Will CCPs Be the Root Cause of the Next Financial Crisis?

Given the growing involvement of our industry in the CCP world, especially in derivative clearing and collateral management, it is worth considering the key risks of CCPs.
Manmohan Singh of the IMF has become one of the most high profile central bankers to express concerns about the risks implicit in the modern CCP model. Given the growing involvement of our industry in the CCP world, especially in derivative clearing and collateral management, it is worth considering the key risks of CCPs. For we have substantial potential exposure, especially in the new world of AIFMD and with the expected advent of UCITS V.

I have long argued that CCPs are an excellent vehicle for risk reduction. But taking the model too far will create risks in a market segment with enormous systemic destructive reach. Given the market love of mnemonics, the key risks, on which I would focus, are the MICS—management competence, instrument coverage, collateral strategy and structural, or capital, strengths.

Management competence is most evidenced in CCPs in the key areas of membership structure, membership supervision and risk management policy. Instrument coverage is critical and needs to allow for liquidity, price transparency and product expertise. Collateral strategy will dictate the reliability of the CCP’s first line of defense against loss, while its structural strength brings on the final barriers to a potential CCP default.

For any intermediary, the major challenge of the CCP world is its diversity and its increasing fragmentation. The reality is that the gross exposures of even smaller CCPs are huge and the ability to focus on the net is a function of a series of risk management and policy decisions. In the ever more competitive environment of the CCP world, there is a real danger that risk becomes a differentiator and the traditional preference of major players for the well-structured and well capitalized CCP holds less sway than it did in the days of plenty.

History tells us, using the metric of loss experience, that CCP management is strong. But history is based on a bygone era that is radically different from today’s multi-instrument, multi-national and legally complex world. As CCPs fight for membership, the danger is that the delinquent firm will gain admittance and cause the contagion we all fear. I sense already a relaxation in the risk approaches of several medium-sized firms. CCPs can protect themselves from problem members by multiple means. The most effective, but often least favored, is to avoid them like the plague! The preferred method is through credit assessment and application of tough margins. But the latter option works best in a monopoly environment and not in today’s multi-choice option of CCP selection. And, if the EU dream of full interoperability were ever to come to fruition, risks unacceptable to one CCP could well insinuate themselves, albeit with added margin, into that platform through the interoperability route.

The second great danger facing CCPs is that of instrument coverage. Traditionally, CCPs have been cautious about expanding their instrument coverage. They have focused on the liquidity of any instruments admitted to clearing. They have assessed carefully any barriers to fast liquidation if they were ever forced to unwind a position. They have sought comfort from the presence of committed parties who would be willing to adopt open positions run by a defaulting member. And they have examined the history of the instrument to ensure that they understand its performance over time in both bull and bear sessions of its existence. Such a prudent approach is, I sense, being challenged both by competitive forces but also, more significantly, by the regulatory thrust for ever more central clearing. The problem with many of the new instruments is both their esoteric nature, appeal to specialized segments of the market place and narrow base of truly committed market makers. The risk is that, in times of turmoil, they may become illiquid. The probability is that, in times of stress, many will become one-way markets. A CCP will only be low risk if it can unwind its positions and realize collateral to compensate for any shortfall with immediacy.

Collateral strategy is one of the most complex aspects of CCP management. The first core component lies well away from the collateral itself in the area of the computation of the open risk position. We all assume that the CCP will have a sound risk basis for its netting which is at the core of its risk computation. In the world of national clearings, this was reasonably clear. But, with the growing nature of extra territoriality or ambiguity as to applicable laws, this assumption is open to new challenges. And we also assume that initial and variation margin will be structured on a sound basis. This also could be challenged if the market moves outside its historic parameters. Most of the algorithms used by the CCP world are based on volatility over a period of time. The trouble is that assumes the period used is relevant to the future and that markets will perform over time in line with historic trends.

Both assumptions are, as history has shown, seriously flawed despite the high levels of mathematical certainty ascribed to them. Paradoxically those levels of certainty were last seen for mortgage backed securities just before they tanked! And finally, we need to consider the collateral that is acceptable. Cash is deemed safe but it is only as safe as the institution with whom it is deployed. Governments are deemed secure, but not with the absolute certainty that was the rule just a decade or so ago. And the adequacy of haircuts on other collateral, where accepted, is dependent on their potential volatility. We have, after all, moved from an age where fixed income stocks rose as interest rates fell to a world where the reverse is more likely. Thus, collateral held has a greater inbuilt risk of decline in value than in the past. And the paucity of top rated collateral in a world that is moving closer to secured finance as a norm will create pressure for degradation in collateral quality, even if technology allows us to increase the velocity and accessibility of available collateral.

Structural strength brings together most of the elements I have noted and adds two further key ones. These are the nature of the collateral pools held by the CCPs and the availability of capital or contingent calls by the CCPs. The demand from institutions for bankruptcy remote vehicles to protect their collateral from third-party claims weakens CCPs. The demand may be justifiable but it removes a component of the collective collateral buffer from the risk equation. And, even where they exist, the contractual ability to call for extra support in the form of contingent capital is less certain in today’s world. The shadow banking sector has increased its hold on many of the underlying derivatives handled by the CCPs and have become, directly or indirectly, mission critical to CCP survival. Capital can only be used once and then needs to be replaced, if exhausted, in order to ensure that the impacted CCP can continue in business.

The reality is that CCPs, like others in today’s financial markets, cannot depend on the support of their largest users. They will, more than ever before, only come to a CCP’s aid if it suits their purpose. The reality, post the problems experienced by so many who were persuaded to bail out failing institutions in the last crisis, is that most will seek to protect and limit their exposures at times of crisis. Although some profited from the fire sales of the last crisis, most found it costly beyond their worst nightmares.

We need to get the CCP equation right. The commercial sector will not voluntarily bail out a CCP in trouble. We all may agree that CCPs are useful risk mitigation tools for the market. But, despite having proven their worth in the last crisis, they are not infallible transformers of risk. We live in an interlinked world with ever greater legal uncertainty. We can expect ever increasing instrument price volatility in the future. There is a high potential for periods of illiquidity in many of the new cleared counters. And there is no great feeling of obligation by the commercial sector to support failing infrastructure. Regulators should take a long, hard look at the speed and structure of the new world they are building. Or they could be the direct cause of the next major financial crisis.