January 17, 2012
Reuters Hysteria: CCPs to be next victim of the crisis
Reuters has posted an attention grabbing headline, but the article needs more research and depth to carry it's argument. The original piece is here, the salient facts from the article are:
"Clearing houses — the plumbers of high finance — could become the next casualties of the crisis as regulators insist that banks run their riskiest and private trades through them"
- Has anyone noticed an announcement from the CCPs that they're going to drop their current conservative approach to launching new liquid products, in favour of illiquid, hard to price exotics? I think we'd have noticed that one.
- Has anyone seen a new rule from the CFTC, SEC or ESMA saying that they will run roughshod over the current product review process – and just slam any old product without a liquid market into clearing? I don't think so.
"But in taking on over-the-counter (OTC) products the concern is that the clearing houses will not have sufficient collateral to cover the scale of possible future positions."
So the article implies that the risk models at the three major CCPs are flawed, they under estimate the amount of IM required, how does he know this? Because he quotes some people who say the numbers should be bigger:
- Manmohan Singh (IMF) says CCPs need $2trn of margin, and Diana Chan (EuroCCP) says OTC contracts can be "very long" so need more collateral
- Neither Manmohan nor Diana are commenting on the underlying models to calculate IM (historic VaR for example), and nor is the article
- If the volume of business at a CCP increases, generally the amount of IM increases (setting aside netting affects). So the article so far doesn't make a case that the way in which IM is calculated is flawed, just that it needs to be "bigger"
- So the article implies that the risk models at the three major CCPs are flawed, they under estimate the amount of IM required, how does he know this? Because he quotes some people who say the numbers should be bigger:
"But banks already face significant difficulties in keeping their own businesses afloat and do not like the idea that they are on the hook in the event of a CCP default while shareholders reap the rewards when times are good."
- The default waterfall at LCH for SwapClear is shown below, and is public knowledge. Members of SwapClear are already on the hook to support the CCP in the event of a default – and would only agree to this if they felt that the layers of protection prior to direct members being obliged to contribute an additional £50m gave them some comfort.
"Ultimately what began as regulatory push to force transparency in over the counter markets may end up being a more fundamental reform of the clearing house sector itself."
- So far the article doesn't suggest in what way the CCPs are to be reformed – only that in the extreme case of a CCP default, currently there is no back stop by the central bank in the location of the CCP (in the case of LCH the Bank of England)
- The article doesn't suggest what (if any) moves are being made to consider adding a central bank as a back-stop in the US or UK, nor what amount of liability a central bank would carry.
"In an ideal world there would be a single global, not for profit, CCP backed by all central banks," said Orchard (BoE)
- Interestingly most people in the market would agree with this logic, it leads to optimum netting for trades, risk and settlement – but the idea of locating all cleared OTC products on one IT platform with one risk model supported by one central bank, scares people so much it will never happen.
So the gist of the article is:
- CCPs are being (or will be) forced to accept illiquid / risky trades – Not proven
- Collateral assets are becoming scarce – well maybe, but that's a topic which needs thorough discussion on it's own (surely good old capitalism will link the cost of collateral to the value of the trades, and balance out supply and demand)
- CCPs need more collateral – well yes, but that's not news
- CCP members don't want to be "on the hook" for a default – They already are at LCH
- CCPs need fundamental reform – Like what?
My summary: The headline suggests CCPs are to be 'victims' of the crisis – the case hasn't been proven – they are thriving at the moment, they sell safety for the assets they clear – what they can't do is prevent a default of non-cleared business, which so far has been the downfall of Lehman and MF Global.
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