Guest post from Satyajit Das:
The key element of derivative market reform is a central clearinghouse, the central counter party (“CCP”). Under the proposal, standardised derivative transactions must be cleared through the CCP that will guarantee performance. The debate surrounding the CCP provides an insight into the problems of controlling countreparty risk, complex interest of different groups affected and the lobbying process shaping the regulations.
The Magic Circle
The CCP proposals do not encompass full standardisation or listing of derivative contracts, due to significant resistance from the industry.
Proponents argue that the over the counter (“OTC”) trading format is essential to enable users to customise bespoke solutions to match underlying financial risks. They also argue that the flexibility of the OTC market is essential to financial innovation. Critics argue that without full standardisation markets will remain opaque and lack transparency. They allege that the lack of formalised trading and poor price discovery allows dealers to earn substantial economic rents from trading. Derivative dealers cite Walter Bagehot’s famous observation about the English monarchy “We must not let daylight in upon the magic“.
Regulatory proposals require that derivatives eligible for clearing must be traded on a new exchange-type trading system – swap execution facilities (“SEFs”) – to increase transparency, improve liquidity, increase competition and lower transaction costs.
Existing exchanges, electronic trading platforms and inter-dealer brokers are already seeking to establish accredited SEFs. In the oligopolistic world of OTC derivatives trading, less than 10 dealers (nicknamed “The Derivative Dealers Club” by Robert Littan of the Brookings Institute) control the bulk of trading activity
As they provide the bulk of trading volume that will dictate the success or failure of individual ventures, these dealers are positioning to control trading through ownership or influence over platforms. As a result, a few SEFs, directly or indirectly controlled or heavily influenced by existing OTC derivates dealers, are likely to dominate.
The CCP is intended for “standardised” derivatives. On Capital Hill in 2009, when asked what was to be included, Timothy Geithner said that he would have to get back to his interlocutor on that point.
In a curious circularity, standardised now means anything that is eligible for and can be “cleared“. Interesting inclusions and exclusions – both in terms of products and parties that must trade through the CCP – are evident.
Foreign exchange (“FX”) swaps and forwards were originally mysteriously excluded from the definition of “swap” and exempted from clearing. Then, the exemption was removed. Following renewed debate, in April 2011, Treasury Secretary Timothy Geithner exempted all FX derivatives from clearing
The case in favour of exemption argues that FX contracts predominantly have short duration, with low risk. The primary risk of FX contracts, dealers argue, is settlement risk, that is, the cross border funds transfer risk on payments. The dealers believe that settlement risk is already mitigated by CLS Bank, an industry initiative, which since 2002 has provided central settlement in 17 major currencies across six instruments, including FX swaps and forwards. Dealers argue that the FX market functioned well during the financial crisis, with no obvious problems and does not need mandatory clearing.
There are substantial reasons for FX contracts not to be exempted. The FX market globally is very large. It is growing rapidly, with current daily turnover of $4 trillion (7% of global GDP) expected to rise to $10 trillion by 2020. The level of speculative activity is significant, with only around 3% of trading related to underlying trade flows. The FX market is highly significant economically and commercially. Financial institutions from almost very country are active in it, and any problem could pose systemic risks.
It is also difficult to differentiate the risk of a FX derivative contract from derivatives in other asset classes. Risk of FX contracts, despite their short maturities, can be larger than longer dated interest rate contracts, primarily due to the volatility of currencies and also the settlement mechanics.
Regulators are developing elaborate rules that specify included and excluded entities. Derivative or Swap dealers are required to deal through the CCP. “Major market participants” who are not dealers must also clear standardised derivatives through the CCP.
Industrial companies do not want to be subject to the requirement to clear derivatives through the CCP, arguing that only trade to hedge risks. They also argue that the CCP is complex and would place uncertain liquidity demands on their cash flows.
Exemption of instruments, asset classes (such as foreign exchange) and participants reduces the effectiveness of the CCP.
The system of exclusions and exemptions also sets up complex loopholes, begging to be exploited. Standardised contracts may be restructured into non-standard instruments that do not require clearing. Dealers may be able to restructure organisationally to avoid clearing requirements for parts of their business. Large derivative users, not classed as swap dealers, but systemically significantly, may be excluded.
To the extent that products are not routed or counterparties are not obligated to trade through the CCP, existing problems remain and new unanticipated risks may emerge. But as American radio and television commentator Charles Osgood observed: “There are no exceptions to the rule that everybody likes to be an exception to the rule.”
