Streetwise Professor

April 5, 2012

When the Levee Breaks, Redux

Recognition is dawning that clearing mandates-the supposed silver bullet for making the derivatives market safe-are not the panacea that their advocates claimed.  Recently, major regulators in the US and the UK have warned about the dangers of concentrating so much risk in CCPs.  The recognition is spreading to the press too, as illustrated by this article in The Economist:

The source of all this angst is the clearing-house, a mundane bit of financial-market plumbing that sits between buyers and sellers in transactions. And the reason why people are fretting is that G20 policymakers have seized upon clearing as the solution to some big problems in the over-the-counter derivatives market.

. . . .

That feeds worries about the other effect of lots more clearing: a new concentration of risk. Moving derivatives trades to clearing-houses mitigates the effect of a default of a clearing member (Lehman Brothers’ cleared trades were handled smoothly in 2008, for example). But it makes the impact of a clearing-house itself going down much worse. They may lack the heft of big banks, but few financial institutions are more interconnected. Failures are rare but they do happen: Hong Kong’s futures clearing-house ran out of resources in 1987, for example, and it took a government bail-out and the closure of the main stockmarket for things to get back to normal.

This should not be a surprise-after all, it’s not like what happened in Hong Kong-or in Chicago-in 1987 was a big secret.  And it’s not as if nobody, ahem, has been raising this point for going on four years now.

And that italicized part is just too rich.  Didn’t Timmy! and GiGi constantly-and I mean constantly-tell us that clearing eliminated interconnections in the financial system? Yes they did! I guess that explanation is now seen to be the BS it always was.  I’ve been calling BS on that for about three years.  I’m waiting for the dynamic duo to admit they were either ignorant, or liars.  There is no third alternative.

The aforementioned regulators are demanding that CCPs be made immune from failure.  The Economist agrees:

The more systemic they become, the more tightly clearing-houses should be regulated. That means more clarity over their collateral and margining policies. It means agreeing on plans for recapitalising a failing entity without tapping the taxpayer. And it means getting clearing-houses to hold more equity: LCH.Clearnet had just €333m ($463m) of capital in 2011, compared with collateral and cash under management that averaged €73 billion. Clearing can achieve many things. Solving the too-big-to-fail problem is not one of them.

Sigh. On the one hand, it is good to see growing awareness of the systemic vulnerabilities that CCPs create.  On the other, it is distressing that regulators and commentators seem to have target fixation and can focus on only one thing at a time.  Put differently, they fail to consider how the financial system will adjust to attempts to make one part of the system safer.

I’ve also written about this ad nauseum.  The point is that raising margins, or increasing the size of default funds, or changing margin calculations, or tightening up restrictions on eligible collateral, or other measures to improve the safety of CCPs will induce reactions and adjustments elsewhere in the financial system, and these adjustments have systemic implications.

For instance, requiring more collateral is likely to lead to the growth of systemically-fragile collateral transformation services and other shadow banking mechanisms to secure collateral to post for CCP margins.  Expanding CCP member commitments to default funds increases their exposure to wrong way risks, and is an important source of interconnection in the financial markets.

I return to the 1987 Chicago experience.  Yes, the big exchange CCPs were under stress, but a major source of stress in the financial system as a whole was due to the extraordinary need for liquidity to meet margin calls-the very mechanism that is put in place to protect CCPs against default.  Sometimes “safety” equipment can be downright dangerous.

I return to a metaphor I’ve used before: that of flood controls.  Building up levees to protect one location can increase the risk of a catastrophic flood elsewhere in a river system.  It is good that more regulators and market observers recognize that CCPs are a source of systemic risk, but the levee-building reflex is worrisome in the extreme.  It suggests an inability to think about the financial system as a whole, a system that reacts to changes imposed on one part of it.  These responses are not necessarily salutary, and can be downright frightening.

The responses need to be anticipated, to the extent possible.  But it is often difficult to do that with accuracy.  Which means that it is necessary to proceed cautiously when making the levee around CCPs higher and higher.  There will be responses to this process, and it is likely best to proceed cautiously and incrementally, seeing what the responses are to the gradual changes, and then adjusting accordingly.  Wholesale changes made in a hurry focused monomaniacally on one part of the system are a recipe for an major disaster elsewhere in the system.

