ln 2010 and 2011 I was a clearing Cassandra, sounding warnings about the potential systemic risks arising from clearing mandates. Prominent among those dismissing my criticisms were “macro prudential” regulators, notably the Federal Reserve and the Bank of International Settlements.
Things are rather different now. Regulators, including notably the Fed and the BIS, are now making the rounds expressing recognition, and arguably concerns, about systemic risks in clearing.
Case number one: Fed Governor Daniel Tarullo:
However, as has been frequently observed, if the financial system is to reap these benefits, the central counterparties to which transactions are moving must themselves be sound and stable. Extreme but plausible events, such as the failure of clearing members or a rapid change in the value of instruments traded by a CCP, could expose it to financial distress. If the CCP has insufficient resources to deal with such stress, it may look to its clearing members to provide support. But if the problems arise during a period of generalized financial stress, the clearing members may themselves already have been weakened or, even if they remain sound, the diversion of their available liquidity to the CCP may prevent customers of the clearing members from accessing needed funding. If the CCP fails, the adverse effects on the financial system could be significant, including the prospect that the CCP’s default on its obligations could amplify the stress on other important financial institutions.
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While the question of what constitutes the optimal default fund standard needs more analysis and debate, I think there is little question that more attention must be paid to strengthening stress testing, recovery strategies, and resolution plans for significant CCPs. The typical CCP recovery strategy does not take a system-wide perspective and is premised on imposing losses on, or drawing liquidity from, CCP members during what may be a period of systemic stress. Many of these members are themselves systemically important firms, which will likely be suffering losses and facing liquidity demands of their own in anything but an idiosyncratic stress scenario at a CCP. Moreover, in at least some cases, uncertainty is increased by the difficulty of estimating with any precision the extent of potential liability of members to the CCP, thereby complicating both their recovery planning and efforts by the official sector to assess system-wide capital and liquidity availability in adverse scenarios.
The failure of regulators to take a “system-wide perspective” in their analysis of systemic risk generally, and in the effect of clearing mandates on systemic risk in particular, was one of my oft-expressed criticisms.
Tarullo is an interesting case. When I made a presentation expressing my warnings about the systemic risks of clearing before the Fed Board of Governors in October, 2011, Tarullo was sitting right next to me at the big table in the Fed Board Room. He was, to put it mildly, dismissive of what I had to say.
Glad to see he’s coming around.
Case number two: Fed Governor Jerome Powell. I was particularly pleased to see that Powell recognizes that the picture that was repeatedly used to sell the benefits of clearing is highly misleading because it fails to take a system-wide approach: I criticized this picture in presentations as early as 2011, and also in some published work. Though I would say that Powell still omits many of the other connections between major financial institutions in a cleared world.
More from Powell:
I am a believer in the potential benefits of central clearing under the right circumstances. But central clearing is not a panacea. Charts similar to that in Figure 1 are often used to illustrate the netting of exposures and simplification that central clearing can bring to an OTC market. The tangled and highly opaque picture of a purely bilateral market is replaced by the neat hub-and-spoke network in which a CCP is buyer to every seller, and seller to every buyer, allowing netting and greater transparency for participants and regulators alike. Of course, reality is not so elegant, as Figure 2 illustrates. There are multiple CCPs, even within product classes, and major dealers act as clearing members across a broad network of CCPs. Clearing members also perform a range of services for CCPs, including custody, liquidity provision, and settlement. By design, increased central clearing will concentrate risks in CCPs; it is essential that, as these risks accumulate, the CCPs build up their ability to manage them. It is often noted that CCPs made it through the recent financial crisis without direct government assistance. But many of their major clearing members did receive such assistance. CCPs must now plan for a world in which these large firms will fail and be resolved without government support.
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All of these efforts are directly aimed at strengthening FMIs. But the strength and resilience of a CCP ultimately depends on the strength and resilience of its clearing members. I’d now like to shift focus to the relationship between these market utilities and the institutions that use them.
Barring an operational event, CCPs only face credit or liquidity risk when one of their members fails to make a payment when due. Thus, one effective way to make a CCP safer is to make its members safer. In that sense, the post-crisis reforms that have greatly strengthened our largest and most systemically important banking institutions have directly benefitted CCPs and other FMIs.
This last part, of course, raises the obvious question: would measures to “[strengthen] our largest and most systemically important banking institutions” been sufficient to address macro prudential concerns about OTC derivatives, making unnecessary clearing mandates?
