The scariest kind of counterparty risk is “wrong way” risk. This kind of risk occurs when there is a dependence between the size of the exposure (i.e., the amount that can be lost in the event of a default) and the probability of the counterparty’s default. In particular, wrong way exists when the exposure is large when the probability of a counterparty default is large.
A canonical example of wrong way risk is a firm that writes a put on its own stock. If the firm goes bankrupt, and its stock becomes worthless, it defaults. When it defaults the exposure is as large as it can be: the strike price of the put. In contrast, a firm that writes calls on its own stock has “right way” risk. If the firm does badly, and indeed goes bankrupt, default losses on the call are zero because the call is out of the money.
Central counterparties–clearinghouses–are touted specifically as ways of mitigating counterparty risk. Post-Financial Crisis, they have been particularly advanced as a means to reduce systemic risk by reducing counterparty risk absorbed by big financial institutions. This raises interesting questions: Do CCPs have a wrong way risk problem? If so, what implications does this have for the performance of CCPs during systemic crises?
The answers in brief: yes, they may well have a wrong way risk problem, and that means that it is dangerous to rely on them as a means of reducing the likelihood and severity of truly systemic crises.
As I noted before, the defining feature of wrong-way risk is a dependence between default probability and the size of exposure. This is often characterized as a “correlation” between default risk and exposure. But as I’ll discuss below, “correlation” is too limiting a concept. Correlation implies dependency, but dependency does not imply correlation.
The magnitude of wrong way risk depends on the nature of transactions and counterparties involved. In particular, out-of-the-money options exposures, very senior tranches of structures, and highly rated counterparties are most vulnerable to wrong way risk. (For a good book on this subject, see Jon Gregory’s descriptively titled Counterparty Credit Risk.)
Moneyness matters because a deep out of the money option generates an exposure only if the underlying price moves a lot. But if the underlying price and the creditworthiness of the option writer tend to move in the same direction, a big movement in the underlying that puts the option in the money also tends to be associated with a dramatic erosion in the creditworthiness of the writer. Thus exposure and default risk peak simultaneously.
The seniority of a tranched structure matters for a similar reason. There will be losses on a senior (or supersenior) tranche only in the event of an extreme adverse shock hitting near simultaneously many of the credits underlying the structure. If this same adverse shock puts the writer of protection on the tranche into financial difficulties, the writer is most likely to default at the same time that it is supposed to payoff on the protection it sold. Think monolines, or AIG.
The credit quality of the counterparty matters because a high quality counterparty is likely to default on a contract only if it suffers a severe adverse shock to its balance sheet. With the right kind–or should I say wrong kind?–of dependence between the exposure and the counterparty’s balance sheet, this big adverse shock leads to a big move in the value of the contract. Thus, exposure is big precisely when the counterparty is highly likely to default.
Let’s see how this relates to CCPs, and in particular to the default funds of CCPs that are the ultimate backstop of cleared contracts. Default funds are analogous to protection written on supersenior tranches. The collateral (margin) that firms must post to CCPs when they hold derivatives positions absorbs most of the losses due to movements in market prices. Indeed, margins are usually set to absorb 95-99 percent of market moves. Beyond margin, CCPs often have their own financial resources to cover the losses associated with the default of any member firm not covered by margin. If the margin and CCP-resource elements of the CCP “waterfall” (note the similarity of terminology used to describe tranched structures and CCPs) are breached, then the members must absorb the remaining default losses, up to some pre-established commitment level.
This means that CCP members must cover defaults only in extreme circumstances, just like writers of protection on supersenior tranches must cover defaults only under extreme circumstances. Indeed, the oft-touted features of CCPs, such as collateralization create the seniority/out-of-the-moneyness that gives rise to wrong way risk if the pre-requisite dependencies also exist.
So it seems that CCPs are potentially vulnerable to wrong way risk. They are effectively financial structures of a type that can, given the right (or wrong, depending on your perspective) dependence, give rise to a serious wrong way risk problem. Which raises the question: are the dangerous dependencies likely to be present? That is, are the contributors to a CCP default fund likely to be in bad financial straits just when their contributions are needed to absorb default losses? Are those that are insuring default losses (through mutualization) likely to be in dodgy condition precisely when they are most likely to have to pay off on that insurance?
Given that we are talking about tail events, it’s difficult to assess that question analytically and empirically. But there are reasons to believe that these dependencies are in fact lurking.