I say again: to understand how policy changes affect systemic risk you need to think of the financial system as an organic whole, a system that responds often unpredictably to changes imposed on one part of it.  Although it is encouraging to see that the magical thinking about clearinghouses is being replaced by sober concern, it is far less encouraging that the concern is leading to policies focused on individual institutions that do not pay adequate attention to how the system will respond.

In other words: Don’t build financial levees without giving very deep study how other financial currents will react to the levees during flood times.

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  1. One big difference from your Levee metaphor is that Army Corp. of Engineers built levees from experience, and iteratively built higher levees when and where they were breached. In contrast, no CCPs were breached during the 2008 financial crisis, and Lehman unwound its derivatives just fine. The Geitner Financial Corp. of Engineers (GFCofE) has no experience where, when or why to build CCPs, only their pie in the sky belief that they personally save the world from Armageddon. Did a CCP get bailed out??? How come no body is asking that question. The CCP debate is a ruse to excuse their bailing out horrendous money managers, and leveraged money-market funds. We don’t need more academic studies about Clearing, we need to put the daylight on disastrous actions of the Fed, Paulson and Geitner during the TARP days, who essentially flooded the earth the new money– destroying all us folks who saved and made prudent decisions prior to 2008. I need a levee from the Fed’s money creation.

    Comment by scott — April 5, 2012 @ 4:17 pm

  2. […] read what Craig has to say about CCPs creating systemic risk – read this piece by him; Streetwise Professor » When the Levee Breaks, Redux. Share this:EmailPrintTwitterLinkedInMoreFacebookDiggLike this:LikeBe the first to like this post. […]

    Pingback by Streetwise Professor » When the Levee Breaks, Redux | The OTC Space — April 5, 2012 @ 4:56 pm

  3. @Scott – amen. @SWP could not agree more that the system needs to be looked at as an organic whole, but with the following proviso: like a drug introduced in a body, its side effects are very difficult to predict, and can take years to manifest themselves. Also any such exercise in the analysis of effects of introducing a regime of CCP’s 9or any other major financial innovation should be made with a certain humility. As Schumpeter pointed out the free market system will create things (and money)working around obstacles on its own. It would be the height of arrogance to assume that any such study would be definitive and not subject to constant reexamination and review in light of new facts as they emerge. Unfortunately our political leadership is about as arrogant as can be. Indeed it would be harder to imagine any group less qualified to “reality test” any such analysis, as they seem to specialize in denying or ignoring inconvenient facts when they contradict their biases.

    Comment by sotos — April 5, 2012 @ 7:55 pm

  4. @sotos-I agree completely. That’s why I said it was necessary to proceed slowly and incrementally. That’s partly what’s so effed up about Frankendodd (and Obamacare for that matter). Re-engineering a complex system in one go, with very no opportunity to observe the effects of modest changes and re-calibrating appropriately. Hubris, arrogance-you name it. And you can never go home again.

    It is even worse than you say. For not only do the politicians and regulators ignore or deny the effects of their handiwork, they always succeed to blame the failures on private actors even when it is their perverse interventions which are at fault. Their f-ups lead to catastrophe-which only leads them to propose more regulations to correct the mistakes and greed of those evil capitalists. No accountability. Who is going to hold Barney and Chris and Timmy! and GiGi accountable when their Rube Goldberg contraption breaks down?

    The ProfessorComment by The Professor — April 5, 2012 @ 8:27 pm

  5. AK just another nod of thanks for your recent Moscow vs. the regions stuff, truly it’s starting to percolate into the mainstream, like Roissy’s (for all his flaws) thesis of female hypergamy…Moscow being a place where the hypergamous competition among the hyper-feminine akuli is at its most stark.

    Contrast that with your Twitter antagonists 40 million bile-filled tweets about nothing (likely using some other more attractive lady’s photo) and flame wars with Registan’s Joshua Foust and I think you’re on the right track. Let SWP, CatFitz and the rest stew in their irrelevance and Cold War nostalgia.

