War Communism Meets Central Clearing
I believe that I am on firm ground saying that I was one of the first to warn of the systemic risks created by the mandating of central clearing on a vast scale, and that CCPs could become the next Too Big to Fail entities. At ISDA events in 2011, moreover, I stated publicly that it was disturbing that the move to mandates was occurring before plans to recover or resolve insolvent clearinghouses were in place. At one of these events, in London, then-CEO of LCH Michael Davie said that it was important to ensure to have plans in place to deal with CCPs in wartime (meaning during crises) as well as in peace.
Well, we are five years on, and well after mandates have been in effect, those resolution and recovery authorities are moving glacially towards implementation. Several outlets report that the European Commission is finalizing legislation on CCP recovery. As Phil Stafford at the FT writes:
The burden of losses could fall on the clearing house or its parent company, its member banks; the banks’ customers, such as pension funds, or the taxpayer.
Brussels is proposing that clearing house members, such as banks, be required to participate in a cash call if the clearing house has exhausted its so-called “waterfall” of default procedures.
The participants would take a share in the clearing house in return, according to drafts seen by the Financial Times.
Authorities would also have the power to reduce the value of payments to the clearing house members, the draft says. In the event of a systemic crisis, regulators could use government money as long as doing so complies with EU rules on state aid.
Powers available to regulators would include tearing up derivatives contracts and applying a “haircut” to the margin or collateral that has been pledged by the clearing house’s end users.
Asset managers have long feared that haircutting margin would be tantamount to expropriating assets that belong to customers.
The draft is circulating in samizdat form, and I have seen a copy. It is rather breathtaking in its assertions of authority. Apropos Michael Davie’s remarks on operating CCPs during wartime, my first thought upon reading Chapters IV and V was “War Communism Comes to Derivatives.” One statement buried in the Executive Summary Sheet, phrased in bland bureaucratic language, is rather stunning in its import: “A recovery and resolution framework for CCPs is likely to involve a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders.”
In a nutshell, the proposal says that the resolution authority can do pretty much it damn well pleases, including nullifying normal protections of bankruptcy/insolvency law, transferring assets to whomever it chooses, terminating contracts (not just of those who default, but any contract cleared by a CCP in resolution), bailing in any CCP creditor up to 100 percent, suspending the right to terminate contracts, and haircutting variation margin. The authority also has the power to force CCP members to make additional default fund contributions up to the amount of their original contribution, over and above any additional contribution specified in the CCP member agreement. In brief, the resolution authority has pretty much unlimited discretion to rob Peter to pay Paul, subject to only a few procedural safeguards.
About the only thing that the law doesn’t authorize is initial margin haircutting. Given the audacity of other powers that it confers, this is sort of surprising. It’s also not evident to me that variation margin haircutting is a better alternative. One often overlooked aspect of VM haircuts is that they hit hedgers hardest. Those who are using derivatives to manage risk look to variation margin payments to offset losses on other exposures that they are hedging. VM haircutting deprives them of some of these gains precisely when they are likely to need them most. Put differently, VM haircutting imposes losses on those that are least likely to be able to bear them when it is most costly to bear them. Hedgers are risk averse. One reason they are risk aversion is that losses on their underlying exposures could force them into financial distress. Blowing up their hedges could do just that.
Perhaps one could argue that CCPs are so systemically important and the implications of their insolvency are so ominous that extraordinary measures are necessary–in its Executive Summary, and in the proposal itself, the EC does just that. But this just calls into question the prudence of creating and supersizing entities with such latent destructive potential.
There is also a fundamental tension here. The potential that the resolution authority will impose large costs on members of CCPs, and even their customers, raises the burden of being a member, or trading cleared products. This is a disincentive to membership, and with the economics of supply clearing services already looking rather grim, may lead to further exits from the business. Similarly, bail-ins of creditors and the potential seizure of ownership interests without due process will make it more difficult for CCPs to obtain funding. Thus, mandating expansion of clearing makes necessary exceptional resolution measures that lead to reduced supply of clearing services, and reduced supply of the credit, liquidity, and capital that they need to function.
It must also be recognized that with discretionary power come inefficient selective intervention and influence costs. The resolution body will have extraordinary power to transfer vast sums from some agents to others. This makes it inevitable that the body will be subjected to intense rent seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens. Rent seeking is costly. Furthermore, it will inevitably inject a degree of arbitrariness into the outcome of resolution. This arbitrariness creates additional uncertainty and risk, precisely at a time when these are already at heightened, and likely extreme, levels. Furthermore, it is likely to create dangerous feedback loops. The prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that pushes it over the edge.
To put it simply, if the option to resort to War Communism is necessary to deal with the fallout from a CCP failure in a post-mandate world, maybe you shouldn’t start the war in the first place.