Streetwise Professor

June 13, 2009

Mandatory Clearing: The Doubts Mount

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 3:12 pm

John Dizard wrote an interesting piece on mandatory CDS clearing in the FT:

There’s a new series of disaster scenarios being talked out, most publicly in Congressional hearings on financial system reform. The two parties, buyside and sellside, are assembling their coalitions.

As is usually the case, the sellside, which is to say the big New York dealers, have so far been fastest off the mark. However, too many people on the buyside are watching this time to allow the sellside an easy win judged by friendly officials.

The CDS dealers now have their ICE Trust clearing platform up and running, have somewhat rationalised the documentation and terms, and have substantially reduced the volume of outstanding CDS contracts. They call the ICE Trust a “central clearinghouse”, by the way, which I would not. A real clearinghouse, of the sort that is used by commodities futures exchanges, is heavily, independently, capitalised, and can call on the resources of its clearing members to meet any shortfalls in capital caused by a failure. It also has clear margining requirements that are substantial in relation to the risks, which must be satisfied daily with cash on pain of liquidation.

The ICE Trust platform, in contrast, is a limited liability company. So no mandatory capital calls. The margining is modest in relation to value of the positions, and is more flexible and forgiving than that on public exchanges. The ICE Trust is a thinly capitalised bank, owned by other banks, and deals only through banks. Even well capitalised non-banks have to go through the likes of Tarp recipients. The security of the CDS clearing is based on trust and the taxpayers who underwrite the security of the banking system.

I share Dizard’s concerns about the capitalization of ICE Trust, although I believe he is wrong about “no mandatory capital calls.”  Chuck Vice, President of ICE, told me that ICETrust members can be required to contribute an amount equal to their original contribution to the guaranty fund in the event of a default that exhausts that fund.  The problem is, even with that feature, the clearinghouse may be less than adequately capitalized.  Moreover, I don’t think that the issue is that ICE margining is more modest and relaxed than at other clearinghouses.  My concern is that ICE doesn’t have the information to set the margins as effectively as bilateral OTC market dealers.  

Dizard also notes something that I mentioned some months back: the reluctance of some Chicago clearing member firms to embrace CDS clearing:

The Chicago traders, who had resented the New York dealers’ monopoly on CDS clearing, gradually realised that clearing CDS on single names (companies or countries) was a poisoned chalice. A Lehman or AIG-like failure could decapitalise all their other markets.

The FT has more information on exchange jitters on an OTC clearing mandate:

The word “standardised” sounds innocuous enough. But its use in a US policy document on the future of over-the-counter derivatives has set alarm bells ringing at derivatives exchanges.

Tim Geithner, US Treasury secretary, has said that to contain systemic risks he wants US laws to be changed to require clearing of “all standardised OTC derivatives through regulated central counterparties [CCPs]”.

This marks a sweeping change to the way OTC derivatives are handled, implying a shift away from the dealers at banks who brokered such contracts to the formal exchanges that have long jealously eyed the huge OTC markets.

But what does “standardised” mean? How much of the OTC markets can and should be shifted on-exchange, whether cleared or – as Mr Geithner also wants – traded?

Nobody has a clear answer, since OTC derivatives come in many shapes and sizes, ranging from straightforward interest rate swaps to more tailored products such as “average price options” used by grain processors to hedge against movements in crop prices.

Exchanges, many of which own their own clearing houses, might be expected wholeheartedly to welcome the Geithner proposals. But they are warning against a strict definition of “standardisation”.

Craig Donohue, chief executive of CME Group, the largest US futures exchange, which owns a clearing house, says: “Standardised is not the right way to do it.”

He and others are concerned that lawmakers in the US Congress may come up with a strict definition that would force a shift of OTC contracts into clearing houses that are ill-equipped for the task.

They warn that such a move could expose clearing houses to unnecessary risks that could even damage the financial system at a time when regulators are looking at ways to protect it against future crises.

Kim Taylor, president of CME clearing, says: “There is a danger in having regulatory mandates that are too broad, that would require clearing of products that clearing houses don’t feel comfortable risk managing.”

Declan Ward, executive director at NYSE Liffe in charge of clearing, says the danger is that certain OTC products with unique specifications negotiated to deal with particular risks are relatively illiquid. Coupled with lack of transparency in pricing “you are adding risk to a CCP”.

These are important points.  “Standardization” is not the only issue.  Certainly, more complex, non-standardized derivatives are problematic to clear.  Illiquidity and lack of reliable pricing information for seldom-traded instruments–standardized or not–can also raise major problems for clearing, as Declan Ward and Kim Taylor suggest: and as I’ve written in my academic work going back to 1997.  

