The advocates of mandated OTC derivatives clearing insisted-insisted-that mandated clearing would simplify the market, and reduce dangerous interconnections between financial institutions. The canonical illustration of this point was something like this, with the first diagram being the messy bilateral, pre-clearing mandate market, and the second being the neat and tidy clearing mandate market:
Uhm, not really. Not at all. These diagrams presume that the only interconnections between OTC derivatives users are via the derivatives markets themselves. In fact, derivatives users are connected via credit and liquidity support mechanisms as well, and the adoption of clearing which results in the unbundling of the credit and liquidity arrangements embedded in derivatives trades will lead to the forging of new connections that will make the post-mandate system as complicated and interconnected and fragile, and perhaps more complicated and interconnected and fragile, then it was before.
These interconnections are of different types. Some are operational. Consider this from an illuminating article in Wall Street & Technology:
A new swaps ecosystem needs to be established in order to enable central clearing. “You’re talking about a whole reinvention of the entire market,” says Henry Hunter, global head of product development at MarkitServ, a provider of middleware and online confirmation and affirmation services to the buy and sell sides in the derivatives space. “That’s a massive infrastructure change that is happening over a period of years.”
Wholesale reinventions always go well. Always. But it gets better:
“It’s a complicated mess,” says MarkitServ’s Hunter, who notes there could be as many as six different players involved in any trade — the client, the executing broker, an execution venue (i.e., the SEF), a CCP, a clearing member acting for the client, and possibly a clearing member acting for the dealer as well. “Managing that choreography can get complicated, so that’s where the middleware comes in.”
And the mess doesn’t stop there. Clearing brokers have the burden of modifying their electronic trading infrastructures and processing systems. According to Morgan Stanley’s Brock Arnason, executive director and global product manager for the Matrix platform, “The infrastructure that is required to support a clearing business is quite significant.” Clearing brokers must capture their clients’ voice and electronic trades and then run them through validation rules to determine clearing eligibility, he explains.
Think of all the operational linkages described in those short paragraphs. Think of all the possible problems that can arise, particularly in stressed market conditions. The financial system is a tightly coupled one as it is, and the rigid schedule on which clearing must work, to initiate trades, close them, and margin them, makes it all the more tightly coupled. The choreography could very well go wrong, and is most likely to go wrong precisely at the most dangerous time.
In addition to the operational connections, there are financial connections, especially related to collateralization: I’ve written about this extensively on SWP, and in places like my recent J. Applied Corp. Fin. paper. More from the WS&T article:
One of the most disruptive changes on the buy side under the new derivatives rules will be the need to manage margin calls from the clearinghouses on cleared swaps. “Some clients are going from never having to post initial margin to now always posting margin,” comments Morgan Stanley’s Swankoski. When clearing becomes mandatory, “All clients, big or small, are going to have to post initial margin on their cleared transactions.”
. . . .
To help buy-side firms complete this process, the clearing brokers are looking to provide collateral transformation services, according to Forkan. “They’re now building in services to ensure that organizations that post one type of asset can convert it into another type of asset,” he says. “That is a cost of clearing that the asset management community is going to have to bare. Given the huge investment that the banks have made in technology and infrastructure, they are keen to offer services that generate profit — it’s a large opportunity for the global banks to grab market share among the asset managers that need services.”
To reiterate, the advocates of clearing asserted that collateralization would reduce leverage in the system by preventing the bundling of credit in derivatives trades. But as I’ve said repeatedly, this will just lead to the substitution of unbundled credit for the proscribed bundled leverage. Collateral transformation is an example of this. Moreover, this form of credit, when joined with the rigidity of the margining process for cleared transactions (and for non-cleared trades which Frankendodd requires to be marked-to-market on a daily basis), these new credit arrangements are likely to be more fragile than the bundled ones they replace.
In brief, there will continue to be a dense web of interconnections between market participants-the second diagram above is a very misleading of the post-Frankendodd world, which will continue to look like the first diagram. Moreover, These interconnections are likely to be even more fragile.
And we’re not finished! Another point that I’ve made for the past several years is also becoming increasingly recognized. Namely, the breaking of netting sets will arguably lead to greater complexity, greater collateral demands, and potentially greater total risk exposures.
