Streetwise Professor

April 19, 2011

Armageddon Time

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 6:50 pm

I haven’t written much about clearing lately, and I just know some people are going through withdrawal as a result, so a quick post to feed your jones.

The ISDA Annual General Meeting was in Prague last week.  Clearing was on everybody’s mind.  There were numerous discussions that echoed things I’ve said on SWP and in my academic writing over the past 2.5 years or so.

One example: the head of UniCredit Group’s commercial and investment banking expressed concerns that CCPs will be  undercapitalized.  He compared them to, yes, monoline insurers:

Mustier said the “thin capitalisation” of CCPs – which will end up clearing hundreds of trillions of dollars notional in standardised derivatives – could be compared with monoline insurance companies that underwrite securitisations. Before the crisis, individuals who questioned the ability of monoline insurance companies to underwrite large amounts of securitisations using little capital were told small levels of capital were appropriate because the underlying deals had high credit ratings and the risks had been modelled, said Mustier – although he emphasised CCPs have other lines of defence, which makes the monoline comparison an unfair one.

“I don’t want to make a comparison between clearing houses and other very leveraged financial institutions of the past such as monoline insurance, for instance, where we had roughly the same ratios, because in clearing houses we have something that is fundamentally different, which is the initial deposits that financial participants provide when they open up a trade, and the margin calls, which should mitigate the risks of clearing the position,” said Mustier. “But, nevertheless, clearing houses are very thinly capitalised even if their structure should protect them.”

On the one hand I agree with Mr. Mustier–there is a danger CCPs will be undercapitalized. On the other hand, I think the comparison with monolines is a very fair one. Indeed, this is the gravamen of my post on wrong way risk in CCPs. As Jon Gregory has pointed out, monoline insurers were subject to wrong way risk because they were insuring very senior claims. They insured AAA tranches, and the junior tranches provided a cushion that made it very unlikely that the monolines would have to pay off. Armageddon had to happen for the monolines to pay off on what they insured. But Armageddon did happen, they had to pay off, and they had far too little capital to deal with it.

The initial margins that Mustier refers too, along with the default fund contribution of a defaulting CCP member, are exactly like the junior tranches of the securities that monolines insured.  Those funds will get blown through only in Armageddon, and it is quite possible that in such a situation, CCP capital will prove inadequate.  And even if it is sufficient, under those circumstances the member firms–primarily banks–are going to absorb huge hits.  Which kind of defeats the whole purpose of CCPs–to insulate big financial institutions from risk during crises.  Actually, there’s no “kind of” about it.

The dangers of fragmentation of CCPs resulting from the desire of each major jurisdiction to have its own clearinghouses was another theme of the AGM:

“We must not fragment the clearing house and exchange environment. A fragmented approach will lead to weaker institutions, and greater risk.”

But while Rohner urged closer co-ordination of regulatory reform, he warned it is not a sure thing: “Governments may be unable or unwilling to achieve the necessary level of co-operation, which could lead policymakers to resort to ring-fencing or other limitations on structures or geographic reach to protect the home market or taxpayer. This could fragment the OTC derivatives market.”

And yet another SWP theme is that low entry requirements for CCP membership are extremely problematic.  Cue Athanassios Diplas of Deutsche Bank and Tom Benison of JPM:

Regulators are pushing for CCPs to lower their barriers to entry, letting weaker firms into clearing’s inner circle – but these firms could be overwhelmed in a crisis, the larger banks argued.

“Let’s say you’re a clearing member with $75 million in capital, and your cost of entry to a CCP is $25 million for the guarantee fund – and you join two CCPs. But those CCPs also have the right to call on you for an additional $25 million if they run out of money,” said Athanassios Diplas, global head of counterparty portfolio management at Deutsche Bank, at a press briefing. “They can’t both get it, they don’t know about each other – and the assessment will come at the worst point in time – the day after the Lehman Brothers collapse, for example.”

Tom Benison, managing director for credit trading at JP Morgan, echoed the point. “If one CCP has to make a call for more funds, it’s likely to mean we’re really far out in the tail when it happens – which means every CCP is really far out in the tail. So how many CCPs are calling for funds?”

Benison’s point is a variation on the wrong-way risk point I’ve made before: CCPs are going to call on member capital during extreme circumstances–the Armageddon scenarios.  That’s precisely when those entities may themselves be facing dire circumstances, meaning that the capital might well not be there  when you need it.

Now, you may just write me off as a running dog of the big banks.  All I can say is that I’ve been making these arguments in my spare time for a long time–in some cases, before the crisis and before clearing mandates were even thought of and before anybody was really thinking about clearing period. And regardless, if the argument is faulty–have at it.

In my view, the concerns expressed at the ISDA AGM are real ones.  Ones that didn’t even enter the heads of  the Sorcerer’s Apprentices who conjured clearing mandates to life.  But they are ones that market participants and regulators are going to have to deal with going forward.  And the very scary thing is that we’ll only find out in the next financial Armageddon time whether they’ve got it right.  Which, given the very unsettled situation around the world, could happen sooner than we’d like.

For some reason, the Clash come to mind:

PS. Hopefully quite soon a more authoritative and complete discussion of these issues that I’ve just completed (the draft, anyways) will be released. As they say: Watch this space!

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