Risk Conservation
The proposal assumes that the CCP is substantially risk free, relying on the ability of the CCP itself to manage risk.
The CCP receives an initial margin or deposit from all parties to a transaction that acts as surety or a security bond against performance. The contract is marked to market daily or more frequently, if market conditions dictate, to establish gains and losses. Parties must post margins to cover the losses on open positions. If a party fails to meet a margin call then the CCP closes out the position, replacing it in the market. The CCP use the initial margin held to cover the replacement cost.
The system is reliant on the ability to value contracts and complex risk models.
The CCP risk management process assumes available market prices to value positions. In the OTC market, all instruments do not trade in a liquid manner and reliable market prices may not always be available. Few instruments will be capable of being marked to market against actual prices. For some instruments, it will be mark-to-model based on inputs that may be validated from market prices. In other cases especially more complex products, it will be a case of mark-to-make-believe or mark-to-myself.
CCP risk management relies on models to establish the level of initial margin consistent with risk. Based on historical data and assumptions about price behaviour of assets, the models proved problematic during the global financial crisis. The models proved unable to capture the actual performance of values under conditions of stress,
The CCP will also aggregate all positions across instruments and asset classes for each clearing party. This requires incorporating unstable correlation between different asset classes and products, casting further doubt on the efficacy of the risk models.
The entire framework relies on the nirvana of continuously liquid and functioning markets. Financial crises over the last 25 years have repeatedly highlighted the failure of these assumption when needed.
Some OTC derivatives may also not be capable of clearing. In its December 2009 report Reforming OTC Derivative Markets: A UK Perspective, the U.K. Financial Services Authority (“FSA”) did not support mandatory clearing because “the clearing of all standardised derivatives could lead to a situation where a …CCP… is required to clear a product it is not able to risk manage adequately, with the potential for serious difficulties in the event of a default.”
The clearing models used may also determine the effectiveness of the CCP. In gross clearing, all participants deal with the CCP directly, lodging margins with the designated clearing entity. Net clearing requires non-clearing participants to deal via a CCP clearing member (also known as a clearing broker or in the US a futures clearing merchant). In net clearing, non-clearing members have no direct relationship with the CCP, lodging margins with the clearing member who deals with and is accountable to the CCP for payments and contract performance.
In a net margin arrangement, clearing members and clients negotiate the level of margins, the form of collateral permitted, netting of positions, the timing for meeting margin calls and the clearing fees. Clearing members may also provide credit facilities, funding margin calls on behalf of clients, enabling trading without credit enhancement. Dealers will push aggressively for net clearing, enabling them to develop a significant business clearing OTC derivative trades for non-clearing parties.
Net clearing means that there is risk at the level of the CCP and at the level of the clearing members. Competition between clearing members may reduce risk management standards for clients, increasing the risk held by the clearing member reducing the overall effectiveness of the system.
As clearing is a undifferentiated product, CCPs, run for commercial profits, may undercut each other on margins and initial deposit requirements to gain market share, in the process undermining the stability of the system itself.
Superficially, there are attractions and potential benefits of moving OTC derivatives onto a clearing platform. But the detailed risk management of CCP clearing is intricate and complex. Without rigorous risk management standards, overall risk levels may not be reduced. It is far from unclear whether regulators understand and can specify and monitor standards to manage the identified risks to the exacting tolerance required.
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 frequently remains constant. Alternatively, a risk is converted into a different, sometimes more dangerous exposure. The CCP is a good example of this phenomenon.
Spreading the Risk Around
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 similarly 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.
The CCP system relies on use of cash or high quality government securities to be lodegd as collateral to secure performance under derivative contracts. 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 $14 billion. AIG did not have the cash to meet this call and ultimately required government support.
The additive effect of the CCP and other liquidity controls now mandated by regulators must also be considered.
The liquidity risk for industrial companies may be significant. 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. 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“.
CCP clearing of derivatives may increase hedging costs to users of derivatives and their liquidity requirements to support trading. This cost and the risk of liquidity shortfalls may affect levels of hedging, preventing exposures from being hedged. The diversion of liquidity to support risk may also restrict availability of financing for other purposes.
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.
The CCP effectively changes the structure of markets from a network which can survive one or more failures to a hub and spoke system that is vulnerable to a single failure. This increases risk concentrations within financial markets. The CCP is the ultimate case of “too big to fail“.
The credit quality of the CCP is crucial. 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. Currently, private clearing houses are contemplated. 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.
