Thomas Krantz Takes a Pop at Clearing in the FT | Is He Right?
In the FT Thomas Krantz formerly secretary-general of the World Federation of Exchanges, lists many questions about the wisdom of moving the OTC market into clearing, but poses questions that seem to have obvious answers and misses the mark on why clearing isn't a panacea. Comments on the piece aren't open on the FT website so I felt the need to answer some of his criticisms here and ask readers their reaction to his commentary. Some points to comment on:
- "First, how many risk managers work in them? … expertise is concentrated in few heads relative to the stakes…"
- Thomas seems to think that only one or two people in each CCP have any idea how to measure and manage the risk in an OTC portfolio. In my experience not only is there a considerable number of people in the Risk teams at CCPs, but the methods they adopt are subject to scrutiny by a variety of oversight committees, Risk experts at member banks, and software vendors who replicate and validate the models.
- "notional OTC of $693tn, compared with world GDP estimated by the CIA at $72tn."
- Comparing a measure of world economic activity with a number used to calculate interest payments isn't apples for apples. As ISDA and this website are keen to point out, the OTC market is smaller in total value than other markets, see How Big is OTC Really for more
- "For OTC, there is no organised market. When it clears OTC, a CCP must accept the price from the participants, with less certainty in particular when it comes to testing for potential adverse market movements."
- In my experience the sources of price data for OTC clearing is acquired either from open market sources or from actual executed prices each day. The end of day valuation from a CCP is intended to reflect the mid market and therefore must rely on the market itself to derive the price.
- Testing for adverse market movements comes down to each CCPs implementation of their marrgin model, and in many cases their use of VaR. In the past few months there have been some test cases of CCPs reaction to market stress events, with news headlines announcing their adjustments (or not) to their margin levels. EMIR and Dodd Frank require banks and CCPs to provide transparency on margin models including stress test approaches which bring greater scrutiny of how risk is managed.
- "Clearing “standardised” OTC contracts has netted risk. But standardisation is a distraction from the difficulties of pricing risk, the essential point. If products can be “standardised,” then why are they off-exchange anyway?"
- The OTC market thrived by being traded bilaterally between participants and with significant flexibility to express a price for a risk. Even before Dodd Frank and EMIR nearly 50% of the Interest Rate Swaps market was voluntarily cleared in response to regulatory capital benefits and processing efficiency.
- OTC products which are illiquid will probably never be cleared and become more expensive due to the coming margin requirements for un-cleared business
- "…price information will be scattered across a multitude of platforms."
- The price information for the OTC market has never been gathered in any sense – in the new regulatory world execution will still be at many venues (whether electronic or not), and the means to gather this information is now easier than ever due to the high degree of automation along the processing chain
I may sound like a defender of clearing, and from experience I have to express a sense of confidence in the current implementation of clearing. But, from a macro perspective no-one has access to a model which provides empirical data on the behaviour of the global capital markets to a shock or stress event. For a different critique of clearing read a recent piece by Craig Pirrong who also echoes the same point that market liquidity will be the key.
What's your reaction? Is Thomas hitting the mark? Let me know.