A big financial shock that is sufficient to cause movements in derivatives prices big enough to breach margin levels, and/or which damages a CCP member’s balance sheet (or multiple members’ balance sheets) severely enough to force it (them) into default is likely to be associated with severe financial difficulties at other CCP member firms. For instance, during the financial crisis all banks were cratering simultaneously and prices were moving dramatically; their stock prices all plunged together and their CDS spreads all spiked togehter. They were all exposed to the same big underlying risk–in the event, real estate prices. When those prices went south, all financial institutions were in distress, most of them in severe distress. The financial tumult also resulted in big moves in stock prices, interest rates, credit prices, and commodity prices–all of which could have and did create widening exposures on derivatives trades. Indeed, since CCPs have zero net positions, a big move in any price is going to create a big exposure for the CCP.
And it’s not just price movements that matter. Financial and economic shocks are also associated with big changes in volatilities that affect exposures on non-linear positions (notably options or contracts with embedded options). Moreover, big volatility makes it more likely that exposure values and creditworthiness will move substantially.
Perhaps even more crucially, big financial and economic shocks tend to result in correlations in prices shooting towards one and minus one. This has both direct and indirect effects. The direct effect is to move–often by a lot–the mark-to-market values on correlation-sensitive positions (e.g., CDOs, multi-product options). The indirect effect is perhaps even more pernicious, as it is exactly these high correlations between the value of assets on financial institutions’ balance sheets and the values of derivatives exposures that generate acute wrong way risks. That is, the effects of stressed–crisis–financial conditions on correlation creates the very form of dependency that gives rise to wrong-way risk.
Liquidity effects of crises can also create dependencies. Liquidity tends to decline during crises, which tends to increase volatilities, thereby exaggerating movements in exposures and creditworthiness. It also makes it more difficult to manage the risk on exposures, and to trade out of positions in order to reduce exposures. (The common liquidity shock may be one reason why correlations tend to risk towards one in absolute value during crises.)
These dependencies can be especially exaggerated for certain kinds of products and CCPs. Consider, for instance, a CCP that clears CDS, a substantial portion of which are written on financial names, and which has financial firms for members. Exposures tend to spike for such a CCP at the very same time its members are suffering dramatic declines in creditworthiness. Not good.
Thus, in crisis periods, dependencies between the value of the backers of CCPs–the member firms (often banks)–and the exposures that CCPs are effectively writing protection against are highly likely to be of the wrong way variety.
This means that CCPs offer dubious protection against systemic risk. A huge economic shock, like that suffered in 2007-2008 creates dependencies that give rise to wrong way risks. They also give rise to big changes in exposures. The structures of CCPs have features that are particularly vulnerable to these dependencies.
Even if a CCP does not fail during a crisis, the wrong way risk problem means that the financial institutions that backstop it will have to make payouts at precisely the times that they are under strain. That is, CCPs load risk onto big financial institutions precisely during crises that are already stressing them.
This is not to say that CCPs cannot share garden variety default risks more efficiently than bilateral arrangements. But that’s not what the advocates of CCPs hyped when arguing for clearing mandates. No, these advocates repeatedly and specifically held them up as an antidote for crisis, as a bulwark against systemic risk.
The foregoing analysis of wrong way risk implies, however, that CCPs themselves are most vulnerable to default precisely at the time that their advocates look to them to be the breaks that contain financial firestorms. Consequently, any sense of security against financial contagion that they provide is very likely a tenuous one, and arguably a false one. Such complacency is particularly worrisome as it can undermine the urgency to find more effective and reliable measures to reduce the vulnerability of the financial system.
I am not saying that CCPs are as defective in concept as monoline insurers, or as AIG was. (Jon Gregory argued back in 2008, and argues again in his book, that the monolines and AIG were fundamentally, fatally and irredeemably flawed.) I am just pointing out that they share key features with those casualties of the last crisis, and as a result, may well be casualties in the next one.
It should also be noted that the Basel III capital requirements for CCPs that I discussed in an earlier post do not capture this risk in any meaningful way. They cannot provide, therefore, an incentive to reduce it in any meaningful way.
In a classic Rocky and Bullwinkle episode, Captain Peter “Wrongway” Peachfuzz sailed his ship up Wall Street. Let’s hope that’s not a metaphor for the effect of mandated clearing. But you should be concerned that clearing concentrates wrong way risk, and that this guy becomes the poster child for Frank-n-Dodd and its clearing mandates: