The ultimate intention of the mandate to centrally clear standardised OTC derivatives was intended in part to reduce systemic risk in the financial system. However, could an unintended consequence be that it actually increases the problem of too big to fail and increases systemic risk?
In a report for the Cato Institute entitled “The Inefficiency of Clearing Mandates” Craig Pirrong says that OTC clearing has become “a deus ex machine” to solve all the problems inherent in the derivatives markets.
He added: “Those making such claims would be at risk of a false-advertising claim if they were engaged in commercial advertising.”
Pirrong argues that the central clearing mandate could increase moral hazard, relating it to a tragedy of the commons: “Each dealer has an incentive to trade too much because it does not bear the associated default costs...and each has an excessive incentive to add risk to its balance sheet because other members of the clearinghouse bear some of these risks,” he says.
This brings us to one of the key questions of the mandate: are clearing houses too big to fail? Apparently the regulators would like to think not. In the US, regulators do not believe LCH. Clearnet to be systemically important.
Meanwhile, Article 37b of Emir, the European regulation that covers the mandate, simply says: “CCPs' risk-management strategies should be sufficiently sound so as to avoid risks for the taxpayer.”
However, in the very next clause, it highlights the problem: “Margin calls and haircuts on collateral may have procyclical effects.”
It says that CCPs, competent authorities and ESMA “should therefore adopt measures to prevent and control possible procyclical effects...to the extent that a CCP's soundness and financial security is not negatively affected”.
But how possible is this? CCPs have very solid risk management procedures and the chance of them going belly up is slim but the implications of such a scenario could be devastating. In addition, while a CCP is generally well protected from the default of a certain number of its members, there will always be a breaking point.
At the same time, CCPs are heavily exposed to wrong way risk, especially when it comes to sovereign debt crises. A clearing member will generally be positively correlated to the credit worthiness of its sovereign both holding and bonds as collateral and heavily exposed to the domestic economy.
Risk black holes
In the situation of the rapid deterioration of the credit rating of sovereign debt, clearing houses could become collateral black holes, sucking in more margin to cover haircuts and exacerbating the liquidity issues that a clearing member is facing as a result of those haircuts and subsequent margin calls, leading to further downgrades and a self-fulfilling prophesy of default.
CCPs protect against sovereign default through increased margins on certain government bonds escalating to a refusal to accept certain government bonds in extreme situations. During the European financial crisis, LCH and others did this with Greek and Irish government debt. But the European crisis has been played out in excruciatingly slow motion.
Other defaults might be quicker and we may wake up to find that the risk princesses have become giant risk monsters sucking up all available collateral from the global financial system. CCPs are too big to fail. In a world of OTC clearing, they might be so big they exacerbate failure.
IOSCO is due to report on its resolution for CCP guidelines imminently. At the same time, the “last gasp” concept is being explored would enable CCPs to take some margin from the net gainers on a position to offset the loss. This is, as the name suggests, an absolute last resort.
CCPs can and do fail. In his definitive history of clearing, The Risk Controllers, Peter Norman highlights three CCP failures over the past four decades: the Caisse de Liquidation des Affaires en Marchandises in Paris, which collapsed in 1974 following the bursting of a bubble in the sugar markets; the Kuala Lumpur Commodity Clearing House, which went bust in 1983 after the default of six members.Then in the wake of the 1987 crash, the Hong Kong Futures Exchange clearing house failed resulting in a bailout by the Hong Kong government.
Too big to fail II
There is another aspect of the problem of too big to fail contained within the mandate though. Gareth Campbell, a partner at financial services consultancy Baringa Partners, says: “One of the possible unintended consequences of the OTC clearing regulation is an increase in the too big to fail problem for banks.
“In our discussions with Tier 2 banks, we are finding that they feel that they do not have the capabilities to offer full service clearing capabilities to clients. If we extrapolate that across the markets it results in a concentration in the large banks, which goes against the G20 mandate,” he says.
The financial crisis of 2008 taught us that spreading risk around an interlinked financial system did not reduce risk. Will the next teach us that centralising risk in CCPs is not the answer either?
Fidessa’s Steve Grob concludes: “The problem with regulation is that it is always backward looking. There may well be another crisis like AIG but it will almost certainly come from an unexpected quarter and so all the regulation that is being put in place now may not be relevant.
“On top of this, the simple fact is that market participants are always able to innovate faster than regulators can legislate.”