Streetwise Professor

October 17, 2022

Clearing Is Not A Harmless Bunny: I Told You That I Told You That I Told You [ad infinitum] That I Told You So

Filed under: Clearing,Derivatives,Economics,Financial crisis,Regulation — cpirrong @ 10:54 am

I have long called myself “the Clearing Cassandra” for my repeated and unheeded warnings about the dangers of letting the Trojan Horse of clearing (and the margining of uncleared trades) into the financial citadel. Specifically, clearing/margining can create financial shocks (and indeed financial crises) rather than preventing them (which is the supposed justification for mandating them).

We have seen several examples of this in the past several years, including the COVID (lockdown) shock of March 2020 (a subject of a JACF article of mine) and the recent energy market tremors. The most recent example, and in many ways the most telling one, is the recent instability in the UK that led the Bank of England to intervene to prevent a full-on crisis. The tumult fed a spike in UK government yields and contributed to a plunge in the Pound.

The instability was centered on UK pension funds engaged in a strategy called Liability Directed Investment (LDI)–which should now be renamed Liquidity Danger Investment. In a nutshell, in LDI defined benefit pension funds hedge the interest rate risk in their liabilities through interest rate swaps that are cleared or otherwise margined daily on a mark-to-market basis, rather than investing in fixed income securities that generate cash flows that match the liabilities. The funds hold non-fixed income assets (sometimes referred to as “growth assets”) in lieu of fixed income. (I discuss the whys of that portfolio strategy below.)

On a MTM basis, the funds are hedged: a rise in interest rates causes a decline in the present value of the liabilities, which matches a decline in the value of the swaps. Even if there is a duration match, however, there is not a liquidity match. A rise in interest rates generates no cash inflow on the liabilities (even though they have declined in value), but the clearing/margining of the swaps leads to a variation margin outflow: the funds have to stump up cash to meet VM obligations.

And this has happened in a big way due to interest rate increases driven by central bank tightening and the deteriorating fiscal situation in the UK (which has been exacerbated substantially by the energy situation, and the British government’s commitment to absorb a large fraction of energy costs). This led to big margin calls . . . which the funds did not have cash to cover. So, cue a fire sale: the funds dumped their most liquid assets–UK government gilts–which overwhelmed the risk bearing capacity/liquidity of that market, leading to a further spurt in interest rates . . . which led to more VM obligations. Etc., etc., etc.

In other words, a classic liquidity spiral.

The BofE intervened by buying gilts in massive amounts. This helped stem the spiral, though the problem was so acute that the BofE had to extend its purchases beyond the period it initially announced.

So yet again, central bank intervention was necessary to provide liquidity to put out fires created by margining.

FFS. When will people who should know better figure this out? How many times is it necessary to hit the mule upside the head with a 2×4?

I just returned from France, and while walking by the Banque de France I thought of a conference held there in the fall of 2013 at which I spoke: the conference was co-sponsored by the BdF, BofE, and ECB. It was intended to be a celebration of the passage and implementation of various post-Crisis regulations, clearing mandates most prominent among them.

I did my buzz kill Clearing Cassandra routine, in which I warned very specifically of the liquidity spiral dangers inherent in clearing as a source of financial instability. I got pretty much the same response as the Trojan Cassandra–a blow off, in other words. Indeed, I quite evidently got under some skins. The next speaker was Benoît Cœuré, a member of the ECB governing council. The first half of his talk was a very intemperate–and futile–attempt at rebuttal. Which I took as a compliment.

Alas, events have repeatedly rebutted Cœuré and Gensler and all the other myriad clearing cheerleaders.

The LDI episode has validated other arguments that I made starting in late-2008. Most notably, clearing was touted as a “no credit” system because the clearinghouse does not extend any credit to counterparties: variation margin/mark-to-market is the mechanism that limits CCP credit exposure. Since one (faulty) narrative of the Crisis was that it was the result of credit extended to derivatives counterparties, clearing was repeatedly touted as a way of reducing systemic risk.

Not so fast! I said. Such a view is profoundly unsystemic because it neglects the fact that market participants can substitute other forms of credit for the credit they no longer get via derivatives trades. And indeed, in the recent LDI episode exemplifies a very specific warning I made over a decade ago: those subject to clearing or margining mandates would borrow on the repo market to fund margin obligations, including both initial margin and variation margin.

And indeed the UK funds did exactly that. This actually increased the connectedness of the financial system (contrary to the triumphant assertions of Gensler and others), and this connectedness via the repo channel was another factor that drove the BofE to intervene.

My beard is not quite this long (though it’s getting there) but this is pretty much spot on:

Clearing is Not a Harmless Bunny

Again: Clearing converts credit risk into liquidity risk. And all financial crises are liquidity crises.

Maybe someday people will figure this out. Hopefully before I snuff it.

And the idiocy of this is especially great with respect to the UK pension funds because they posed relatively little credit risk in the first place. So there was not a substitution of one risk (liquidity risk) for another (credit risk). There was an addition of a new risk with little if any reduction of any other risk.

The LDI strategies were right way risks. Interest rate movements that cause swaps to lose value also increase the value of the funds (by reducing the PV of their liabilities). The funds were not–and are not-leveraged plays on interest rate risk. So the prospects of defaults on derivatives that could be mitigated by clearing were minimal.

Here I have to part ways with someone I usually agree with, John Cochrane, who characterizes the episode as another example of the dangers of leverage. He cites to a BofE document about the LDI episode that indeed mentions leverage, but the story it tells is not the classic lever-up-and-lose-more-when-the-market-moves-against-you one that John suggests. Instead, in figure in the BofE piece that John includes in one of his posts, the increase in interest rates actually makes the pension fund better off in present value terms–even including its LDI-related positions–because its assets go down less in value than its liabilities do. In that sense, the LDI positions are an interest rate hedge. But there is a mismatch in the liquidity impacts.*. It is this liquidity mismatch that causes the problem.

The BofE piece also suggests that the underlying issue here is pension fund underfunding. In essence, the pension funds needed to jack up returns to close their funding gap. So instead of investing in fixed income assets with cash flows that mirrored those of its pension liabilities, the funds invested in higher returning assets like equities. Just investing in fixed income would have locked in the funding gap: investing in equities increased the odds of becoming fully funded. But just investing in equities alone would have subjected the funds to substantial interest rate risk. So the LDI strategies were intended to immunize them against this risk.

Thus, the original sin was the underfunding. LDI was/is not a way of adding interest rate risk through leverage to raise expected returns to close the gap (gambling on interest rate risk for resurrection). Instead it was a way of managing interest rate risk to permit raising returns to close the gap by changing portfolio composition. (No doubt regulators were cool with this because it reduced the probability that pension fund bailouts would be needed, or at least kicked that can down the road, a la US S&L regulators in the 1980s.)

No, the real story here is not the oft-told tale of highly leveraged intermediaries coming to grief when their speculations turn out wrong. Instead, it is a story of how mechanisms intended to limit leverage directly lead to indirect increases in debt and more importantly to increases in liquidity risks. In that way, margining increases systemic risk, rather than reducing it as advertised.

*The BofE document describes an LDI mechanism that is somewhat different than using swaps to manage interest rate risk. Instead, it describes a mechanism whereby positions in gilts are partially funded by repo borrowing. The borrowing is necessary to create a position large enough to create enough duration to match the duration of a fund’s liabilities. But a swap is economically equivalent to a position in the underlying funded by borrowing, so the difference is more apparent than real. Moreover, the liquidity implications of the interest rate hedging mechanism in the BofE document are quite similar to those of a swap.

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  1. what would be the solution, in your opinion? any suggestions? other than undoing the forced migration of trading to clearinghouses?

    Comment by Mario — October 17, 2022 @ 11:26 am

  2. When the defined benefit pension schemes recalculate their liabilities in light of the current increased death rates then perhaps their financial positions will look better.

    I suppose it depends on patterns of death. If someone dies at 65 so that instead of paying him a pension the scheme need only pay 50% to his widow, the liabilities have reduced.

    But if someone is killed at 30 by the dreaded “mysterious” myocarditis he will stop paying into the scheme while his widow will be paid a 50% death-in-service pension for life and his children will be paid pensions until they are (say) 21. Sounds expensive to me. (Though few private sector DB schemes are still open to thirty years olds. Just as well, eh?)

