I’ve been hammering on the theme of the systemic risks of central clearing-especially mandated central clearing-for around five years. And now those concerns are being expressed with greater frequency. Fed Governor Jerome Powell gave a speech focusing on the most straightforward source of systemic risk in mandated clearing: the concentration of risk in the clearinghouse, which becomes a single point of failure whose collapse could jeopardize the broader financial system. Bernanke made a similar argument a couple of years back.
Some articles from the last several days highlight more subtle, but in my view more important, concerns. This Reuters piece mentions several things I’ve focused on over the years: the strains that clearing can put on the liquidity of individual firms, and the system at large; margin pro-cyclicality; and crucially, the fact that self-preserving actions taken by CCPs may have destabilizing effects elsewhere in the financial system.
This last point demonstrates a danger in the Powell approach which focuses on making CCPs invulnerable, which I’ve referred to as the levee effect. Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a CCP can redistribute shocks elsewhere in the system in a highly destabilizing way. CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects. Indeed, greater reliance on CCPs increases the tightness of the coupling of the financial system, which can be highly problematic under stressed conditions. Liquidity and funding are the primary channels by which CCP decisions will have external effects on the broader financial markets.
These considerations are related to a broader point, which is that CCPs are merely parts, albeit important ones, of a broader financial system, and they must be evaluated in the context of the entire system. An article in the International Financing Review by Christopher Whittall provides another illustration of this, again related to liquidity. He notes that Basel III’s leverage ratio clashes with the tremendous thirst of CCPs for liquidity:
“The move towards central clearing creates a focus on how to fund margin requirements, which should dictate an increase in repo activity from banks. The problem is repo becomes very unappealing for banks under the leverage ratio.”
So sayeth the head of fixed income at a major bank. CCPs create tremendous funding needs, and particularly contingent funding needs that are especially large in stressed conditions when liquidity is hard to come by. These needs are hard enough to address in the absence of a leverage ratio, but as the fixed income guy notes, this is an even bigger problem when it is present. As he says: “Viewed as a whole, we can start to start to see how these different regulations don’t quite hang together from a macro-prudential perspective.”
Exactly. Illustrating another theme: Regulatory responses to the crisis have tended to focus on the individual pieces with too little attention paid to how regulations of one piece affect the other pieces. The interaction between the leverage ratio and clearing mandates is a particularly worrisome example. In any complex system, it is the interaction between interconnected pieces of the system that can lead to abrupt collapses. Making each piece of the system more robust doesn’t necessarily make the system more robust. Indeed, the opposite can be true.
Yes, I’ve been a Cassandra on these issues. So in some sense, it’s good to see that the concerns that prompted my prophesies are now getting more widespread attention. But methinks that the post-crisis regulatory juggernaut is impossible to reverse, and that although some of the problems in clearing and the interactions between clearing and other aspects of financial regulation can be ameliorated, the basic sources of systemic risk inherent in the new financial and regulatory structure will persist.