It is unlikely first century Roman satirist Juvenal was
thinking about the G20 pledge to reform the swaps markets when
he said it but his question is relevant: Who will guard the
The decision by the group of 20 nations in 2009 to force
standardised swaps through many of the funnels used in the
exchange-traded world was at the time grudgingly accepted as a
fairly practical step.
Some five years on, the reality suggests otherwise.
Trade reporting (arguably the least controversial of the
three principles backed by G20) has been far from
straight-forward, not least in Europe where one bank recently
estimated less than 1% of the trades that should be reported
are actually being reported almost six months after the law
The execution mandate to force standardised swaps on to
exchange-type platforms has fared little better. Volumes on
swap execution facilities in the US are increasing slowly but
are still well short of the levels expected.
This is because some firms have stopped trading in the US
while others are trading lookalike products that are exempt
from Dodd-Frank but are very close to those bound by the
Yet mandatory swap clearing arguably represents the greatest
threat to the stability of the financial system.
Forcing the swaps market to clear effectively concentrates
the risk into a handful of clearing houses to which all the
world’s trading firms are exposed.
Clearing houses are (they claim) experts at managing risk
and to be fair to them most of them stood up well in the
aftermath of the Lehman collapse in 2008.
But the inclusion of hundreds of trillions of standardised
swaps ups the ante massively and the industry has been for the
last couple of years trying to work out what happens if a
clearing house were to collapse?
The clearers themselves have run scenario tests based on the
premise that their two largest clients were to collapse on the
same day and they have found (surprise, surprise) that they
would be fine.
The procedure in the event of a default suggests there could
be an impact on clients however.
Clearers typically use a default "waterfall" that lists
sequentially the various sources the clearing house can call on
to make good on any losses incurred by members as a result of
another member going into default.
At the top of the waterfall are the defaulting
member’s margin contributions and at the back of
the queue are the clearing house’s cash and
finally that of members.
This then acknowledges that a clearing house could be on the
hook in the event of major client going down and that,
ultimately, the banks themselves might have to step in if the
clearing house can’t handle it.
This dilemma has prompted (academic) discussions between the
world’s top investment and central banks.
The commercial banks argue that a default waterfall reaching
them in the event of clearing house failure will have
catastrophic effect because they would be hamstrung and the
markets would seize up.
Investment banks think central banks should step in and
bail-out a failing central counterparty as this would ensure
the markets can at least carry on and the impact of the default
can be minimised by trading out the positions.
This line was backed this week by Professor Scott Lubben of
Seton Hall University, School of Law who has concluded a study
with the finding that the US government should be prepared to
step in and support a clearing house on the brink.
But central banks are not having it. They insist they are
not going to stand as the lender of last resort in the event of
a clearing house collapse and it is up to the clearing
house’s clients to make any struggling clearer
Governments and investment banks have not agreed on much
since the financial crisis but they would surely agree that
no-one wants to find out what would really happen if a clearing
house went under.