But the biggest, and most surprising case is the BIS:
Clearing though a CCP creates a centralised network of trading exposures. Conceptually, this may influence systemic risk in two main ways. First, central clearing may affect the propagation of an (exogenous) shock through domino effects: the losses deriving from a counterparty default could trigger further defaults and spread the shock through the system. Second, central clearing, and the associated risk management practices, may affect the likelihood and impact of endogenous “run and deleveraging” mechanisms even in the absence of an initial default. While, in practice, both mechanisms may interact, considering them separately helps us to understand possible changes in the nature of systemic risk.
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For example, the size of a shock would matter for systemic risk to the extent that defaults inflict a liquidity shortage on a CCP. If one or more clearing members fail to meet their clearing obligations, the CCP itself must provide liquidity in order to make timely payments to the original trading counterparties. The CCP’s own liquid assets and backup liquidity lines made available by banks may provide effective insurance against liquidity shocks resulting from the difficulties of one or a few clearing members. But they can hardly provide protection in the event of a systemic shock, when a large number of clearing participants – potentially including the providers of liquidity lines – become liquidity-constrained, thereby triggering domino effects.
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A centralised structure of trading exposures may also affect the likelihood and nature of endogenous shocks in the form of forced deleveraging, fire sales and runs. The critical issue in this regard is the interaction between CCPs’ risk management practices and those of clearing participants. On the one hand, if stringent risk management by a CCP replaces lax counterparty risk management in bilateral markets, central clearing would tend to reduce the risk of such procyclical behaviour. On the other hand, an unexpected tightening of CCP risk management could still lead to liquidity pressures on participants that could ultimately trigger fire sales and a self-reinforcing deleveraging (Morris and Shin (2008)).
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Turning to the risk of endogenous deleveraging, the assessment of the impact of post-crisis trends is similarly ambiguous. The fact that an increasing share of trading positions is subject to daily variation margin payments has arguably reduced the risk that counterparties are confronted with sudden big losses, as was for instance the case with AIG. However, the shift towards the centralised risk management of trading positions, including collateralisation and high-frequency margining, is also likely to affect market-wide liquidity dynamics. For example, extreme price movements in cleared financial instruments could result in large variations in the exposure of clearing members to the CCPs and therefore in the need for some of them to make correspondingly large variation margin payments. Such payments can be large, even if margin requirements remain unchanged. But they may be exacerbated if the CCP increases initial margins and/or tightens collateral standards in the face of unusually large price movements.
I made all of these points, or closely related ones, going back as far as 2008-2009, at times to the disdain of the BIS. One example occurred when made a presentation at the Notre Dame Financial Regulation Conference in May, 2011, where two BIS economists said I was being alarmist. Another was at a conference sponsored by the BofE, ECB, and Banque de France in September, 2013.
So it’s nice to see them come to their senses.
The last point in what I quoted is particularly amazing. One BIS position that I have ridiculed was that variation margin flows created no liquidity demands because they were zero sum: every dollar paid by the loser is received by the winner, allowing the collateral to be recycled. Presumably by having the winners lend to the losers. Even overlooking the operational impossibilities of this, what’s the point of variation margin (which reduces credit exposure in derivatives contracts) if variation margins are funded by credit? And there are operational issues. Liquidity is needed precisely because payments are not frictionlessly and instantaneously recycled. Timing mismatches create a need for liquidity and credit.
So it’s particularly nice to see the BIS get beyond its risible dismissal of the possibility that variation margins can create systemic risks via a liquidity channel, and recognize that this is a serious issue. Because it is. The most important risk in clearing, in my opinion, and one that becomes even more important when regulators take other measures to protect CCPs.
All in all, it’s good to see regulators starting to grapple with the potential systemic risks inherent in clearing. It is better than continued cheer-leading, as was the norm from 2009 until very recently.
But that said, the time to start worrying about potential major design flaws in an aircraft isn’t when it is just reaching cruising altitude. Takeoffs are optional, landings are not. It’s best to make sure that a safe landing, rather than a crash, is highly likely before taxiing down the runway. In their wisdom, legislators and regulators in a hurry didn’t do that. They rushed a new, complex, and untested design into the air. Let’s hope that the newfound awareness of the potential risks allows them to make in-flight repairs and adjustments that will make a crash unlikely.