The Three Challenges with Central Counterparties

Central counterparties are a good thing. We were told that by the world leaders in their 2009 Pittsburgh summit. And ever since, legislators and regulators have run riot in their rush to drive bilateral trades into the new nirvana of the financial marketplace.

There are, though, three core challenges facing this brave new world. They are legal certainty, valuation and quality. Legal certainty could become a victim of a world of ever more complex, and often unintelligible, rushed legislation and regulation. Valuations in increasingly volatile markets risk becoming obsolete faster than ever before. And collateral quality is decreasing in an uncertain world where prime country risk is a rarity rather than a norm.

Legal certainty in the context of CCPs has a critical dependency. This relates to their ability to realize their collateral and unwind transactions in a timely fashion. The law in most countries gives the CCP unique rights of protection against bankruptcy and challenges to title. It may well be that the weight of legal opinion is correct and that right will survive any challenge. Were that not to be the case, there would be a catastrophe. If there is a challenge, though, and delays in unwinding of positions as a result, then we will just have a major crisis! For an inability to unwind transactions, pending finalization of a lawsuit, would create market risk (as valuations would alter), solvency risk (as positions would be frozen) and liquidity risk (as out-of-market positions of the CCP may still need to be margined). It is true that Lehman did not cause any such problems, and positions were unwound in an orderly fashion, but we cannot depend on this as an undoubted precedent for future behavior. It would only take one powerful investor to hinder the process. Activism at a time of default and crisis cannot to be ruled out if one of the powerful has a vested interest in such action.

Valuations are valid for a minimal point in time only. Collateral is in short supply. And those two factors impact the prices used and the margins applied by CCPs to cover their risk positions. There is a growing shortage of prime collateral, and thus all pressure is on takers to broaden their range of eligible instruments. And that pressure will increase as CCPs extend their product range into more volatile, and often less liquid, markets. Those risks can be offset by more conservative margining, and there is evidence to show that this is indeed happening. But conservative margining demands more collateral, and that may not exist in the quantities required. And valuation and margin assessments are still based on historical trends (and often relatively near-term ones). There is a huge risk that the new larger instrument range, with its billions of dollars of gross exposure, could break out of those trend lines and destroy the business models used to assess collateral needs. Could it really happen? In reality, the failure of the 99.9% certainty rule has been an enduring feature of many of the recent defaults in our world, and most CCP valuations use models with that (or even lower) degrees of certainty.

So how do CCPs protect themselves from these risks? Most CCP members are required to give capital support, either through contractual obligations to meet calls for new capital or through an initial mandatory call and subsequent non-obligatory calls. The trouble with calls, even the mandatory ones, is their systemic implications at a time of potential market turmoil due to the failure of a major player. Will the call merely escalate the collapse of other players? And will players volunteer non-mandatory calls? The chances of any global altruism happening appear low.

And I fear there are further signs of flawed regulatory thinking. As an example, a common question regulators pose to CCPs is whether they could withstand the collapse of their two or three largest members. Apparently they could, but only if there is no legal challenge, acceptable levels of volatility and they can unwind or place with third parties the exposure of the delinquent members. That premise is ridiculous. In crisis, markets will be volatile; markets will be illiquid, and there will be risks of legal challenge.

The trouble is that the Pittsburgh summit may have had the unintended consequences of persuading the market that the CCP routing reduces risk. It does, but nowhere near the levels often assumed. And it creates new risks, especially concentration and collateral quality risks. Regulators need to work more with CCPs, the pace of change should be slower or the public purse will, at some time in the future, be called upon. And it may be politically impossible for it to be there the next time!