Streetwise Professor

November 27, 2013

Some of Cassandra’s (AKA SWP’s) Warnings on Clearing Begin to Take Hold

Filed under: Clearing,Derivatives,Financial crisis,Regulation — The Professor @ 9:49 pm

I’ve been hammering on the theme of the systemic risks of central clearing-especially mandated central clearing-for around five years.  And now those concerns are being expressed with greater frequency.  Fed Governor Jerome Powell gave a speech focusing on the most straightforward source of systemic risk in mandated clearing: the concentration of risk in the clearinghouse, which becomes a single point of failure whose collapse could jeopardize the broader financial system.   Bernanke made a similar argument a couple of years back.

Some articles from the last several days highlight more subtle, but in my view more important, concerns.  This Reuters piece mentions several things I’ve focused on over the years: the strains that clearing can put on the liquidity of individual firms, and the system at large; margin pro-cyclicality;  and crucially, the fact that self-preserving actions taken by CCPs may have destabilizing effects elsewhere in the financial system.

This last point demonstrates a danger in the Powell approach which focuses on making CCPs invulnerable, which I’ve referred to as the levee effect.  Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a CCP can redistribute shocks elsewhere in the system in a highly destabilizing way.  CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects.  Indeed, greater reliance on CCPs increases the tightness of the coupling of the financial system, which can be highly problematic under stressed conditions.  Liquidity and funding are the primary channels by which CCP decisions will have external effects on the broader financial markets.

These considerations are related to a broader point, which is that CCPs are merely parts, albeit important ones, of a broader financial system, and they must be evaluated in the context of the entire system.  An article in the International Financing Review by Christopher Whittall provides another illustration of this, again related to liquidity.  He notes that Basel III’s leverage ratio clashes with the tremendous thirst of CCPs for liquidity:

“The move towards central clearing creates a focus on how to fund margin requirements, which should dictate an increase in repo activity from banks. The problem is repo becomes very unappealing for banks under the leverage ratio.”

So sayeth the head of fixed income at a major bank.  CCPs create tremendous funding needs, and particularly contingent funding needs that are especially large in stressed conditions when liquidity is hard to come by.  These needs are hard enough to address in the absence of a leverage ratio, but as the fixed income guy notes, this is an even bigger problem when it is present.  As he says: “Viewed as a whole, we can start to start to see how these different regulations don’t quite hang together from a macro-prudential perspective.”

Exactly.  Illustrating another theme: Regulatory responses to the crisis have tended to focus on the individual pieces with too little attention paid to how regulations of one piece affect the other pieces.  The interaction between the leverage ratio and clearing mandates is a particularly worrisome example.  In any complex system, it is the interaction between interconnected pieces of the system that can lead to abrupt collapses.  Making each piece of the system more robust doesn’t necessarily make the system more robust.  Indeed, the opposite can be true.

Yes, I’ve been a Cassandra on these issues.  So in some sense, it’s good to see that the concerns that prompted my prophesies are now getting more widespread attention.  But methinks that the post-crisis regulatory juggernaut is impossible to reverse, and that although some of the problems in clearing and the interactions between clearing and other aspects of financial regulation can be ameliorated, the basic sources of systemic risk inherent in the new financial and regulatory structure will persist.

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  1. Is it your case that clearing is more risky than otc settlements?

    Comment by bala srini — November 28, 2013 @ 8:58 am

  2. @bala. I cannot make a categorical statement to that effect. The risks are different. The channels of contagion are different.

    All along my argument has been that central clearing has too often been advanced as a panacea for systemic risk arising from derivatives, that this incorrect, and worse than that it is dangerous. I have emphasized the systemic risks in clearing to redress the imbalance.

    The ProfessorComment by The Professor — November 28, 2013 @ 9:52 am

  3. The Juggernaut will roll-on; QE will come off; liquidity will be squeezed and Banks will very selectively offer transformation services (within their limited capacity to do so). Inevitably this will necessitate further innovation – look out for new Collateral Pricing feeds, new Listed Forwards on Collateral and transformation shifting into the “shadow banking” space.

