Streetwise Professor

November 5, 2012

Wrong Way Risk on ICE

In more non-Benghazi news, some clearing stories.  (Contain your excitement, people.)

First, Gretchen Morgenson is still wretched. (So I said this was a post about news.  Sue me.)  She kills CO2 absorbing trees to criticize the very thought of providing CCPs access to central bank liquidity:

But placing them at the bailout trough is wrong, according to Sheila Bair, the former head of the Federal Deposit Insurance Corporation. In a recently published book, Ms. Bair wrote that top officials at the Treasury and the Fed, over the objections of the F.D.I.C., pushed to gain access for the clearinghouses to Fed lending.

The clearinghouses “were drooling at the prospect of having access to loans from the Fed,” she wrote. “I thought it was a terrible precedent and still do. It was the first time in the history of the Fed that any entity besides an insured bank could borrow from the discount window.” .

“The Treasury’s and the Fed’s reasoning was that since another part of Dodd-Frank was trying to encourage more activity to move to clearinghouses, we should provide some liquidity support to them,” she said in an interview last week. “Our argument back was, if you have an event beyond their control with systemwide consequences, then you have the ability to lend on a generally available basis. What they wanted was the ability to lend to individual clearinghouses.”

Look, one of the reasons I think Frankendodd is monstrous is precisely because clearing and collateral mandates impose tremendous contingent liquidity demands.  Last week I spoke at in Osaka at the annual meeting CCP12, an organization of 30+ CCPs (which apparently uses the Big Ten as a naming role model).  An exec at an Aussie CCP asked me what the most worrisome unintended consequence of derivatives “reform” would be.  I answered before the words were out of his mouth: the potential for a liquidity crisis in times of market stress.

That’s what happened 25 years ago, on Black Monday and the following Tuesday morning.  The Fed prevented an apocalypse by leaning on banks to lend to FCMs to meet margin calls.

Clearing mandates without some mechanism to provide additional liquidity, either directly to CCPs or indirectly via clearing members, are a recipe for disaster.  Like Gary Gorton, I am increasingly skeptical of moral hazard being the major concern: the major concern is the inevitability of periodic liquidity crises even in efficiently structured financial markets.  Forcing use of clearing and collateralization of uncleared swaps while simultaneously depriving CCPs or their members of access to central bank liquidity would be like mandating the use of matches in an oil refinery and banning fire extinguishers.

So, not surprisingly, Wretched Gretchen goes the wrong way, yet again.

And speaking of wrong way, ICE has received approval to clear European sovereign CDS.  I’ve written before that clearing sov CDS is very problematic, due to the wrong way risk inherent in these trades.  The sovereign-bank feedback loop means that clearing members-or a CCP’s default fund-are required to make big payouts on sovereign CDS precisely when they are under severe financial strain.

ICE Clear Europe claims that it has taken measures to reduce the wrong way risk.  I am deeply skeptical that these measures are adequate.  (Sorry, Paul-I calls ‘em like I sees ‘em.)

One thing ICE Clear Europe points to is that margins and default fund contributions will be in dollars, not Euros.  This actually creates a new risk. One thing we’ve seen is that during flare ups of the Eurozone crisis is that European banks have faced serious problems accessing dollar liquidity.  Meaning that in the event of a jump to default by a major European sovereign, Eurozone some banks that are members of ICE Clear Europe may well need to come up with big dollars to pay margin calls, or to cover the costs of a defaulting customer, or to meet default fund contributions, but need to do so precisely when they find dollars very hard to come by.

Meaning that (pace Wretched Gretchen) they will be desperately dependent on Fed support through dollar swap lines.

The other measure ICE has taken is to preclude “affiliates” of a sovereign from clearing CDS on that sovereign. Yeah, have to do that, but that doesn’t really come close to addressing the real wrong way risk.  If Spain or Italy-or even Portugal or Ireland or Greece-jump to default, a Eurozone-wide financial crisis that hits all banks will likely result.  Meaning that all major Eurozone banks-including members of ICE Clear Europe-and not just affiliates of the defaulting sovereign, are likely to be in distress at that time.  Further meaning that they will be in distress precisely at the time they are expected to absorb some costs arising from the default (big margin calls, covering the losses of defaulting customers, or incurring default fund obligations).   That’s the wrong way risk we really need to worry about, and nothing that ICE Clear Europe says in its filing with the SEC provides any inkling that their plan addresses that risk.

I also have serious concerns about the risk modeling here.  Wrong way risk is devilishly complicated, especially in a sovereign risk context especially in Europe (given all the potential cross-country linkages).  I am skeptical in the extreme about the ability to set margins properly, and strongly suspect that any methodology is likely to be highly procyclical.

In brief, I continue to believe that clearing sovereign CDS is highly dangerous.  It’s good that ICE Clear Europe recognizes the inherent wrong way risk problem, but in my (strong) opinion, they haven’t really addressed that problem, and indeed may have introduced another source of wrong way risk via the cross-currency mechanism inherent in their design.

I hope I’m wrong.  I hope for all of us it never comes to a test.

Finally, Deutsche Boerse is going to have to stump up $150 mm or so in new capital for Eurex’s clearinghouse, in order to meet European capital standards.  And that’s cheap! LCH.Clearnet will have to come up with 375 mm Euros (or about $500 mm) in new capital:

However, tough new European regulatory capital rules appear to have caught the industry unaware. Eurex is the second major clearing house to admit to a shortfall after LCH.Clearnet, the Anglo-French group, said it would need to increase regulatory capital by an estimated extra €300m-€375m last month

So much for clearing mandates being a cheap way of mitigating credit risk.

We are just approaching the G-20 deadlines to move most derivatives trading into clearing.  And the fun just can’t wait for the official kickoff.  There will be much more fun-and cost, and risk-to come.

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1 Comment »

  1. NYSE Euronext just said they are reducing their interest in LCH.Clearnet from 9%. Great timing. WSJ suggested they may take $50 million out and retain 3-4% interest. But if LCH.Clearnet must raise as much new regulatory capital as reported, NYSE Euronext interest may be diluted to 3-4% while they generate no sale proceeds.

    Comment by TheOtherHand — November 8, 2012 @ 8:13 pm

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