Streetwise Professor

A board member of the ECB, Benoît Cœuré, gave a speech that discussed “the new risks associated with central clearing.” It is evident that Cœuré is a proponent of central clearing, though it is annoying to see him identify multilateral netting as the main benefit (<holds head in hands>).  But it is good to see yet again that central bankers are aware that central clearing does create new risks, and that regulators must be proactive in addressing them.

The problem is that he overlooks the most important risks.  Reading between the lines, like most regulators, Cœuré focuses on the solvency risks of CCPs, and about policy tools that can limit the probability of CCP insolvency and mitigate the adverse impacts of such an insolvency.

But as I’ve written repeatedly in the past, it’s not the insolvency risk per se that should keep people up at night.  Indeed, the measures taken to address the solvency risk can actually exacerbate the real risk a dramatic expansion of central clearing creates for the financial system: liquidity risk.

Liquidity crises are what threaten to bring down financial systems.  For most financial institutions, there is a connection between liquidity risk and solvency: banks become illiquid because (in a world of imperfect information) people believe they might become insolvent.  Maturity mismatches plus imperfect information plus possibility of insolvency combine to create liquidity crises.

CCPs don’t have the maturity mismatches, and they aren’t leveraged.  They cannot experience liquidity crises in the same way banks can.  The direct liquidity risk of CCPs is related to their ability to turn collateral into cash in the event of a member default.

But as I’ve said over and over, clearing affects the needs for liquidity by market participants.  Central clearing can be a source of, or accelerant of, liquidity crises.  Big price moves lead to big margin calls lead to spikes in liquidity demand. These are most likely to occur during periods of financial stress, and can greatly exacerbate that stress.  Moreover, failure of a CCP is most likely to occur due to the inability of traders to fund margin calls due to the shortage of liquidity.   This old article by Andrew Brimmer discusses two episodes I’ve analyzed on several occasions-the Hunts in silver and Black Monday-and shows how it is liquidity/credit/funding of margin calls for CCPs that can create stresses in the financial system.

This is where the systemic risk of clearing arises.  But the subject is totally absent from Cœuré’s speech.  Which is worrisome.

There is also the fallacy of composition problem.  The measures that Cœuré advocates to make CCPs stronger do NOT necessarily make the system stronger.  Strengthening CCPs can actually exacerbate the liquidity problems that clearing causes during a crisis.  The CCP may survive, due to these measures, but the stresses communicated to the rest of the system (and the stress has to go somewhere) can cause other institutions to fail.

This is what scares the bejeezus out of me.  Regulators don’t seem to get the fallacy of composition, and aren’t focused on the liquidity implications of greatly expanded central clearing.

These fears are heightened by reading this DTCC report about collateral and collateral management.

It contains this heading that should make every central banker and financial regulator soil his armor:

Margin Call activity to increase By up to 1000%

Then there’s this:

Operational Capabilities and Settlement Exceptions Management: The potential ten-fold increase in margin call volumes, and the resulting complexity due to market changes, could overwhelm the current operational processes and system infra-structures within banks, buy-side firms and their administrators. As a result, firms will need to invest in technology and also reengineer the settlement, exceptions management and dispute resolution processes in place today. According to a 2011 De- loitte paper, investments in operations required to build and sustain advanced collateral capabilities is estimated at upwards of $50 million annually for top-tier banks.

Be afraid.  Be very, very, very afraid.

The dramatic increase in the scope of clearing substantially increases the operational complexity of the system.  More importantly, it increases the system’s operational rigidity, because cash has to flow quickly, and according to a very precise schedule.  From client to FCM to CCP to FCM to client.  Any failures in that chain can bring down the entire system.

I say again.  Systemic risk in financial systems is largely due to the fact that these systems are tightly coupled.  Clearing increases tight coupling.  This almost certainly increases systemic risk.

More players have to move more money in more jurisdictions as a result of clearing mandates.  As the DTCC report makes plain, this is a new responsibility for many of these players, and they do not have the capability or experience or systems.  Greater operational complexity involving more parties, many of whom are relatively inexperienced, creates grave risks in a tightly coupled financial system.

The irony of all this is that the evangelists of clearing, including notably Timmy! and GiGi in the US, argued that central clearing would reduce the interconnectedness of the financial markets.  Wrong. Wrong. Wrong. Wrong.

It reconfigures the interconnections.  The entire collateral management system the DTCC document describes is a dense web of interconnections.  And to reiterate: under central clearing (and the mandate to margin and mark-to-market uncleared derivatives) these connections (couplings) are tighter than in the old system.  Both old and new systems are highly interconnected.  The connections in the new system are tighter, and are more vulnerable to failure as a result.

I’ll tell you what makes me have to go change my armor: the regulators seem oblivious to this.  To the extent they are focused on collateral, they are focused on initial margin. No! It is variation margin calls during periods of large market movements that will threaten the stability of the system. Now there will be more such calls–1000 pct more, according to DTCC–and more participants are involved, meaning that there are more links and nodes.  The tightly coupled nature of the system means that the breakdown of a few links can bring down the entire thing.

In other words, there seems to be a disconnect on interconnections, most specifically on how clearing has not reduced interconnections but reshaped them, and how the new system’s interconnections are much more rigid, tightly coupled, and time-sensitive.

Not to pick on Cœuré: his speech is just one example of that disconnect.  The thing is that most speeches by regulators and central bankers exhibit the same disconnect.  Target fixation on making CCPs invulnerable does not address the main systemic risk that an expansion of clearing creates.  That systemic risk involves the financial/funding and operational risks of meeting large margin calls in a stressed environment on a precise time schedule.

It’s about liquidity, liquidity, liquidity.  Clearing transforms credit/solvency risk into liquidity risk.  The operational aspects of clearing-the need to move cash and collateral around in large amounts on a tight time schedule-affects the demand for liquidity, and also create points of failure that can cause the liquidity mechanism to seize up, threatening the entire system.

This is what should be the focus, but I’m seeing precious little evidence that it is.  Someday we’ll pay the price.