Streetwise Professor

December 29, 2009

Burn the Village to Save It

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 3:24 pm

The mouse-cat-dog-elephant-mouse dialectic is starting to dawn on a select few, especially in Europe.  Jeremy Grant of the FT reports that the new head of the London Stock Exchange, Xavier Rolet, has issued a pretty clear warning:

Clearing houses in Europe should be regulated by central banks to guard against the risk of a catastrophic failure by one of them, the  London Stock Exchange’schief executive said.

Xavier Rolet, a former  Lehman Brothers and  Goldman Sachs banker, said that it was “very dangerous” for clearing houses’ capital bases and risk models to differ from country to country.

His comments come amid growing concerns that the insistence by policymakers that more financial instruments – such as over-the-counter derivatives – should be processed through clearing houses could overwhelm a clearer and spark a new crisis. [Emphasis added.]

In honor of the new Holmes movie just released on Christmas: no sh*t, Sherlock.

Some other “duh!” moments:

The Financial Services Authority, which regulates clearing houses in the UK, said last week: “The drive to have a significantly greater proportion of OTC derivatives markets centrally cleared will further increase the systemic importance of [clearing houses].”

Mr Rolet said it was possible that a clearing house could be overwhelmed if in the case of a default the clearing house members were unable to cover the margin calls that the clearer would make to cover the losses.

You mean that clearing doesn’t make the risk of default disappear, but just shifts it around in a different–and potentially worse–way?  Next, they’ll tell us there’s no Santa Claus.  I am so disillusioned.

Sarcasm aside (but never far away 🙂 ), Rolet has clearly recognized the dialectic that the mandated expansion of clearinghouses will launch:

He said that clearing houses should have access to the funding provided by central banks through their discount window in the case of an emergency.

“This is not about fear-mongering, but where a clearing house has a substantial amount of ‘binary risk’ products that require a potentially huge collateral [margin] call which the [members of the clearing house] are not able to supply then the question is: who funds it?” said Mr Rolet.

“It seems sensible to us that the central banks should have at least a funding relationship to clearing houses.”

He said Europe needed a “harmonised, integrated clearing industry with standardised regulation” and “lending arrangements” with central banks.

In other words, world governments are responding to fears that interconnected financial institutions are too big to fail and will inevitably receive central bank or treasury or central bank + treasury bailouts by creating new interconnected financial institutions that are too big to fail and providing them with a guarantee of central bank support.

The inherent logical disconnect here is as stark as the old line from Vietnam: “We had to burn the village to save it.”  The only difference is that the Vietnam line was almost certainly apocryphal (the figment of Peter Arnett’s imagination), whereas what is happening in financial markets is all too real.

This is an improvement?  It’s always advisable to start thinking about living with the mice before bringing on the elephants.  If we are serious about attacking too big to fail, rather than creating institutions that concentrate risk and establishing new implicit and explicit commitments to support them in a crisis we should be doing the exact opposite.  Xavier Rolet is doing a great service by pointing out the logical implications of force-feeding central countperparties.  The question is, whether anybody–especially in the US, and particularly in the US Congress (yeah, that means you, Barney & Chris, living, breathing weapons of financial mass destruction)–is paying attention.  Or even cares.

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  1. Clearing for some OTC products works extremely well. LCH-Clearnet has been successfully handling billions in repos for 10 years now. And SwapClear is expanding steadily. Both RepoClear and SwapClear performed very well during the Lehman’s default, with large Lehman’s positions being closed out at no lose to the clearing house and I expect to see increased volumes go through this sort of clearing mechanism as the members realise the advantages.

    However the knee jerk reaction that Credit Default Swaps should be cleared, and the failure of the clearing houses to stand up and point out the obvious – that these products are GROSSLY unsuitable for clearing – is alarming.

    There seems to be a common misapprehension that if a product is simple then it can obviously be cleared. I am not trying to claim that CDSs are Horribly Complicated Financial Engineering That Need A PHD To Understand Them. They are simple products, however, a clearing house needs much more than that.

    It needs an assurance that there will always be a market in the contracts which it clears, providing continuous pricing. This doesn’t have to be easy – clearing houses can cope with unusual contracts with weird pricing – Natural Gas prices can sometime go negative!

    A clearing house collects margin in two forms – variation margin, which is a daily mark-to-market which would in the case of CDSs be easy in normal conditions, and initial margin, which is essentially the amount the contract may fall in value between the point where margin is not paid because of a default and the point where the clearing house closes out the contract.

