Streetwise Professor

April 25, 2013

Fools Rush In: CCP Mandate Edition

I was invited to participate in a panel on clearing at ISDA’s Annual General Meeting in Singapore, but unfortunately I had to decline on account of my teaching obligations.  I therefore have to nod (vigorously0 in agreement from afar, because much of the discussion there has focused on the unintended consequences of the clearing and collateral mandates.  Consequences that I have been warning about for over four years.

One of the things that infuriated me about the advocacy for clearing (and yeah, I’m looking at you GiGi) was the claim that clearing would reduce the interconnectedness of the financial system.  I said this was patently false.  Clearing mandates would reconfigure the topology of the network of connections among financial institutions, but they would remain interconnected.  I noted that: CCPs would be vital interconnecting nodes in this new network: failure of these nodes would be catastrophic: and perhaps most importantly, CCPs could be vectors of contagion precisely during periods of financial stress.  I pointed out very early on that CCPs were repositories of wrong way risk because losses would hit default funds precisely during periods of extreme financial stress, and via that channel would bring that stress right back to the balance sheets of the banks with exposure to the default funds.  You know, when they were least able to stand the shock.  The CCP circuit connecting banks would be closed precisely when they were least able to stand the shock.

In retrospect, I seem like a Pollyanna.  Compared to people like HSBC’s Gary Dunn, anyways (Risk link-requires a subscription).  Gary went all Jeremiah at the AGM, warning of an apocalypse emanating from the clearing system.  Actually, his word was “Armageddon”:

Mandatory clearing of over-the-counter derivatives could jeopardise policy-makers’ hopes of a no-bailout financial system, according to Gary Dunn, senior manager for regulatory and risk analytics at HSBC.

Speaking at the annual general meeting of the International Swaps and Derivatives Association in Singapore today, Dunn sketched out an “Armageddon scenario” resulting from the fact that the same group of international banks are all members of the majority of central counterparties (CCPs) – so, a big bank default would simultaneously hit all CCPs of which it is a member.

“What happens when one bank defaults across six CCPs? The remaining members will have to pick up the bill. Given that they are almost certainly members of the other CCPs, this will result in a default contribution bill so large it could potentially lead to their failure also,” he said.

Given the key role CCPs will play in the future financial system, Dunn argued this would ultimately result in a taxpayer bailout amounting to trillions of dollars. In his Armageddon scenario, that bailout would be preceded by the complete liquidation of CCP initial margin stocks – much of which would likely be held in the form of government debt.

The wrong-way risk in the current CCP system is so large it could potentially lead to a sovereign default,” he said. [Emphasis added.]

Interconnections between SIFIs via clearinghouses, with the fragility of these connections perhaps exacerbated by the fragmentation of CCPs (due to fragmentation along jurisdictional lines, perhaps).  Where have you seen that before?  Hint: Not in a Gensler speech.

The clearing panel also fretted abou the possibility that in its attempt to eliminate TBTF, the G-20 has just created new TBTF institutions.  Too big, and too interconnected:

Central counterparty clearers stand to be the next “too-big-to-fail” institutions and could pose an acute threat to the financial system if regulators stall on plans to manage the potential failure of a clearing entity.

At the annual general meeting of the International Swaps and Derivatives Association in Singapore today, a group of panelists highlighted the lack of clarity over resolution for failed CCPs as a significant concern for the G20 objectives of eliminating systemic risk.

“There are still no resolution plans for CCPs and it is murkier now that clearing houses have moved away from the utility model,” said Athanassios Diplas, senior adviser to the ISDA board, speaking at the event earlier today.

The G20 objectives agreed in 2009 deem that no financial institution should be considered too big to fail and that taxpayers should not bear the costs of resolution for any institution that does fail

While regulators have been busy penning rules to deal with the problem of too-big-to-fail banks, concerns are shifting to clearing houses, and the increased concentration of risk held in them as the Dodd-Frank Act in the US and the European Market Infrastructure Regulation push an increasing number of standardised over-the-counter swaps through central counterparties.

“We’re getting very close to solving too big to fail globally for banks, but I worry that this risk could move to CCPs. I’m not convinced that we have made CCPs deeply resolvable yet – we have to do that to address systemic risk issue in a thorough way,” Wilson Ervin, vice-chairman of the group executive office at Credit Suisse told IFR.

All of which was perfectly foreseeable in 2009 when the G-20 blessed clearing as the silver bullet solution.  Foreseeable-and foreseen by some.

And the late start on addressing this issue before CCP mandates went into effect has left the world financial system in highly exposed:

While the Financial Stability Board addressed basic principals for clearing house resolution in June 2012, the issue remains on the back burner with many regulators as they continue to get to grips with a workable bank resolution regime

CCPs are the solution.  So in their wisdom governments decided to load risk onto them.  But dealing with the failure of these government-mandated SIFIs “remains on the back burner.”

