Streetwise Professor

May 31, 2012

The Global Sorcerer’s Apprentices

Filed under: Clearing,Derivatives,Financial crisis,Financial Crisis II,Regulation — The Professor @ 8:13 pm

Global regulators are lumbering towards announcing proposals on the margining of non-cleared swaps, though they will miss the original G-20 deadlines:

Global regulators said on Wednesday they will issue proposals in coming weeks on rules to encourage banks to put derivative trades through a central clearing house, but they won’t be ready for the G20 summit in June.

. . . .

The FSB said it will issue a consultation paper on setting globally agreed margin rules for trades that are cleared directly between two parties rather than through a central clearing house.

“Momentum on OTC derivatives has accelerated in recent months,” FSB Chairman Mark Carney said at a news conference in Hong Kong.

The FSB is expected to push for a minimum margin that banks must post on derivatives trades that aren’t processed through a central clearing house. The aim is to provide an incentive for trades to be centrally cleared, or at least ensure there is a lower risk of an uncleared trade running into difficulties.

Here we go again.  Regulators believe they know how to determine the risks of transactions, and price those risks.

This of course worked out so well with Basel II, which deemed that mortgage loans and mortgage backed securities and sovereign debt were low risk and provided incentives for financial institutions to invest in them.

How’s that working out?

The clearing proposals in particular are frightening for at least two reasons.  First, they are predicated on the view that clearing necessarily mitigates systemic risk, a highly misguided view as I’ve pointed out here for years. Second, and relatedly, the very policy of attempting to encourage the movement of transactions to CCPs will tend to increase the riskiness of CCPs by leading them to clear products that are not well-suited to clearing, thereby increasing the riskiness of CCPs.  And because these CCPs are systemically important, this creates systemic risks.

It is also interesting to note that this one regulatory effort my be undermined by another one.  The New! Improved! Basel Rules will set capital requirements for exposures to CCPs.  The prevailing belief is that this will result in low risk weights (2 percent) on exposures to CCPs.  But an analysis by JP Morgan suggests that actual risk weights are likely to be far higher:

New capital rules outlined under Basel III are designed to incentivise the use of a CCP by levying a relatively small 2% risk weight against a bank’s exposure to a clearing house. This charge is much lower than the punitive charges proposed against traditional bilateral non-cleared trades and is designed to make clearing more financially attractive.

However, in-depth research by JP Morgan analyst Kian Abouhossein and his European banks team has cast doubt on this presumption. Taking a hypothetical clearing house that is only 45% funded against its theoretical capital requirements, they argue that the move towards central clearing could in fact prove far more costly under the new rules than initially thought.

This is because the new Basel III rules are expected to require a higher risk weight for exposure to central counterparties that may be regarded as underfunded; the rules will also levy a higher charge depending on whether the ultimate counterparties to the trade are clearing members, or clients of clearing members. Banks that clear trades on behalf of clients will also be required to take credit valuation adjustment charges against those clients which represent a measure of potential loss in the event that client counterparty goes bust.

In summary, JP Morgan finds therefore that the proposed floor 2% risk weight can only be attained under specific circumstances. In reality, the bank argues, the real risk weighting could shoot up dramatically.

So on the one hand, global regulators are trying to encourage the movement of trades to CCPs, but other global regulators are devising rules that will (unintentionally) make CCP exposures extremely expensive.

I am sure this process of setting prices for counterparty risk will turn out just swell, and lead to an efficient allocation of  these risks.

All these various efforts to regulate margins and capital weighting for counterparty exposures are a species of centralized price control.  All such schemes are doomed to failure.  Doomed.  The regulators lack the information to determine the right prices, and are in fact at an information disadvantage relative to private actors, so these schemes inevitably result in substantial losses arising from adverse selection problems.  Moreover, it is grimly ironic that these schemes are touted as a means of reducing systemic risk, when in fact they are far more likely to create systemic risks.  As I’ve noted repeatedly (and as others, such as Roberta Romano have also pointed out), these regulated pricing schemes tend to encourage everyone to load up on the same risks, and it is these correlated risk exposures that create systemic risk.

These global Sorcerer’s Apprentices believe that they are preventing the next crisis.  It is more likely that they are casting the spell that will bring it about.

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  1. I think it would be instructive for all these regulators to recall one of the fundamental laws of physics: the energy doesn’t come from nowhere and it doesn’t disappear anywhere. It just transforms from one form to another.

    In many ways it is true about the risk, too. No matter how you clear it, there is a fundamental generator of risk and that ain’t the derivatives market. Derivatives market helps to redistribute risk by transferring it from parties unwilling to take it, to those not willing to do so. One way or another, it is still in the system and the system, the one beyond the derivatives industry has to be able to absorb it through cumulative risk-premium collection mechanisms – in some ways similar to the insurance and reinsurance industries.

    As mentioned earlier, I wrote an article on this and related subjects recently and submitted. Waiting for it to be published (I was told it will come up in series of short articles as its volume was beyond their accepted practices).

    Comment by MJ — June 1, 2012 @ 3:34 am

  2. SWP, I think you should have this clear warning publicised more widely. Submit it to FT Alphaville and Zerohedge perhaps? For as sure as the night follows the day, herein lies the next timebomb which will surely destroy all that it touches (assuming we survive the current Greece/Euro/Debt bomb). And all the while they will say “Who could have seen this coming?”

    Comment by Kelv — June 2, 2012 @ 7:36 am

  3. Screw it – I did it for you as I think this issue is too important. Hopefully someone listens.

    Comment by Kelv — June 2, 2012 @ 7:55 am

  4. @Kelv-Thanks. I have been playing Cassandra on this for some time. FT Alphaville has linked to some of the pieces, but perhaps it would be worth pinging them to see if there is any interest about a guest post. (I wrote a guest post for them a couple of years ago.)

    Zero Hedge-LOL. Not one of their fans; search for “Zero Hedge” to see why. (The post from November, 2011 in particular).

    Thanks for your suggestion, and for your recognition that this is the next time bomb. It is very frustrating at times to watch this process lurch forward, to see where it is going and try to make people aware of the dangers, and to have those warnings largely fall on deaf ears. The WSJ did highlight some of my work in an OpEd some time ago. Maybe I’ll ping them too to see if they are interested.

    The ProfessorComment by The Professor — June 2, 2012 @ 8:59 am

  5. @Kelv-You did what for me? I just saw that message when replying to your earlier one.

    The ProfessorComment by The Professor — June 2, 2012 @ 9:00 am

  6. I pinged them is all – and yes, ZH are not fans, but I hope the article stands on it’s merits.

    Comment by Kelv — June 2, 2012 @ 6:51 pm

  7. Thanks, Kelv.

    The ProfessorComment by The Professor — June 2, 2012 @ 8:33 pm

  8. [...] Yahoo via the Streetwise Professor, “Global regulators said on Wednesday they will issue proposals in coming weeks on rules to [...]

    Pingback by Compliance dates for clearing delayed again « — June 18, 2012 @ 6:18 am

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