    Clearing houses are designed to cope with the failure of a member and the liquidation of its positions, the aim being to insulate other members who happen to have traded with the defaulter from any effects.

    They are NOT designed to cope with the failure of cleared products. So after Lehmans defaulted, the CDSs on other banks which Lehmans had with a clearing house could have been dealt with in a straightforward manner. But the CDSs that other members had on Lehmans could not be closed in the market by the clearing house as the contract had effectively ceased to exist.

    The only way to get a reasonable valuation on them would be to organise exactly the same sort of auction process that was done anyway. Clearing would not have made this any easier at all.

    After the auction process there were concerns about domino defaults if counterparties were unable to meet the resulting obligations – in a cleared system these would have been larger as the clearing house would have been likely to:

    (a) set the price for the variation margining of the Lehmans CDSs at below 10% the day Lehman’s defaulted, requiring collateral against these immediately and giving less time for orderly liquidation of positions

    (b) to immediately raise the initial margin levels on CDSs on any members which it knows are highly exposed to Lehmans contracts. This could provoke further panic in the markets – clearing houses usually manage to take extra margin from dodgy members on the quiet (nb this is VERY rare), but a CDS clearing house would effectively be forced to publish its views on the soundness of its members through initial margin setting that affects other members. Say (choosing a silly example) the clearing house knew that HSBC had huge positions in Lehamns contracts that it was going to have trouble covering – does the clearing house promptly increase the margin it charges on HSBC CDSs? So who wants to deal with a counterpaty the clearing house has obviously just added to its watch list?

    And there are also significant complications in the netting. On a simplistic basis, there are two sorts of large participants in the CDS market. There are firms that tend to mostly write protection. These firms will get little netting gain from a clearing house and will find the costs of proving both variation and initial margin unpleasantly high. And there are firms that buy and sell CDSs, using them to hedge moving positions held by the firm. Here the CDSs may or may not net down considerably, but by removing one side of a hedge into a clearing house, the firm may find that its netting position actually gets worse, or (more likely) doesn’t improve by enough to justify the higher margin costs.

    And finally the idea of clearing a market where defaults are caused by the government deciding that one firm needs to go under as An Example to the others, is just horrible.

    Clearing is not a good idea for these contracts. The clearing house will not be able to manage its risk. And a central counterparty which cannot effectively manage its risk is a far greater systemic problem than an uncleared CDS market.

    Comment by Dover Beach — December 30, 2009 @ 3:56 am

  2. @DB–thanks for your detailed comment. I’ve written extensively, here on SWP, in some working papers, and in a piece published in Regulation, arguing similarly to you that clearing is not for everything; that it is inappropriate for some products and some counterparties due to a variety of information problems. Since these information problems vary by product and by counterparty, the costs and benefits of clearing vary too.

    That’s my problem with clearing mandates. The adoption of a “one size fits all” approach to diverse instruments and counterparties is a recipe for disaster.

    Thanks again, DB; hope to hear from you again.

    The ProfessorComment by The Professor — December 30, 2009 @ 8:18 am

  3. @SWP –

    viewed from ‘the sharp end’ your usual set of comments on information asymmetries is, er, mildly interesting but way too academic – largely missing the real problems of clearing CDS.

    I agree with your comment on a ‘one-size fits all’ approach being a disaster. But curiously that leads me to dislike intensely Rolet’s argument that CH’s should be subject to uniform regulation by central banks. If that had been the case, we would never have got to the point of having successful clearing for instruments such as Repos. I don’t think there is ANY evidence that banks have ever gone in for ‘regulatory arbitrage’, shopping around for the ‘cheapest’ CH. In my (pretty extensive) experience, the major users are generally a lot more acutely aware of systemic risk than some of the other major players such as the exchanges, who seem fixated on the idea that transparency solves all known problems.

    Contact me off board (I think you have my email) if you want – I prefer to remain anonymous in this sort of forum.


    Comment by Dover Beach — December 30, 2009 @ 10:11 am

  4. DB: re “way too academic”–LOL. Leopard, spots, and all that.

    I like Rolet’s argument only because it demonstrates the logical implications of the mandates, and one-size-fits-all. Or should I say, the logical absurdity thereof, and the complete disconnect between the stated objective and the reality.

    I’ll take you up on your offer re off-board.

    The ProfessorComment by The Professor — December 30, 2009 @ 3:15 pm

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