    As I’ve said so many times, IF SWP were actually blogging about crimes committed in his futures industry i.e. MF Global and going on financial TV about it he’d be more famous and probably make more money on the consulting side. But he prefers staying mum on those topics and writing very boring stuff that gets lifted by The Economist and rants for his amen corner on Russia instead. All in all, a true waste of talent in favor of pro-Establishment me-tooism. I don’t get what the pay off is, since he already seems to go to the conferences subsidized by the type of folks who’ll tell you with a straight face that the MFers and Feds don’t know where the stolen money went AND that there’s no evidence of oil price manipulation in 2008 whatsoever. Not even by the hated Kremlins!

    Comment by Mr. X — April 6, 2012 @ 8:00 pm

  6. I do not see any good reason for procesing derivatives through the clearing markets: its like closing the door after the horse has bolted. Financial institutions have been sufficiently burned by the CDO debacle to exert their own policing on derivatives transparency, market price etc. Any future financial crisis will not be repeated via derivatives necessarily. So what do we have with the clearing house mandate? Change for change’s sake

    Comment by Ivona Poyntz — April 8, 2012 @ 3:12 am

  7. The Economist mentions that the too big to fail doctrine, applying as it thinks to clearing houses (or -houses, as it renders the term), means that there will be legislative and regulatory tinkering with them. A better solution would be to go back to the pre-Fed institutional set up in which clearing houses played a crucial if unsung lender of last resort role. During the panics of 1857, 1873, 1893, 1nd 1907 they issued loan certificates to banks when some of the latter suspended payments. When the Fed entity was created in 1913 some of the clearing houses were shut down; those that remained were relegated to clearing payments and later derivatives. The Fed monster usurped and monopolized the lender of last resort function.
    A big advantage of clearing houses performing this role would be that competition, innovation, and the market would work just as they do in other markets.

    Private clearning houses 1
    Fed entity 0

    End the Fed!

    Comment by Bill Stepp — April 8, 2012 @ 5:32 pm

  8. […] Streetwise Professor » When the Levee Breaks, Redux […]

    Pingback by Morning Caffeine Links 4-10-2012 | Modern Monetary Realism — April 10, 2012 @ 4:46 am

  9. I was at the New York Fed in October 1987, explaining to my elders and betters why the payment system drained of liquidity every hour as Chicago’s intraday margin calls came again and again. Until then New York couldn’t find Chicago on a map. After that we set up the Payment Systems Studies Group to better understand the linkages.

    It still amazes me that central bankers ignore the risk of destabilising liquidity demands from margin calls, meanwhile insisting on more and more central clearing. Margin reduces credit risk, but increases liquidity risk. At a time when bank balance sheets are heavily encumbered by securitised borrowing, any unanticipated liquidity demand is going to go straight through to the central bank as a systemic threat. It’s even worse for asset managers and corporates who will have to margin their OTC portfolios under Dodd-Frank and EMIR. Volatility could actually force defaults on the non-financial actors that actually produce something worthwhile in the economy, with huge implications for unemployment and economic destabilisation.

    Corporates are seeking exemptions from mandatory central clearing, but it may actually cost them more to post unilateral initial margin at the punitive Basel III CVA rates. We could see some serious deflation as an unintended consequence of misguided margin requirements.

    Comment by KTQ — April 11, 2012 @ 6:38 am

  10. @KTQ. Amen. To all of that. Can’t agree more. You may want to check out my article in the latest Journal of Applied Corporate Finance, titled Clearing and Collateral Mandates: The New Liquidity Trap? I discuss some of these issues in detail.

    The inclusion of non financial players and asset managers in the clearing/non-cleared swap collateralization mechanism only exacerbates the problems, as you note.

    I spoke to the head of risk at the gas trading operation for an oil supermajor. He said these mandates had turned credit risk problems into liquidity risk problems, and he would much rather deal with the former than the latter.

    Bottom line: as you say, ignoring the risk of destabilizing liquidity demands is an amazing oversight that is almost certain to come back and bite us, big time.

    Thanks for your comment.

    The ProfessorComment by The Professor — April 11, 2012 @ 9:38 am

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