Great.  That will turn out well.

Fools rush in where angels fear to tread.  Governments have rushed into prescribing the Clearinghouse Cure, but have relegated addressing the very dangerous potential side-effect of that cure “to the back burner.”

But we’re not done!  The panel also fretted about the potentially destabilizing effects of increasing collateral and margins-both initial and variation margin (can’t find a link to this Mary Childs story: I think it is only available on Bloomberg terminals):

The numbers are large enough to be very worrisome,” Athanassios Diplas, principal at Diplas Advisors LLC and a senior adviser to the ISDA board, said on the panel. “I don’t

think anyone has trillions lying around the couch cushions.” Regulators should be careful in setting the collateral requirements given that margin calls contributed to the escalation of the financial crisis in 2008, according to Kim Taylor, president of CME Group Inc.’s clearinghouse.

Spiraling Losses

“Margin calls triggered liquidation of assets for positions, which triggered mark to market losses for other parties. It contributed to the spiral, and I think there’s the  potential for threshold-based margin” to help avoid a repeat, she said on the panel.

Margin calls exacerbating a crisis.  Whoever heard of such a thing?  Only anyone who has studied past financial panics and market crashes.  But Gensler and Timmy! and so many others assured us that collateral is only good: the more collateral the better.  Just another item on the bill of goods they sold the world-and for which we may have to pay dearly later.

Scary addendum.  At a recent Chicago Fed conference, I told someone from a major central bank that although the initial margin issue was important, it worried me that central banks and regulators seemed to be ignoring how variation margin could destabilize the system, especially with an expansion of clearing, which creates a very tightly coupled system of margin payments that must operate on a very tight and rigid time schedule.  He told me that there wasn’t as much concern about variation margin because it netted out to zero.

Seriously.  I kid you not.   It’s as stupid as the Krugman “we owe national debt to ourselves” mantra.  The payers have to find the liquidity to make the payment to the receivers.  In stress situations, they have to find a lot of liquidity precisely when liquidity dries up.  In response, they do things that impose additional stress on the system, and can break it.  Money is not transferred instantaneously and frictionlessly between those who owe and those who receive.  Those frictions-and just the timing required to recycle the payments-can cause the system to freeze up during periods of stress.

The “what, me worry?” approach to variation margin is very worrisome indeed.

But don’t worry!  Regulators will ensure that CCPs don’t engage in a race to the bottom when setting margins:

Britain’s new regulator for market operators warned clearers of tougher policing of fees to stamp out cut-throat competition that risks undermining financial stability.

. . . .

“We are not in the business of preventing competition but what’s important is the terms of that competition,” Britain’s new clearing supervisor, Edwin Schooling Latter, told Reuters in an interview.

The Bank of England became the regulator for clearing houses this month and Schooling Latter said in his first media interview he will not tolerate “a race to the bottom” such as clearers allowing banks to post too low margins against trades.

Margins refer to traders of derivatives posting government bonds or other high quality collateral to help cover any losses and the level of margins is determined by the clearing house.

“We want a world where the clearing houses compete on the quality of their risk management and not on how low their margins are,” Schooling Latter said.

Because regulators, of course, are so skilled at pricing risks.  They did such a bang-up job of it when setting capital requirements under Basel.  And by “bang-up” I mean like a train wreck.

The Sorcerer’s Apprentice metaphor seems more apt by the day.  Regulators and legislators have cast the spell to bring massive CCPs to life, but cannot control the consequences-which can be dangerous indeed.  They intended to solve one problem, but they have created others, and are scrambling to deal with them.

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  1. […] Read the articles below then come back and read Craig Pirrong’s take on them: […]

    Pingback by ISDA AGM 2013 | Virtually There | The OTC Space — April 25, 2013 @ 4:15 pm

  2. It still seems to me that this game of “hide the liquidity risk” cannot be ended until our fundamental contract-law enforcement rules build in a “force-majeure” type doctrine for systemic liquidity crises. Everybody can’t fit through the doorway at once, so insisting that creditor’s rights must be instantly enforced come hell or high water is in denial of reality. I recognize that such rules could stimulate extra liquidity crises as anticipation of getting locked in made parties try to liquidate earlier, but I’d be willing to trade off, say, a 2X increased frequency of liquidity crises if each one had a 10X less serious impact.

    Comment by srp — April 29, 2013 @ 8:15 pm

  3. […] Fools Rush In: CCP Mandate Edition I was invited to participate in a panel on clearing at ISDA’s Annual General Meeting in Singapore, but unfortunately I had to decline on account of my teaching obligations. […]

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