    I am struck that the pension actuaries seem to be largely silent on the matter, at least in the UK. The remarks I’ve seen have been from Life Insurers in the US and Germany.

    Of course I’m wandering off topic here since this is an insolvency/solvency speculation rather than a comment on illiquidity and investment risk.

    Comment by dearieme — October 17, 2022 @ 1:11 pm

  3. A slight correction here:

    “The BofE intervened by buying gilts in massive amounts.”

    Not quite. BoE agreed that it could spend massive amounts, stated it was willing to spend massive amounts. The actual amounts spent were very, very, much lower. Possibly £20 billion out of the stated £65 billion.

    OK, £20 billion is real money. But worth making the point still. Central banks rule by expectations as much as by anything else.

    Comment by Tim Worstall — October 18, 2022 @ 1:33 am

  4. Don’t forget some folks did listen (mainly the LDI funds in Uk and Holland) and they granted an exemption from clearing. However many of those funds will have been paying cash on their bilateral VM too.

    Comment by Greenwichmeantiger — October 19, 2022 @ 5:16 am

  5. When the CFTC approves the FTX scheme I am sure there will be no costs since it’s so efficient.

    Comment by Jeff Carter (@pointsnfigures1) — October 19, 2022 @ 3:35 pm

  6. Thanks for ‘clearing’ that up, Prof. Dr. Cassandra Buzzkill.

    As a former regulator, my jaw dropped when I read what was going on, that pension funds had exposed themselves – or, really, their investors – to margin calls. The old regulator in me thought ‘this should never have been allowed’; the former employee of regulatory agencies thought back to the people I used to work with/for, and thought ‘yeah, I can see how this was allowed’.

    No one would have thought through the risks. I’ll bet no one even conceived that, a bit like Jellicoe at Jutland, they were at risk of losing EVERYTHING in an afternoon.

    The collateral damage is incredible, possibly extending to the pole-axing of yet another Prime Minister some time soon. More seriously (!) the pension funds and the gilt markets are still staggering. Wanna buy some sterling? LOL!

    O well. ‘Play stupid games, win stupid prizes.’

    This episode strengthens my confidence in my conclusion that the risk desk/function at securities market regulators – with which I have some experience! – is a useless function. The Bill Huang episode taught us that not even the players themselves, with their squillions and their battalions of Ivy League quants, know where the risks lie and/or how to manage them. If they don’t, poor me and those around me, confined to our desks, with little information, and surrounded by retards uninterested in anything but their monthly pay-cheque, had no chance.

    The anecdote about your BdF meeting says so much. Count Axel said it best:

    ‘Don’t you know, my son, with how little sense the world is governed.’

    I suppose we can take some comfort in that incorrigible stupidity and ‘the institutional imperative’ (as manifest in M. Couré, GiGi et hoc genus omnes) provide a predictable one-way bet in the markets – take advantage, as one can.

    Comment by Ex-Global Super-Regulator on Lunch Break — October 19, 2022 @ 5:35 pm

  7. “the risk desk/function at securities market regulators…is a useless function.”

    I would say all functions at most regulators are useless. I mean that literally, not as snark. The FCA, for examples, admits to receiving 5,000 STORs (Suspicious Transaction or Order Reports) per year from the trade, ~80% of which are about insider trading in equities. The other 20% are about market abuse. Since the regime came into effect in 2016 this means they have received 6,000 reports of market abuse. The number of sanctions issued for market abuse?


    When your chances of getting away with it are 5,999/6,000 even if you are caught and reported, why wouldn’t you do it? Whatever ‘it’ is?

    Comment by Green As Grass — October 20, 2022 @ 10:47 am

  8. On topic: as we have discussed before, whenever clearing comes up, I always think of this

    Comment by Green as Grass — October 20, 2022 @ 10:51 am

  9. @ Green As Grass Yes, good points.

    My thoughts recently have been that financial regulation is such a disaster that all of it should be struck from the legislation books and we just go back to ‘self help’: if you want to take the risk of wading into the financial markets, good luck to you; otherwise, keep your money in a government-guaranteed bank account, or buy gold and bury it in your garden, or buy bitcoin, stick it on a thumb drive, and pray that when the day comes you remember where you wrote down your list of access words.