With respect to operational complexity:
Another big challenge for buy-side firms will be managing their existing bilateral OTC derivatives business alongside cleared swaps to gain a holistic picture of counterparty risk. Since not all trades will be required to be cleared, buy-side firms will have both a bilateral book of trades that they are still managing as well as daily collateral calls for the cleared book of swaps, says Omgeo’s Leveroni. “You will end up with a mixed clearing environment and operational complexity that you didn’t have before,” he cautions.
. . . .
“The buy side is going to struggle with having enough collateral to post for the book of business,” Leveroni says. “This is worrying a lot of people. You want to make sure you manage that collateral right, so you only send cash to the cleared call and you send the corporate bond to your bilateral call. You have to be smart in the collateral you send to each call. Those are the real risks to the buy side.”
With respect to increased needs for collateral, consider this from Matt Leising:
Derivatives users will face significant challenges to meet new collateral requirements as the trades are forced into clearinghouses, according to industry executives.
Investors have pledged about $200 billion to back futures trades around the world, Bill de Leon, a managing director at Pacific Investment Management Co., said today on a panel discussion at the Futures Industry Association annual conference in Boca Raton, Florida. That amount could be 10 times as large for the majority of trades in the $708 trillion over-the-counter derivatives market, he said.
“This is going to be one of the biggest challenges going forward,” said Jeffrey Jennings, the global head of listed derivatives at Credit Suisse AG. Exchanges such as CME Group Inc. (CME) are expanding the collateral they accept to allow corporate bonds to be pledged and are offering to reduce margin across assets like futures and interest-rate swaps. “That’s not going to be enough,” he said.
. . . .
Other plans by brokerages to offer to transform for their customers unacceptable margin into cash or U.S. Treasuries that are accepted by clearinghouses won’t solve the problem, and may add to risk during volatile times, said David Olsen, global head of OTC clearing for JPMorgan Chase & Co. (JPM)
“In my opinion, collateral transformation is really just a marketing term for repo,” he said. The collateral obtained from selling securities to garner cash or Treasuries in the repurchase market don’t fit many type of derivative users, such as pensions, that may have 30-year swaps they need to maintain, he said.
With respect to the fact that fragmentation of clearing across jurisdictions and instruments and the elimination of netting economies across cleared and non-cleared positions (a point I’ve made, as have Duffie-Zhu) consider this very readable paper by David Murphy.
It is not an exaggeration to say that every claim made by Frank, Dodd, Geithner, Gensler, and all the other clearing fanboys and fangirls around the world are extreme exaggerations at best, and often flatly wrong. New vulnerabilities have been substituted for old. New interconnections have supplanted those that prevailed in the bilateral world-and many of the new interconnections are more problematic. Financing and liquidity and credit arrangements remain deeply meshed with derivatives transactions. Mandated clearing eliminates some netting benefits, while creating others, and it is by no means clear that the mandates have reduced exposures.
The whole top down restructuring of the derivatives markets-which represent a complex, emergent order-does not lead to the replacement of a complex and sometimes chaotic system with a simple and ordered one. It will result it a new complex system that will emerge in response to the new laws and regulations. The regulations were motivated, in essence, by fears of the instabilities and non-linearities in the old order: but the new system will have its own instabilities and non-linearities. Indeed, I believe that a mandated, top-down attempt to impose a new order is likely to result in a less supple, more rigid, and less stable system than the (imperfect and sometimes unstable) one it is intended to supplant.
An analogy that comes to mind is the Corps of Engineers. For decades the Corps has intended to impose order on a complex system of rivers. The results have been less than happy. The imposed order has too often proved illusory, and attempts to control the system have resulted in an increased likelihood of catastrophic floods and the destruction of valuable natural ecosystems. Attempts to control complex systems are usually futile, and tend to result in the replacement of more frequent small crises with a few mega-crises (this is a point also made by Taleb and Bookstaber).
In this regard it is always useful to remember Hayek’s warning about the illusion of control: “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Chris and Barney and Timmy! and Gary think they know a lot more than they really do. They see like a state (to use James Scott’s phrase), and as Scott shows, these attempts to re-engineer complex systems from above almost always end in grief.
But as the continued existence and persistence of the Corps of Engineers shows, the illusion of control and the faith that top-down re-engineering of complex systems can work is enduring. The idea is hard to kill, and ironically, its failures often lead to demands for more and more and more control. I expect, alas, that this will be the case in the derivatives markets.