Josh Galper, Managing Principal, Finadium
CCPs bring counterparties together and manage the risk of financial transactions between them. But by becoming an essential infrastructure, CCPs can possibly pose significant systemic risk to the market.
The "heart of the issue", said Josh Galper, managing principal of consultancy firm, Finadium, can be found within the tangled network of bilateral and CCP transactions.
"The CCPs are not a direct cause of concern; CCPs are unlikely to fail because of poor internal risk management. The cause of concern is how much risk is concentrated among large clearing members who could potentially fail," said Galper.
One bank failing could strain, but not incapacitate a single CCP. But banks like JP Morgan, Citi or HSBC could be members of a dozen or more CCPs. In a worst case scenario, a number of major banks could fail and any CCPs in which they are members would have to liquidate positions.
"A collapse of one or more major CCP without an orderly regulation would create very substantial disruption in the financial market and in domestic economies," he said.
WHAT'S THE PROBLEM?
Proposals in both the US Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR) stress the importance of having over-the-counter (OTC) derivative transactions cleared through CCPs, but a number of organisations, and in some cases, CCPs themselves, have raised concerns.
Diana Chan, CEO of EuroCCP, which provides equities clearing services on a pan-European basis, said bilateral transactions can create a web of unknown, opaque risk between financial market participants.
It is essential that transactions, particularly in the OTC derivatives world, can be unwound in an orderly way.
Source: Office of Financial Research
"Some of the OTC contracts are not liquid, they do not have easily available market prices to reference to, so it is very difficult to mark to market, which increases the possibility of an OTC derivative CCP being short of margin because it cannot calculate accurately how much it needs," she said.
The challenge of marking to market - the process by which contracts are reconciled and risk exposures identified among counterparties - is that the price and liquidity of OTC derivatives are not known for being transparent.
"When it is difficult to find a market price, it literally means it is impossible to mark to market," Chan said. "(A CCP) will then have to rely on assumed pricing based on mathematical models which may become invalid as correlations may change quicker than the underlying assumptions can be adjusted."
Diana Chan, Chief Executive, EuroCCP
BUT AREN'T CCPS SUPPOSED TO MAKE US SAFE?
The benefit of CCPs for those involved is that if one party defaults and cannot meet its obligations, the CCP would then close out that party's trades.
Moreover, CCPs reduce risk by bundling trades together throughout the day to only account for the net exposures rather than each individual deal.
Chan said, "EuroCCP provides protection to about €40 billion in market exposure every day. We net down these transactions so it ends with a €10 billion of obligations that needs to be settled."
Without CCPs, €30 billion of market exposure, accounting for between 70% and 75% of the total exposure, could not be netted away.
But even in the case of a default CCPs have safety nets to call on to break the fall, Chan said. Exposure to participants is managed on the basis of the margin that is calculated and collected.
"Equities are traded on organised exchanges and MTFs. If a participant defaults, the margin it has given to the CCP will be used to fill any losses the CCP may incur when it closes out the defaulter's trades at the prevailing market price," she said.
Without sufficient margin, a "CCP could be in great trouble" according to Chan, which is why every member has to contribute to a loss-sharing mechanism - the clearing fund.
Variation margin covers the value of a clearing member's swap portfolio at the time of default. Initial margin should cover costs the CCP may incur from the time of default to the completion of the close-out of defaulting member's portfolio.
Source: Association for Financial Markets in Europe
"If the defaulter's margin and contribution to the clearing fund are not enough to cover the loss, the CCP will use its own skin in the game, which is a part of the capital that it has to put up before it can use the clearing fund contributed by the non-defaulting participants," she said.
In the event that all of the above steps are not enough to cover the losses then most CCPs' rules provide for a top-up of the clearing fund by the non-defaulting members.
Still, if a large major bank fail impacted multiple CCPs at one time there is no avoiding the fact that the ability of providers to call in that credit will be severely affected, starting a chain reaction like the financial crisis of 2008/9.
Finadium's Galper said: "CCPs frequent rely on bank credit lines, and both CCPs and banks can have access to central bank liquidity. A CCP crisis would come back to impact central banks in case of another serious financial crisis."
In other words, the credit risks of the last financial crisis are replaced by CCP liquidity risk because the chain effects and systemic relationships of major players are just as strong and interconnected as before.
"There is no such thing as 'no credit risk'. In the event of a freeze in the equity or derivatives markets, the credit markets would soon follow," said Galper.
Post financial crisis, a great debate ensued, particularly among lawmakers, whether the bail out of failing financial institutions created a moral hazard. If everybody knows the government and central bank will step in to save the day, what is the incentive to reduce risk?
In the cases of CCPs, it might be a bit more complicated since risk management is the traditional function.
"For the most part, I do not think that moral hazard poses a risk in CCPs. I think that the risk is that a major market participant would fail and that would impact more than one CCP at the same time. On individual cases, I do not believe CCPs are overly risky," he said.
However, individual CCPs cannot account for what happens outside of their own risk management activities. An implicit government backstop for systemically important CCPs could suggest to individual traders that "a CCP would bail them out."
"Moral hazard could potentially come into play here but this is not the norm," Galper said.
EuroCCP's Chan defended the role of CCPs as risk managers.
"There are vigorous regulations to regulate us. I think too big to fail has to be seen in the context of what we do to reduce risk in the first place. What we are centrally managing is the residual risk after netting, which is much smaller than when the market had no CCPs."
But that still leaves an elephant in the room. In the case of a crisis, a state bailout would once again make taxpayers the ultimate guarantors.
The rising prominence and importance of CCPs means that they are part of the fabric of derivatives trades. The upsides of their benefits since the financial crisis in comparison to OTC and other less regulated trading has also meant CCPs have become indispensable.
Craig Pirrong, Professor, University of Houston
Craig Pirrong, professor at University of Houston, doesn't mince words.
"CCPs are certainly too big to fail and are too connected to fail," he said. "But what also scares me is that all the methods that are intended to protect CCPs from failure can have spill over effects to devastating effect in the financial markets."
Every financial crisis, Pirrong said, is associated with substantial breakdown in the mechanism of liquidity supply. Meanwhile, a tightly coupled clearing system that relies on day-to-day margining is creating a new source of liquidity.
Pirrong explained that there are two ways to reduce credit risk in derivatives transactions, which is the stated reason for the regulatory push for clearing houses. One is to collateralise derivatives transactions and draw initial margin, another is through daily variation margin or intraday variation margin.
But if that's not sufficient, then there should be an end-of-waterfall loss sharing mechanism, he added, where the loss associated with the default of a CCP is spread among the members.
How it all plays out remains to be seen. But one thing does seem quite clear: the world's risk management community is intent on making sure that the chaos of unwinding Lehman doesn't happen again.
Gross v Net
Netting is one of the major points of contention between US and European regulators seeking equivalence in clearing.
Gross posting is the US preference, meaning the clearing member must post for each customer. The result is that US clearinghouses receive more, sometimes much more, collateral than under net posting.
In an analysis, the CFTC calculated the margin requirements under both sets of rules for a defined set of accounts. In the US, that figure came out to some $58 billion. In Europe, it was more like $23 billion.