By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
This four part paper deals with a key element of derivative market reform – the CCP (Central Counter Party). The first part looked at the idea behind the CCP. This second part looked at the design of the CCP. The third part looked at the risk of the CCP itself and how that is managed. The last part looks at the market effects of the effects of the CCP on the market.
In the Renaissance, popes often annulled the marriages of Catholic monarchs. The annulment preserved, theoretically, both the authority of the Papacy and the sanctity of marriage. The CCP proposal is similar. It gives the impression that regulators and legislators are reasserting control over the wild beasts of finance. In reality, the proposal may not work or materially reduce the risks it is intended to address.
Risk conservation means that risk in financial markets never decreases. Risk can be altered and reconstituted in infinite combinations and transferred between participants. In aggregate, the risk remains constant. Alternatively, a risk is converted into a different, sometimes more dangerous exposure. The CCP is a good example of this phenomenon.
Margins on cleared contracts will significantly change liquidity and cash flows within the financial system. Derivative traders will need to post initial margin and may experience volatile cash flows as a result of changes in values of positions. As these requirements will have to financed, counterparty risk will morph into liquidity risk.
The risk is not insignificant. Under its bilateral collateral arrangements, AIG’s CDS contracts were subject to the provision that if the firm was downgraded below AA-, then the firm would have to post collateral. In October 2008, when AIG was downgraded below the nominated threshold, this triggered a collateral call rumoured to be in excess of $18 billion. AIG did not have the cash to meet this call and ultimately required government support.
As an intermediary, trades by derivative dealers will generally be reasonably closely matched. The margin calls on the net position should be modest as payments and receipts will be matched. In addition, dealers, especially where they are part of large financial institutions, have ready access to liquidity and also greater experience in managing variability in cash positions.
The liquidity risk for clients is different. Where a company is hedging, a margin call on its derivative hedge will generally not be matched by an offsetting cash flow on the underlying exposure. Unleveraged investors will generally have the underlying asset or cash being hedged but the precise cash flows may not match. Leveraged investors will be affected as they use derivatives to increase the size of their positions. Large margin calls may force them to liquidate the position or sell other assets to finance the payment.
Industrial corporations have been critical about the liquidity risk of CCP cleared derivatives, being one of the primary reasons for resistance to being required to clear trades. Lufthansa claimed that clearing would “cause severe cash and liquidity risks”. During the GFC, the company claimed that cash flow requirements from margining derivative contracts “would have erased many corporations with a domino effect reaching every . . . corner of business activity”.
Some elements of liquidity risk already exist under existing credit enhancement arrangements. Lower rated customers and even better rated firms with large derivative exposures are already subject to bilateral collateral provisions. The posting of collateral (cash or government securities) enables these companies to access derivative markets. The arrangements are generally customised between the parties but impose potential liquidity claims on the client. The CCP merely formalises this arrangement. Companies with bilateral collateral arrangements have generally been able to manage their liquidity without the severe consequences claimed.
A client concerned about volatile liquidity demands could always negotiate a line-of-credit from the dealer to cover its potential funding requirements. This would transfer the liquidity risk to a dealer, but at a cost.
CCP clearing of derivatives may increase hedging costs to users of derivatives and their liquidity requirements to support trading. This points to a fundamental existing problem – the chronic and systematic under pricing of counterparty risk in financial markets.
Problems of risk are difficult to resolve with no cost to market participants. The additional liquidity requirement is effectively the cost of reducing the risk of derivative trading. This cost and the risk of liquidity shortfalls may affect levels of hedging. The diversion of liquidity to support risk may also restrict availability of financing for other purposes.
As in the old proverb, the CCP may be like a pessimist who confronted with two bad choices, selects both.
Clearing the House …
The CCP is designed to reduce systemic risk but in reality, the CCP may become a node of concentration. The clearing arrangement centralises contracts in a single entity – the CCP. This increases risk concentrations within financial markets. The CCP is the ultimate case of “too big to fail”. Riccardo Rebonato observed correctly that: “We are moving away from a network system that can survive the failure of a single thread, to a hub-and-spoke system that must be 100% resilient. If the hub is ever allowed to fail, the aftermath of Lehman’s default is going to look like a picnic. So we are placing a lot of reliance on regulators to get these standards right and ensure CCPs are really robust.”
The credit quality of the CCP is crucial. Currently, private clearing houses are contemplated. The CCP’s capitalisation and financial resources as well as the risk management systems will be important in ensuring its credit standing. The specific criteria and detailed oversight arrangements are unclear. Commercial motivation (for market share and profit) may conflict with risk management requirements. It is not immediately apparent how these competing pressures will be accommodated.
