Streetwise Professor

Marco Dialosa of the Pension Insurance Corporation echoes some SWP clearing themes in an interview on Derivsource.com (sorry we didn’t connect in London last month, Julia):

Q. Given the liquidity squeeze that will result from CCP clearing, where do you see the liquidity coming from?

A. We believe that the amount of high quality liquid assets on balance sheets will increase. We see the repo market as a mean to provide liquidity for cash variation margins. What is less clear at this stage is whether the repo market is the right place for collateral transformation and how this market will behave in times of stress. One of the unintended consequences of the clearing initiative is that it may be transferring systemic risk away from the OTC world into the repo market.

Q. Does the movement of systemic risk away from OTC world and into the repo market an unintended consequence concern you or do you view it as just inevitability?

A. It is an unintended consequence in our view. The OTC market is akin to an ecosystem, it is in a stable equilibrium. A small change in a particular parameter (i.e. central clearing) will be corrected by some negative feedback that will bring the parameter back to its original point of balance. It is extremely difficult to eliminate systemic risk in practice without disrupting the balance of the whole system.

Just so.  Most of the effects of clearing mandate are to redistribute risk, not to reduce it.  Moreover, the equilibrium in the system will adjust in response to an exogenous policy shift: the “negative feedback” will attempt to find a way to replicate the old equilibrium as closely as possible, given the constraints imposed by the new rule or regulation.

In other words: you need to take a systemic approach to analyzing systemic risk.  You have to understand how a change imposed on one part of the system is going to be transmitted to other parts of the system, and how those other parts are going to respond to this impulse.   Systems achieve a particular configuration for particular reasons, and it is very difficult to change these configurations fundamentally.  The particular reasons that led to its particular configuration lead to the negative feedbacks that Dialosa mentions.  And a good thing too.  Negative feedback is a stabilizing force.