    Not only is the job beyond the capacity of mortals, but the mortals that do the job couldn’t do it even under ideal conditions. Your numbers bear this out. We have a similar problem here in Oz: one of our gadflys recently did a similar analysis, and discovered that less than one per cent of complaints were investigated; not prosecuted, not won at trial, but investigated. With these numbers you have to ask: what is the point?

    Comment by Ex-Global Super-Regulator on Lunch Break — October 20, 2022 @ 5:30 pm

  10. @ EGSROL

    The problem is systemic among regulators and similar bodies. The FCA’s record is actually even worse than I paint it. While basically smiling upon all market abuse, they go after intermediaries, and sanction them instead – for not having proper measures in place to prevent market abuse by their clients. That is, they should have prevented the market abuse that the FCA don’t consider it necessary or important to sanction.

    This is akin to fining householders who get burgled for not having enough locks on their windows, while letting the actual burglars off scot free. This immoral, cowardly and profoundly lazy ethos arises because to sanction market abuse, you’d have to produce evidence that would convince a jury. To sanction someone’s controls, you just have to say that in your own opinion as records the controls weren’t good enough. They cannot catch real offenders, so they label as offenders those whom it requires no effort to catch.

    The “British FBI”, the NCA, is as bad. It receives about 750,000 Suspicious Activity Reports every year. That’s 500 per NCA investigator per year, ten a week. It investigates none. Literally none. It just runs stats on them. So in 2021, most money laundering reports concerned Malta (or whatever). It doesn’t do anything about Malta, or even suggest anyone else might do anything about Malta.

    The same thing happens here with what is laughingly called “Action Fraud”. There is so much fraud, and so few police stations, that when you are defrauded you report it online. You then find that Action Fraud are in fact Inaction Fraud, because like the NCA, all it does with the crime reports it receives is run reports off them.

    The UK police “solves” about 6% of crimes. In fact, even that is a gross overstatement. It relates to reported crime, and you don’t bother reporting crime to the police at all unless you need a crime number for your insurance claim. Furthermore, “solve” often means “get a thief to confess to 100 other offences in return for a lighter sentence”. It never means “the theft victim got their stolen property back”. The solve rate in that sense is probably 0%.

    So I think on balance I agree with you. Every body tasked with enforcement appears corrupted by indolence and institutional mediocrity. We should simply disband the FCA and the NCA, and not replace them with anything at all. We could disband much of the police too, and instead have private security contractors patrolling streets, deterring crime in the first place rather than letting it happen and then totally failing to address it. In each case, you’d know that the safety of your person and property are down to you, and you would need to be on your guard accordingly. Wholly ineffective state bodies are actually worse than none at all.

    Comment by Green as Grass — October 21, 2022 @ 4:31 am

  11. @GaG


    Comment by Ex-Global Super-Regulator on Lunch Break — October 21, 2022 @ 3:29 pm

  12. “We could disband much of the police too, and instead have private security contractors patrolling streets …”

    That reminds me that when I was a freshman I was hired to be a bodyguard for a stripper.

    I was also recruited as a ringer for a shooting team. “Why me?” “We thought you were the sort of chap who would know how to shoot.”

    I still don’t know how to interpret these events. Was I a natural for the police? For the SAS? For MI5 or MI6?

    Evidently not for the FCA. I suppose they must hire people who would know about how to crochet.

    Comment by dearieme — October 21, 2022 @ 5:54 pm

  13. The chief personality traits required at the FCA are cowardice and indolence.

    The cowardice is because, when someone abuses the markets, their approach is to attack the easiest target. The never attack the abuser, because then they’d have to prove their case to a court. Instead, they accuse the abuser’s former employer of lacking systems and controls, for which the evidentiary standard is, er, their own opinion.

    The indolence is necessary for all this to take between eight and fourteen years.

    If you aren’t a slothful clock-watching spineless fuckwit, dearieme, you’d not have fitted well into the FCA monoculture.

    Comment by Green as Grass — October 24, 2022 @ 3:33 am

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