Financial blogger Alea points to this paper on clearing houses ahead of OTC derivatives reform:
Are we building the foundations for the next crisis already? The case of central clearing
It came out about a month ago, but it’s a good summary of potential risks pertaining to clearing. And it’s extremely topical given that US politicians look poised to push derivatives into central clearing.
The thinking behind the idea is pretty simple.
Run derivatives trades through central party clearing houses (CCPs), and you help eliminate some of the counterparty risk that contributed to the crisis. The CCPs stand between institutions engaging in derivatives, which means if one of them were to go bankrupt its contracts would be guaranteed by the CCP.
The CCP calculates and collects required initial margin from the counterparties. But if its losses on a bankrupt counterparty were to exceed that margin, it starts collecting from its other members.
And therein lies some of the risk, according to consultant and author Jon Gregory:
It is often argued that a CCP is in a good position to manage the risks of a member that becomes financially distressed . . . However, the idea that a CCP will perhaps ignore scurrilous rumours and thus create stability is a dangerous one, as it seems to go against the idea of the efficient markets hypothesis and stability. Market observables, such as widening CDS spreads may be symptoms rather than causes. A CCP ignoring rumours may create worse problems later when the rumours are proven. In the event that a CCP has effectively to ask members to cover losses that exceed initial margin and other resources, the members will presumably be surprised since they originally viewed the CCP as a risk-free counterparty and now have to subsidise other member’s losses.
There are also issues of the ‘right’ amount of margin requirements, profitability and monopoly potential. We’ve already seen some CCPs squabbling over ‘loose’ margin standards. In terms of monopoly:
On the one hand, the market is best supported by a single CCP, since this maximises cross-product netting and margining efficiencies. The ideal of a single CCP must be balanced against monopoly concerns and cross-border issues due to regulatory and operational differences. The financial markets would be probably best served via a reasonable number of CCPs, large enough to offer good product coverage but not so large that their failure could trigger a global financial crisis. However, CCPs will naturally compete and regulation may favour a certain CCP, which may lead to suboptimal outcomes and market instability.
The risk of a Too Big To Fail CCP (TBTFCCP, ha). In other words, concentration risk.
Instead of having your derivatives exposure channelled through a myriad of financial entities, you could end up having it sitting with just one major CCP. That eliminates the domino effect of financials refusing to deal with each other, but not the risk of something happening to the CCP itself :
Although CCPs reduce counterparty risk for market participants, funnelling market activity through one institution leads to a concentration of risk. Since CCPs limit the risks to other market participants, their own potential failure becomes a critical component that would potentially lead to a systemic event. In the recent crisis, the interconnectedness of institutions such as AIG and Bear Sterns was a massive problem, reinforcing the concept of too big to fail financial institutions. Yet a CCP will be interconnected in the same way.
There’s also the not-insubstantial issue of the CCP’s own risk management. CCPs are likely to use a Value-at-Risk (VaR) type model to forecast market risk at certain confidence levels, and come up with safe levels of margin calls to cover them. But they’re probably not going to scrape enough margin to cover all probabilities — i.e. the the tail event of some major financial disaster.
Gregory’s paper ends with the following:
Clearinghouses are one of many solutions to the problem of counterparty risk management if they are run well. If not then they can become the centrepiece of the next crisis. A CCP would, of course, have its own highly advanced risk management capabilities and be subject to prudent supervision and capital requirements in order to make its failure highly unlikely. That’s right, just like banking institutions before 2007.
Back to the future then? Thoughts on a postcard to:
U.S. House of Representatives,
Washington, DC 20515
United States Senate,
Washington, D.C. 20510
And quickly. The US House of Representatives and the Senate are scheduled to vote on Tuesday.
Related links:
Broker calls for OTC rethink – FT
Clearing of derivatives must be at core of reforms – FT
Craig Pirrong vs Gary Gensler: Who’s right on OTC derivatives – FT Alphaville
Prof Craig Pirrong on the pricing-clearing link in the derivatives market – FT Alphaville