Post Trade Forum debate on Are CCPs Increasing Risk? was held at the London Stock Exchange [a couple weeks ago]. Cheers, Gary, for letting me take part in such a fun event!
My slides are available to download here:
Are CCPs Increasing Risk?
Short story is that I see rising risks from mandatory margin of OTC derivatives with CCP fragmentation, and this will intensify during the transition. We are not in normal times, and this sort of reform would have been challenging under the best conditions.
CREDIT RISK: I concede that mandatory CCP clearing and CSA margin will generally reduce credit risk. BUT . . . (a) Netting fragmentation means counterparties to multiple trades lose the big credit risk reduction of 100 per cent netting coverage; (b) Multiple
variation margin flows on fragmented portfolios mean it is impossible to tell whether payments are reducing or increasing overall risk without consolidating all variation flows with the residual exposures for a close out value; (c) Tiered clearing and custody
arrangements introduce other credit risks and dependencies; (d) It is a bit bizarre as a matter of public policy to ban banks from extending credit in connection with OTC derivatives while beating them about the ears in the media for not lending more.
VALUATION RISK: CCPs normally rely on exchange price discovery for valuation of assets and exposures. As OTC markets are not subject to exchange rules and price discovery, CCPs will not have access to reliable pricing or liquidity to the same extent. Valuations
for variation margin movements will be the CCPs' best estimate of the value of a series of future obligations, with the CCP having discretion over methodology. Unlike bilateral pricing, there won't be any scope for objection or negotiation. The risk of mispricing
is significant, particularly given sensitivity of OTC markets to liquidity conditions, falling liquidity in many instruments and markets, and a likely further decline in participation as higher lifetime costs of holding OTC derivatives drive business away.
The high concentration of OTC derivatives trading - with 90 per cent among just 5 dealers - makes these markets particularly at risk to price distortions, intentional and unintentional.
LIQUIDITY RISK: The numbers are staggering. The IMF Global Financial Stability Report is projecting a big shortfall in safe assets at a time when demand is rising due to Basel III Liquidity Coverage Ratio, mandatory CCP clearing and bilateral margin, and increasing
reliance on secured lending facilities for liquidity. There just aren't enough "safe" assets in the world to margin all the CCPs and all the bilateral exposures by 2012 without a massive liquidity dislocation. Whether the number is $200 billion (the Heller
and Vause BIS estimate for just the G14 dealer banks) or $2 trillion (the Singh IMF estimate for all uncollateralised exposures), a huge margin call is looming. Mandatory margin will be especially burdensome for 2nd tier and end user hedgers who may lack
native liquidity in the assets demanded by CCPs or under stricter and more limited new ISDA CSAs. Add to that the need to pre-position or reserve cash and assets against variation margin calls or increases in initial margin under volatility, and there is
a real risk that CCPs will exacerbate pro-cyclical liquidity risks across the system. Any default to a CCP will have wider destabilising effects on credit and asset liqudity.
OPERATIONAL RISKS: The regulations aren't even final yet! One thing I know from building clearing systems is that systems built from incomplete specifications and requirements are likely to prove unsatisfactory, if not be abandoned. It's unlikely all the
CCPs being built right now (over 20 in total!) are going to get their systems right. For the industry, ISDA is just finalising the new documents that will be required to implement CCP clearing and new CSA structures. Blackrock alone has over 1000 CSAs to
renegotiate toward standardised margin practices. And not everyone will be cooperative or responsive to the drive to standarise on the new document formats. On the technology front, the complexity of more than 20 CCPs with their own processing requirements,
timelines and data formats presents a major integration challenge. Add to that the need for treasuries to shift to multi-currency variation margin payments and reconciliations, along with pre-positioning initial assets, tracking asset usage and monitoring
mandates at custodians, and it's going to be a busy year for operations and IT staff.
CASH, CUSTODY AND CLEARING RISKS: The big risk issues here:
- Different segregation models among CCPs and Clearing Agents (pooled, LSOC and fully client account segregation);
- Portability of client accounts and positions will be mandatory under the new CPSS-IOSCO principles for CCPs, despite it being a challenge under some resolution regimes;
- CCP and margin will force much greater concentration risks among the top clearing bank/custodians, reinforcing their already mammoth moral hazard in the system and giving them huge liquidity subsidy from deposits of margin cash by CCPs to their tender care
as Settlement Banks behind the CCPs;
- CCPs will have differing default waterfalls, tiering claims on client margin, member margin, capital, Default Guarantee Funds, and contingent claims on members.
- Local resolution regimes are ill-adapted to quick resolution of claims and create risks around CCPs, which are by their nature systemic risks for the wider financial system.
- Falling liquidity and rising shortfalls of safe assets for capital and margin make the whole system more fragile;
- There is a high risk of severe volatility returning as credit markets normalise to positive interest rates - or of deflation if investors give up on ever seeing a positive return again under financial repression;
- Markets are not normal, with very high asset class correlation and increasing concentration risks.
Summarising some points from the discussion:
- Dodd-Frank and EMIR seem to be politically motivated to reduce derivatives trading without objectively banning it by making it more costly and burdensome;
- Getting all the regulatory compliance in place within the deadlines will be a huge challenge all around;
- Some CCPs have access to central bank liquidity facilities, but not all do. Interesting to reflect on what kind of risk the UK taxpayer is taking on with so many CCPs concentrating in London, and potentially all making similar risk management mistakes
under the same regulatory regime.
- Consolitation of CCPs would be desirable for efficiency and netting gains, but is difficult because of the prestige and protectionism of certain countries. Even where governance has been consolidated by mergers in the past, often systems remained fragmented
with different processing cycles and formats.
- The EMIR passport for pan-EU CCP operations might promote some consolidation on the merits.
- Clients are going to be hit hard by higher costs, lower returns, more complexity, and poor liquidity.
- Default funds should be broken out by asset class to prevent cross-subsidy and mutualisation of risk.
Only one person in the room believed that the overall impact of the forced migration to margin would be net risk reducing (she works for a CCP), and many are worried about the transition proving very stressful.
Finally, congratulations to Gary and Cathy Wright on their 30th wedding anniversary!