Several clearing related stories, each of which gives me a sense of deja vu. Or deja dit, to be more accurate.
The Bank of England just released a paper warning about the potential pro-cyclicality of CCP initial margin methodologies. I have expressed concern about this for some time.
BofE expresses concern that pro-cyclicality threatens to cause a measure intended to reduce credit risk create liquidity risk instead. This is another Clearing Cassandra theme. (Speaking of Cassandra, I will be returning to the old stomping grounds of Troy next week. And I don’t mean a city in upstate NY.)
BofE recommends that CCPs make public their margin methodologies, something that sends the clearinghouses into paroxysms of rage. But it makes sense to do that. And not just to reveal to the marketplace the potential liquidity demands that these methodologies can create, thereby allowing them to prepare accordingly. But to permit clearing participants to estimate their exposure to CCPs.
Clearing member exposure to CCPs depends on the likelihood that initial margins are sufficient to cover losses. Estimation of this exposure requires CMs to be able to evaluate margin calculations under a variety of market scenarios. If CCPs keep their methodologies secret, this is not possible. Discriminating choice among CCPs also requires market participants to understand margin costs and exposure under different scenarios. Such choice is not possible if CCPs keep secret their calculations.
CCPs are the beneficiaries of clearing mandates. Due to margin spirals and other feedback effects, margin calculations have external effects. There is therefore a strong efficiency case favoring disclosure to mitigate the externality, and any commercial/competitive inconvenience CCPs suffer as a result is more than compensated for by the fact that government mandates force huge quantities of business their way.
Another story that has come to my attention is that RBS is cutting back its rate clearing business, in large part due to the substantial capital commitment required, and the operational overhead.
This is another long-time SWP theme. The regulatory burdens of being a clearing member create scale economies that will result-and is resulting-in substantial consolidation of the clearing business. Thus, the systemic risks associated with clearing arise not only because of concentration of risk in CCPs, but in concentration of risks in a dwindling number of clearing firms who participate in multiple CCPs. Concentration of risks in a small number of CMs is, in my view, actually more systemically worrisome than concentration of risks in a small number of CCPs. Indeed, it is precisely the concentration of risks in CMs that makes failure of a systemically important CCP more likely.
Recall the good old days, when Gensler fought to reduce the minimum capital requirement for CMs to $25 million in order to spur competition in the supply of clearing services? Good times, good times. Little did he recognize that the other myriad burdens of Franendodd and Emir would inevitably lead to consolidation, making the minimum capital requirement irrelevant.
But this was only one of Gensler’s delusions (or was it lies?) about clearing. I was therefore pleased, and admittedly somewhat shocked, to see his (interim) replacement, Mark Wetjen, (implicitly) call bull on Gensler’s Panglossian propaganda on clearing:
He made an interesting and refreshingly blunt departure from the superseded Gensler script, by referring to Clearing Houses as potential sources of systemic risk.
“A clearinghouse’s failure to adhere to rigorous risk management practices established by the Commission’s regulations, now more than ever, could have significant economic consequences.”
His predecessor’s evangelical belief in CCPs as universal risk-mitigants, refused to countenance the heresy that central clearing may at best merely transfer credit risk, and may actually result in concentration of and increase in systemic risk. Fundamentalism should have no place in regulation, especially the more fundamental reforms; Wetjen’s implied recognition that a central pillar of the Dodd-Frank reforms is open for objective discussion, represents an important and consequential change in the Agency’s culture and governance.
That last part is the opinion of Nick Railton-Edwards (a somewhat Pythonesque handle, eh?), who wrote the piece, rather than Wetjen. (He sounds like a like-minded, not to say right-minded, bloke.) But it is a realistic characterization of the implications of Wetjen’s remarks. I would add that this evangelism is exactly what I hammered Gensler for repeatedly in 2009-2013: Indeed, I repeatedly used the term evangelist to refer to Gensler and his allies. (And that hammering is why he banned me from the CFTC building-something that I have on unimpeachable authority.)
The sad thing about all this is that all of these things were foreseeable before legislators and regulators* went all in on clearing as The Solution. Certain Cassandras did foresee it. But now this is where we are, and some adults like the BofE and Wetjen are trying to mitigate the dangers that this rash and thoughtless plunge created.
Would that this had occurred at the front end of the process rather than the back. Better late than never, perhaps. But better early than late.
*Timmah! was Gensler’s partner in crime on this. Geithner has just released his memoirs, and is flogging the book. I will give him another flogging in due course. For old times’ sake.