Maximisation of benefits of central clearing requires a single clearing house. The CCP will be most effective if all instruments and participants are covered. However, a single CCP covering all products and market participants seems unlikely to be achieved.
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.
International agreement on clearing and the CCP may prove elusive. It is also not clear who will regulate and oversee the system, especially where it transcends national boundaries.
The CCP is not a comprehensive solution – a magic silver bullet. It is likely to disappoint and create different but equally potent risks.
Alms for Derivative Dealers
Contrary to the popular narrative, current proposals will not impact significantly on dealer earnings.
Derivative dealers have resisted clearing, primarily because of the effect of greater transparency on profit margins. The five largest U.S. derivative dealers alone generate annual revenues of at least $60-70 billion from trading derivatives and cash securities. Global revenues are probably two to three times that number.
Only standardised derivative transactions are likely to requiring mandatory clearing. Lucrative non-standardised derivatives will continue to be traded in the opaque over-the-counter (“OTC”) markets, preserving dealer profits.
The CCP also creates profitable new opportunities for dealers.
Derivatives eligible for clearing must be traded via a regulated exchange or through an alternative swap execution facility (“SEF”), that is open to multiple participants. In the oligopolistic world of OTC derivative trading, fewer than 10 dealers (nicknamed “The Derivative Dealers Club” by Robert Littan of the Brookings Institute) control the vast majority of trading activity. These dealers provide the bulk of trading volume, which will dictate the success or failure of individual SEFs. Dealers will parlay their control of volumes into control of trading, through de facto ownership or influence over the dominant platforms.
Dealers will play a crucial role in clearing on behalf of client and non-dealer financial institutions. The clearing model is unlikely to require all participants to deal with the CCP directly. Instead, non-clearing participants will deal through a CCP clearing member (known as a clearing broker or in the US a futures clearing merchant). Non-clearing members will have no direct relationship with the CCP, lodging margins with the clearing member who deals with and is accountable to the CCP for payments and contract performance (a system known as “net clearing”).
Under this arrangement, the clearing dealer will negotiate arrangements with clients, including the level of margins, the form of collateral permitted, netting of positions, the timing for meeting margin calls and the clearing fees. Clearing dealers may also provide credit facilities, funding margin calls on behalf of clients, enabling trading without credit enhancement.
Under the CCP, dealers will gain a profitable business clearing non-member trades. In existing exchange traded markets, most of the profits from futures broking comes from not from execution but clearing, including crucial access to client funds that can be reinvested at a profit.
Only a few large derivative dealers have the capita resources to finance the large capital investment required to support the systems and infrastructure for trading platforms and clearing through the CCP. Other dealers will inevitably be forced to trade, clear and settle trades through these dealers. This will perversely create credit risk as well increasing systemic risk and problems of concentration.
The CCP system has competing objectives, which may prove irreconcilable in practice. Regulators want to encourage competition, broadening the range of SEFs and clearing houses by lowering eligibility thresholds. However, inadequately capitalised smaller members would increase risk for other members and the CCP, in the event of a collapse of a member. Large highly capitalised banks argue that risk management considerations favour higher capital requirements, which would help ensure their dominant position.
Proposed ownership restrictions of SEFs and clearing houses may not be effective. Dealers have historically been adroit at using the hunger of market infrastructure providers for volume to enhance revenues from commercial arrangements other than direct ownership, such as revenue sharing, volume rebates and other incentives.
Regulators have generally tolerated concentrated ownership and oligopolies in market infrastructure, such as SEFs and clearing houses, citing economies of scale and scope as well as limited anti-competitive effects. While true in standard, simple debt and equity securities, it is not clear that this is the case with OTC derivatives. OTC derivative markets already exhibit high concentration, more complex instruments (frequently with non-transparent values), and greater information disparities between participants.
The position of major dealers is likely to be strengthened, rather than weakened. 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. This is at odds with the dire predictions emanating from leading banks, arguing that the CCP and other regulations will cripple trading and decimate profitability.
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. Whatever is implemented will be reminiscent of French philosopher Jean Paul Sartre’s words: “Once you hear the details of victory, it is hard to distinguish it from a defeat.”
Some of this content have been published as “Tranquillizer Solutions Part I: A CCP Idea” and “Tranquillizer Solutions: Part 2 – CCP Risk Taming” in Wilmott Magazine (May and July 2100)
© 2011 Satyajit Das All Rights reserved.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010)
