Streetwise Professor

December 2, 2011

Mandate in Haste, Repent at Leisure–If We’re Lucky

The Bank of England’s most recent Financial Stability Report includes an extended discussion of the various systemic risks posed by CCPs.  For SWP readers, the analysis will be familiar.  It focuses on the margin mechanism as a channel of contagion, procyclicality, and wrong way risk.  It emphasizes the risks arising from the pivotal role of sovereign debt in the clearing system.  Adverse shocks to sovereign debt prices can initiate the destabilizing margin cycle.  Moreover, given the correlation between the financial condition of CCP members and sov debt prices, sovereigns are a source of wrong way risk in teh system

Recognizing the very real possibility for a CCP failure, the BoE recommends the implementation of a resolution regime for CCPs to ensure that the market can continue to operate even if a CCP exhausts its financial resources.  I recommended this in  my ISDA white paper.

So I concur wholeheartedly with this BoE analysis.  But as was the case with Bernanke’s warnings about the systemic risks of CCPs, I ask: where the hell was the BoE  when everyone was drinking the clearing KoolAid?  Some of this realism would have been much more constructive before Frankendodd, the G-20 clearing commitments, and other moves to mandate clearing around the world.   Right now, the BoE, the Fed, and more than a few financial journalists remind me of someone who stood on the platform waving goodbye to a departing train, but are now running down the track screaming that its brakes are defective.

So regulators are no scrambling to figure out how to buttress the much expanded clearing system against its inherent vulnerabilities.  Would that as much thought and effort had been expended to identify, anticipate, and mitigate these vulnerabilities before regulation and legislation imposed such heavy reliance on CCPs.

Clearing was mandated in haste.  Unfortunately, given the current tumult in world financial markets, we may not have the luxury of mitigating the risks of these mandates at leisure.

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