Ever since the launch of the European Market Infrastructure Regulation (EMIR) and Dodd-Frank, I have expressed concern about the risks in central clearing counterparties (CCPs) and the apparent acquiescence of the regulatory authorities to the structures they adopt to mitigate that risk. My argument has been simple. Regulation is forcing more transactions into CCPs. This has, subject to the legal integrity of their netting structures, reduced risk. Regulation has improved the quality of collateral backing for aggregated net exposures and that has reduced risk, albeit at the cost of increased demand from a finite pool of prime collateral. Regulation is moving people away from bespoke to traded derivatives. And this has reduced complexity risk but increased unhedged or partly hedged exposures across the market. And EMIR and Dodd-Frank has also led to a build-up of risk in two key areas; namely the robustness of the margining structures and the deployment of collateral.
Many years ago, I objected, as a board member of the then London Clearing House, to the assumption that margining could be adequate to withstand the default of our two largest members. My argument was that such an event was cataclysmic and would create substantial and unpredictable market volatility and illiquidity. And that would most likely exceed the protective ring-fence of the margins we had assigned to the different contracts. I also recall becoming increasingly concerned at the quantum of cash collateral held and the paucity of absolutely secure instruments for its redeployment. It should be noted that, at the time, the London Clearing House was owned (following a previous default) by a group of London clearing banks. It was risk, when it became clear that the Central Bank saw them as lender of last resort, which made those banks willing sellers of their stake to the different market participants.
Both the risk issues, I noted, are alive and kicking today! The markets, in the old days, when national central banks raised their eyebrows and their clearing bank subjects took the hint, had a lender of last resort in the guise of those domestic banking institutions. But markets today are less obedient. First of all, the major markets are global in reach and membership. The different users are subject to a variety of regulatory regimes, most of whom, irrespective of the cross-border cooperation agreements signed, in a crisis, will be fighting to ensure they retain the maximum share possible of the assets of any defaulting entity. Second, the major players will balance the losses they incur in default against the losses they risk in bail out. In my experience, the paradox is that the deeper the potential pocket of a user, the more likely that they have less to lose in a CCP failure than a bailout. And finally, the acquisition route, for a bankrupt or illiquid financial services business, is most likely well out of scope, especially since the liabilities of that member are transferred to the new parent, as many an acquirer post the last crash has discovered to their cost.
The response of the regulators is to seek to strengthen the clearinghouse capital and guarantee backing, but this retains the fundamental flaw that the loss assessment process is dependent on normal conditions prevailing. In most cases normal conditions will prevail. I would define normal conditions as volatile markets operating within a reasonable range. The trouble with any extreme crisis is that a volatile market may not operate within such normal ranges. The regulators appear to see that eventuality more as a liquidity than a solvency issue. They purport to be willing to be liquidity providers to CCPs in that case. But when does a liquidity risk become a solvency issue? This is a question of timing and again is a function of the nature and causes of the risks.
Let us, though, be clear of what will happen in that volatile period. Firstly, we will get material stock volatility. Normally assets across the board will lose value other than certain safe haven assets – triple and double “A” country bonds, gold and a few other minor asset classes. The stock of triple and double “A” country bonds will also be reduced by the crisis, impacted by re-assessments based on the risk profile of their indigenous financial institutions, and thus their potential bailout costs. Bank deposit appetite will also dry up as traditionally they pull back from the financial sector in times of such crisis, the financial sector being the logical home for a major portion of short-term lending and mirroring much of the cash margining money placed out in money markets. And investors, even if market utility collateral structures have improved certainty of ownership, will start worrying about asset safety. They will revisit their traditional concerns about default risk, especially the potential for a “Lehman” risk where they find themselves unable to unwind their repo or lending positions, thereby causing another market to dry up. Thus, at the point when CCPs, if their members remain solvent, will be flush with collateral, we are likely to see a market with reduced appetite.
And in extreme cases secondary defaults are likely. And that re-starts the cycle. The reality is that, in the extreme cases, whereby a crisis causes the default of major players, as the last crisis did, we need more than a simple liquidity arrangement. We need to have more brutal closeout options. We need to have more substantial support arrangements from CCP members. We need to have broader collateral eligibility. And we need to revisit the balance of risk between bilateral arrangements and central clearing, albeit with mandatory risk management structures for the bilateral world.
And the regulatory world should have no illusions. As many a banker has found, liquidity support is simple to give but more problematical to unwind. And how many short term support arrangements have ended up as equity, term loans or claims on the liquidator?