    Comment by JCmoves — December 2, 2013 @ 5:33 am

  4. @JCmoves-I agree completely. In a paper I published in early-2011 titled “The New Liquidity Trap” (J. Applied Corp. Fin.) I argued that one effect of clearing and collateral mandates would be to lead to the manufacture of new collateral via shadow banking, and that this was one of the perverse unintended consequences of Frankendodd. In presentations (including one I’ll be making in Amsterdam on Friday) I have a slide titled “Where Does Collateral Come From, Daddy?” The essence is that the demand for collateral will increase as a result of clearing and non-cleared collateral mandates, and this demand will call forth a supply response that will most likely come through the shadow banking sector which will create very fragile, systemically risky securities.

    This is just another example of the effects of regulators/legislators overlooking the systemic effects of their actions. This is one of my main objections to the whole G20 agenda.

    The ProfessorComment by The Professor — December 2, 2013 @ 10:06 am

  5. […] Craig Pirrong has a good overview of what’s going on, and I’m glad to say that Thomson Reuters is leading the charge in terms of reporting about all this: see, for instance, recent pieces by Karen Brettell, Christopher Whittall, and Helen Bartholomew. The problem is that it’s not an easy subject to understand, and most of the coverage of the issue tends to assume a lot of background knowledge. So, let me try to (over)simplify a little. […]

    Pingback by The $5 trillion dilemma facing banking regulators | Felix Salmon — December 3, 2013 @ 11:16 am

  6. What the world desperatly needs now is some genius to come up with a non linear navier stokes type of equation for financial flows to truly understand how the non linearities created by regulations increase failure risk.
    If you want to predict where will the next crisis come from just look at the current focus of regulators. In the 2000s it was all about rwa in basel 2 and this is how we got the subprime / structured credit blowup. The next one will be about liquidity that’s almost certain.

    Comment by joe1 — December 3, 2013 @ 12:59 pm

  7. @joe1. I agree completely. I’ve been saying for several years, since Frankendodd was a gleam in its authors’ eyes (scary mental image, I know) that the next crisis would be caused by the attempts to prevent a recurrence of the last crisis. I’ve also been on and on about how the regulations are putting tremendous demands on liquidity and that this is extraordinarily dangerous, not to say insane. They are replacing credit risk with liquidity risk, and liquidity risk is far more dangerous. It’s worse than that, actually. They are merely displacing/relocating the credit risk, and creating liquidity risk in the process.

    The ProfessorComment by The Professor — December 3, 2013 @ 1:13 pm

  8. […] Craig Pirrong has a good overview of what’s going on, and I’m glad to say that Thomson Reuters is leading the charge in terms of reporting about all this: see, for instance, recent pieces by Karen […]

    Pingback by The $5 Trillion Dilemma Facing Banking Regulators — December 3, 2013 @ 4:52 pm

  9. Prof, seeing that you will be delivering a speech in Amsterdam – regretfully I will not be able to see it but would you have those slides available you mentioned? And – good piece here and also the other thoughts about clearing, collateral et al… Thanks!

    Comment by Tom Riesack — December 5, 2013 @ 2:58 am

  10. Hi, Tom. Thanks for the kind words. Sorry you can’t attend. I will post the slides. I appreciate your interest.

    The ProfessorComment by The Professor — December 5, 2013 @ 12:00 pm

  11. It is interesting that the liquidity issue is only now coming to the fore: the joke is that a real life example of systemic liquidity risk was actually unfolding right under the eyes (assuming they were looking)of our lords and masters DURING the 2007-9 fiasco, namely in the ABCP market. The failures of the SIV’s and the continuing difficulty with conduits argues your points empirically. What is the difference between liquidity support of a conduit, which supports unique assets, with a netted clearing house? If the market cannot support ABCP at 30-40% of its pre crisis levels, what happens if the amount subject to marks/collateral calls quadruples this number?

    Beats me.

    Comment by sotos — December 5, 2013 @ 1:51 pm

  12. Thanks Prof, appreciated – so your flight back in the US was cancelled – shame that. But you got compensated which is good again 🙂 All the best from the “old world”

    Comment by Tom Riesack — December 9, 2013 @ 6:23 pm

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