Clear danger ahead

As the regulators push us towards centralised clearing for OTC derivatives they may actually be making the world distinctly less safe. At face value it makes obvious sense; if one party defaults the CCP steps in. As always, though, the problem lies in the detail but this time not too far below the surface.

The first problem concerns the efficient use of margin. As CCPs start to uncouple from their parent exchanges and compete more directly with each other it’s only natural for them to start trying to differentiate more. An obvious step is to offset margin requirements from equivalent (but not fungible) products, especially given the opportunity cost of capital these days. This could now include OTC products and exchange-traded ones, say a Euro-Swap and a Bund. This is OK in principle, but 'equivalent' is very different from 'same' and a race to the bottom in this type of competitive activity will increase systemic risk rather than reduce it. 

The second problem lies in post-trade and allocations. In derivatives this is complicated enough, especially when the executing broker is different from the clearing broker (or brokers) for the actual fund sub-accounts. Now multiply this complexity by the number of SEFs (or OTFs) that emerge, then multiply it again by every clearing house and, finally, throw in the fact that there is no agreed sequence for the messages and you start to get a distinctly queasy feeling.

I think I’ll keep my hard-earned cash under my mattress.