CME’s Craig Donohue favors letting the market sort out what is, and what’s not, appropriate for clearing:

Mr Donohue says: “I worry that those kinds of definitions wouldn’t have all that much durability given the level of innovation.” Like other exchange heads, he argues that the market must have a role in deciding which OTC products should be cleared. A recent jump in the number of OTC energy derivatives being cleared through the CME’s Clearport clearer has been driven purely by market demand, he points out.

MarketWatch provides additional evidence of skepticism, including from a regulator (Britain’s FSA) and the DTCC:

Broad proposals for tighter regulation of the over-the-counter derivatives market have already been put forward in the U.S. and Europe authorities are widely expected to follow suit.

Alexander Justham, director of markets at Britain’s Financial Services Authority, said the derivatives market has grown without transparency.

The natural response is the “vanilla-ization” of contracts, by standardizing the terms so they can be traded on an exchange or cleared through a so-called central counterparty (CCP), which acts as an intermediary and absorbs the loss if one party defaults, Justham said.

“But not everything can be put on an exchange and not everything can be cleared,” he cautioned at a recent Mondo Visione conference in London.

Other commentators agreed, saying clearing houses would struggle to handle some of the more complex derivatives.

“The danger is that too much reliance will be placed on CCP clearing,” said Diana Chan, CEO of clearing house EuroCCP, which is a unit of the U.S.-based Depository Trust & Clearing Corp.

In order to be suitable for clearing, a derivative contract must be relatively easy to price, so the CCP can collect the right amount of margin, and trading must be sufficiently liquid for positions to be closed quickly, Chan said.

AIG’s downfall

Credit-default swaps have been at the center of the argument over derivatives because of their role in the near collapse of American International Group Inc.

CDS are similar to an insurance contract and pay out if a company defaults on its debts.

But volumes soared in the lead up to the credit crisis, and the opaque nature of the market meant it was almost impossible to track where the exposure to these derivatives lay.

Justham said a straight-forward CDS on, say, supermarket chain Tesco, might be suitable for trading on an exchange. But more complex contracts, such as bespoke agreements linked to several different credit events, wouldn’t work.

Even liquid contracts such as simple credit-default swap can pose problems, because when the underlying debt gets close to default, that liquidity can dry up very quickly, said Roger Liddell, CEO of LCH.Clearnet, a clearer mostly held by its users.

Glad to have company, folks.

Mandatory clearing, and the associated greater rigidity in margining, could also dramatically reduce the utility of the derivatives markets as hedging vehicles.  Rigid, daily mark-to-market payable in cash, subjects hedgers to cash flow risks.  Even if a derivatives position and an underlying position have mark-to-market values that are almost perfectly correlated, cash margining with daily mark-to-market generates cash flow changes on the derivatives hedge position that may not be matched by offsetting cash flows on the position being hedged.  This mismatch can greatly reduce the utility of hedging, and lead firms to do less of it–and hence result in them bearing more price risk.  That’s a highly undesirable outcome, and a cost that advocates of mandatory clearing do not address.  OTC markets permit more flexibility in managing these cash flow considerations, which is one reason why hedgers often prefer OTC markets to cleared exchange markets.

(As an aside, it’s also one reason why the LME fought introducing clearing even in the aftermath of the tin crisis, and even when forced to do so, implemented a clearing system that permitted more flexibility and use of credit.  This was intended specifically to meet the needs of metal hedgers, who would often have a gain on a hedged metal position, but since this gain did not generate a cash inflow, would be required to stump up additional cash to pay the MTM loss on the hedge under standard futures margining practice.)  

In sum, there are a lot of reasons to have a variety of methods for trading derivatives, and for allocating the default/performance risks associated with them.  These go a long way to explaining just why such a variety of methods exist, side-by-side.  As I’ve said before, the advocates of a mandate have not even attempted to provide a credible explanation as to why market participants would avail themselves of a variety of different mechanisms, if one is decidedly superior.  In contrast, there are numerous, well-articulated (if I do say so myself;-) arguments as to why they do so, and why it is best to let them do so.  As the foregoing articles suggest, moreover, numerous market participants–including those, such as exchanges and the DTCC, who might otherwise seem to have an interest in supporting a mandate because it would send business their way–also recognize that these considerations are quite important.  One hopes that they are sufficiently persuasive to convince Congressmen, regulators, and our Secretary of the Treasury, all enamored with clearing, that it is not a good idea to try to pound a square peg into a round hole.

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