An important piece in the Financial Times by Manmohan Singh, a senior economist at the International Monetary Fund, describes persuasively how one of the central vehicles for reducing derivatives risk, that of having a central counterparty (CCP) and requiring dealers to trade with it rather than have a web of bi-lateral exposures, or rely on banks to act as clearers (making them too big to fail) has gone pear shaped. While the immediate reason for this outcome is the unwillingness of national banking regulators to cede powers to an international clearinghouse, Singh fingers an equally important cause: the reluctance to recognize that the underlying problem was and remains undercollateralized derivatives positions. His introduction to the mess:
Little progress has been made on crisis resolution frameworks for unwinding large banks, let alone huge new institutions called CCPs that would house trillions of dollars in financial derivatives. Thus, the underlying economics of having more “too-big-to-fail” entities needs to be justified.
Financial statements show that each of the large banks active in the OTC derivatives market in recent years carries an average of $100bn of derivative-related tail risk; that is, the potential cost to the financial system from its collapse after all possible allowable “netting” has been done within the bank’s derivatives book and after subtracting any collateral posted on the contracts. Past research finds that the 10-15 largest players in the OTC derivatives market may have about $1.5tn in under-collateralised derivatives liabilities, a cost taxpayers may have to bear unless some solution to the “too-big-to-fail” question can be proffered.
Housing derivatives in one single global CCP backstopped and regulated by the leading central banks would have been an ideal “first-best” solution as it would enhance netting, reduce collateral cost and “house” overall risk in one place. A “second best” solution would have involved a few linked CCPs scattered around the globe. However, local politics has resulted in the least-best outcome. A plethora of CCPs are being created because countries such as Australia and Singapore do not want to lose oversight to an overseas entity incorporated in a foreign country.
Singh also mentions that any implementation of a CCP scheme should result in less re-using of collateral (and the main use for collateral is securing over-the-counter derivatives positions). Dealers already are planning to vitiate that outcome, as we discussed last month:
More obviously troubling was a Bloomberg story on how major financial firms are going to undermine the effectiveness of clearinghouses by engaging in “collateral transformation”:
Starting next year, new rules designed to prevent another meltdown will force traders to post U.S. Treasury bonds or other top-rated holdings to guarantee more of their bets. The change takes effect as the $10.8 trillion market for Treasuries is already stretched thin by banks rebuilding balance sheets and investors seeking safety, leaving fewer bonds available to backstop the $648 trillion derivatives market.
The solution: At least seven banks plan to let customers swap lower-rated securities that don’t meet standards in return for a loan of Treasuries or similar holdings that do qualify, a process dubbed “collateral transformation.” That’s raising concerns among investors, bank executives and academics that measures intended to avert risk are hiding it instead.
Understand what is happening here: clearinghouses are one of the major elements of Dodd Frank to reduce counterparty risks. But the banks are proposing to vitiate that via this “collateral transformation” which will simply create new, large volume counterparty exposures to deal with fictive clearinghouse risk reduction program. And get a load of this:
U.S. regulators implementing the rules haven’t said how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment
Translation: the regulators are aware of the banks’ plans to finesse the clearinghouse requirements, and they neither intend to put a kebosh on it (which could easily be done by taking the position that any collateral transformation to meet clearinghouse requirements was an integrated part of the clearinghouse posting and could not be done separately on bank balance sheets) nor understand the impact of their flatfootedness.
This massive fail results from the refusal to deal with the derivatives problem head on.
Back to the current post. Singh draws the obvious conclusion:
The result could be more, not less, moral hazard. In the most extreme scenario, a temporary liquidity shortfall at any of these CCPs would immediately cause systemic disruption. It is likely central banks, and governments, would have to give whatever support was necessary at taxpayers’ expense. In essence, this is a roundabout way for derivatives risk to be picked up by taxpayers.
Singh proposes an elegant solution: taxing derivatives liabilities. What is simply not discussed enough in the post mortems of Lehman is that the reason the losses were SO large was because the derivatives liabilities blew out when markets got roiled. I’ve had savvy readers (in particular Hubert, but he’s not alone) puzzle again and again over the Lehman financial statements, unable to get to the total losses by haircutting the assets on the balance sheet. That’s because that was only one of Lehman’s problems. Remember, under the 2005 bankruptcy reforms, counterparties to derivatives trades can grab collateral first and be asked questions later. Having again and again looked at the size of the Lehman black hole, it’s clear that overstated assets and the additional losses resulting from the “disorderly failure” of the firm (estimated at $50 to $75 billion by the official minders; people on the other side of the table put it at more like $30 billion) don’t come close to explaining the shortfall. The gap is due to the crisis-induced increase in derivative liabilities. So this is not a theoretical risk; this was a big part of why Geithner decided to become “bailouter in chief” as the most expedient remedy.
So a tax on derivatives liabilities would curb the very sort of “heads win, tails you lose” risk-taking that is likely to get dumped on taxpayers eventually, by squarely addressing a major source of systemic risk that regulators have been all too cautious in addressing. It would leave it up to the banks to decide how to adapt to a regime that would force them to price derivatives as if they were adequately collateralizated. Singh again:
A levy on derivative liabilities is a more transparent approach given that the costs to bail out CCPs will ultimately fall on taxpayers. If the levy is punitive enough, large banks will strive to minimise their derivative liabilities, which could eliminate the systemic risk in the derivatives market should a large bank fail. This proposal addresses the source of the problem – under-collateralisation in this market – and does not bury it in technical jargon such as SEFs, FCM, DCM, DCO, DCE, MSP, LEI, portability, interoperability, non-cleared trades and extraterritoriality. The levy will force banks to take (and give) collateral with clients when it is due on the derivatives.
Also, some by-products of the levy will be most welcome. First, a fund from levy revenues could be used to bail out banks that prefer to keep OTC derivatives on their books and thus pay the levy. Second, when all derivative users including sovereigns post their fair share of collateral, banks will not need to hedge positions where they are in-the-money but with default risk. Demand for hedging leads to higher credit default swaps spreads that may increase the cost of debt issuance. The CCP proposal that regulators are so enamoured with is a sleight of hand that instead of resolving the “too-big-to-fail” problem deflects it back to taxpayers.
This sort of tax is philosophically similar to the one that Lee Sheppard advocated on high frequency trading, set at a level that is high enough to discourage socially undesirable outcomes. While these reform discussions are still, sadly, all theoretical, it’s important to have simple, effective remedies ready when opportunities arise to curb banks’ power.