeting of ‘swaps’ captures most other classes of derivative; among other things, it would require that most swaps be cleared via central counterparties (CCPs), as well as traded on exchanges.
The ecology of central clearing
The problem is that the jury is still out on how well CCPs will do the job allotted to them of absorbing risk from defaulting counterparties.
For example, we’ve wondered whether CCPs might concentrate risk instead.
BarCap’s paper shows how the Dodd-Frank Act is shifting responsibility on a system of CCPs that’s already been organically — and idiosyncratically — developing for some time. (Successfully, too. LCH Clearnet quickly unwound $9,000bn Lehman interest rate swaps in 2008.) We’re now going to enter a period of forced evolution.
The potential problem came to us via an ominous comparison made by BarCap (our emphasis):
It is important to recognize that despite their very useful public purpose, CCPs are run for profit. In effect, in our view, they are GSEs in the making, given how systemically important they will be to the financial infrastructure. In addition, and concerningly, the major CCPs are currently regulated in different jurisdictions/countries, and have widely varying margin requirements… Over time, risky counterparties could migrate to CCPs that have the least-stringent requirements, a trend that could, if left unchecked, lead to greater systemic risk than the current regime.
That’s not to suggest CCPs will one day collapse like GSEs. But as BarCap explain, surviving a clearing member’s default depends a great deal on the initial margin it posts when it completes trades — and margin requirements vary a lot from CCP to CCP.
First, initial margin repayment looks like only the first step in the process of getting through a default situation, as per this LCH chart, via BarCap (click to enlarge):
However, as BarCap note, it’s important to understand that the initial margin is by far the biggest line of defence in practice:
The obverse of this is that LCH was able to deal with Lehman’s default all through margin, for example, so this might not be such a problem. Unless sizes for margins vary from CCP to CCP — which they do, widely. LCH charges a margin five times larger than IDCG, a younger clearinghouse (although this difference is reduced at the portfolio level).
As BarCap note, this is an area to be watched (emphasis in original):
…we think financial regulators need to keep the following issues in mind: 1) the criteria for determining initial margin are critical for avoiding systemic failures; 2) default fund contributions and CCP equity should be strengthened, and 3) there should be consistency in margin requirements across different CCPs in various jurisdictions…
In practice, because initial margins are computed on a portfolio basis, the aggregate collateral requirement (and consequently, the difference between clearinghouses) is likely to be lower. However, given the systemic importance of CCPs and the significant differences in member requirements, we think it is vital that regulators closely supervise the growth of this industry.
Let’s hope so. And to be sure, one of the big advantages of central clearing is that there’ll be fewer counterparty inter-linkages for regulators to sift through. Additionally, margin rules will be far easier to enforce via CCPs than on a trader by trader basis.
That said, we’ve doubted ever since the original Dodd bill whether regulatory discretion is a good substitute for actual rules. So we’re really not sure.
Full BarCap note in the usual place.
Derivatives Laws Could Cost Companies $1 Trillion: ISDA – Reuters
Derivatives compromise all about enforcement – American Banker
Default Fund Rules (PDF) – LCH Clearnet
Exchanges vs. Clearinghouses (This is important) – Economics of Contempt