US regulators propose limits on bank ownership of the CCP. Clearing house members, exchanges and SEFs will be limited to 20% and aggregate bank interest to 40%. While addressing conflicts of interest, it obscures the fact that these entities are the natural shareholders. It is not clear who other potential shareholders, with the required capital resources and expertise, may be.
If, as likely, net clearing is used, the credit quality of clearing members is important in managing the risk of entire CCP structure. Here competing considerations may prove irreconcilable in practice. For example, the CFTC’s current proposes that capital requirements for individual clearing should be scalable and proportionate to risk, with a $50 million cap on any minimum capital requirement set by clearing houses for membership. Regulators want to encourage competition and broaden the range of clearing houses. However, inadequately capitalised smaller members would increase risk for other members and the CCP, in the event of a collapse of a member. Predictably, large highly capitalised banks favour higher capital requirements, ensuring their dominant position.
Maximisation of benefits of central clearing requires a single clearing house. Currently, multiple CCP appear likely, as different commercial clearing houses compete for the latest frontier land grab in financial markets.
National prejudices, inherent mutual distrust, promotion of national champions as well as feared loss of sovereignty and control of financial markets will mean multiple CCPs located in different jurisdictions. This will require, if feasible, inter-operability, cross margining and clearing arrangements between exchanges and jurisdictions. Instead of decreasing risk, this may create new and complex exposures, including exposure to cross-border bankruptcy law issues.
International agreement on clearing and the CCP may prove elusive. Regulators in major jurisdictions support the concept of clearing. However, there are significant differences between the positions of individual countries. For example, international regulators are yet to agree on the definition of a standardised contract or the market participants required to transact through the CCP. It is also not clear who will regulate and oversee the system, especially where it transcends national boundaries.
The CCP will be most effective if all instruments and participants are covered. In a 2009 paper, Darrell Duffie and Haoxiang Zhu examined whether a CCP would reduce counterparty risk concluding that a CCP for some but not all class of derivatives can actually increase risk and liquidity demands. Duffie and Zhu also concluded that it is inefficient to introduce more than a single CCP for the same class of derivatives. However, a single CCP covering all products and market participants seems unlikely to be achieved.
Victorious Defeat ..
Superficially, there are attractions and potential benefits of moving OTC derivatives onto a clearing platform. The details are intricate and little understood by non-practitioners.
Attempts to regulate derivatives trading are complicated by existing entrenched interests and complex benefits and costs. The five largest U.S. derivative dealers generate annual revenues of around $60-70 billion from trading derivatives and cash securities. Global revenues are probably two to three times that number. Dealers will defend their business franchises.
If required to clear through the CCP, industrial companies would suffer from lower hedging flexibility, cash requirements for collateral and additional operational demands. They may face problems in meeting existing hedge accounting requirements if only standardised products were available. On the other hand, they would gain from greater transparency of pricing, lower costs (tighter bid-offer spreads) and perhaps increased liquidity.
A framework for clearing OTC derivative will emerge, if only because finance ministers, central bankers and regulators have invested too much political capital in the proposals.
Interestingly, the position of major dealers will be strengthened, rather than weakened. This is at odds with the dire predictions emanating from leading banks, arguing that the CCP and other regulations will cripple trading and also decimate profitability.
Dealers will extend their control of OTC derivatives trading, through de facto control of SEFs and the clearing process. The ability of dealers to determine success or failure of SEFs and CCPs by directing volumes to or away from specific concerns will enable them to control developments.
The heavy investment required to establish the infrastructure to clear trading platforms and contracts through the CCP will mean that a few large derivative dealers will quickly dominate the business. Other dealers will inevitably be forced to clear and settle trades through these dealers creating counterparty credit risk, perversely increasing systemic and concentration risk. This corresponds to the experience in exchange traded futures and options markets.
Lower profit margins from any increased transparency and liquidity will be offset by new revenue flows. from investments in SEFs and CCP, earnings from clearing on behalf of clients and efficient cash arbitrage of client margins and collateral.
The CCP is not a comprehensive solution – a magic silver bullet. It is likely to disappoint and create different but equally potent risks. The CCP is consistent with the observation by journalist and columnist Max Lerner: “What is dangerous about tranquillisers is that whatever peace of mind they bring is packaged peace of mind. Where you buy a pill and buy peace with it, you get conditioned to cheap solutions instead of deep ones.”
The CCP does not address the real issues of derivatives or the risk they pose to financial markets.
Earlier versions of this piece have been published as “Tranquillizer Solutions Part I: A CCP Idea” and “Tranquilizer Solutions: Part 2 – CCP Risk Taming” in Wilmott Magazine (May and July 2010)