Collateral Crisis? The Risks in CCPs and Central Clearing

By Miles Reucroft, Thomas Murray

Originally published on TABB Forum 

With mandatory central clearing being worked through in Europe, there are, at the time of writing, 13 approved CCPs (central counterparty clearing houses) approved under the European Market Infrastructure Regulation (EMIR). The move to mandatory clearing, while aimed at reducing systemic risk in the markets, will, of course, bring with it a whole host of additional risks.

Risk in CCPs is something that all market participants will need to be very aware of. As competitive entities, each CCP operates differently from the next, so it is crucial for market participants to carefully select, and subsequently monitor, each CCP with which they are involved.

Further down the line, with other European directives such as UCITS V, depositary banks will need to monitor these financial market infrastructures closely, too. The financial world is changing rapidly, and with the change has come a shift in the way risk presents itself.

“One thing that is fashionable to talk about, but I do not think is talked about in the right way, is liquidity risk,” explains Mas Nakachi, CEO of OpenGamma. “Liquidity risk and credit risk are at opposite ends of the spectrum. If you work to reduce credit risk, you actually increase liquidity risk and vice versa. The focus on daily margining is a good thing from a credit risk perspective, but what people do not concentrate on is the impact to liquidity risk of doing that. It is the equivalent of having to pay your credit card bill every hour, rather than at the end of every month. That is the sort of impact we are looking at. What if you could also only pay your credit card bill in £20 notes? That is the sort of constraint you are talking about when only certain types of collateral are eligible.

“You have to measure and monitor calculations a lot more closely on a daily basis,” he continues. “Precision has to be a lot higher than it used to be, as being out by 1% could mean the difference between you being able to pay your credit card bill or not. The risk across credit risk and liquidity risk is under-reported, and people do not seem to realize that the two are related.”

Margin calculations and margin efficiency are areas that OpenGamma is helping its clients with. As such, the conversation turns to the impact of margin requirements at CCPs and the potential for there to be a collateral crunch with the arrival of mandatory central clearing. “I do not see this (a potential collateral crunch) as being the CCPs’ fault; rather, the regulators trying to force everything in one direction,” Nakachi says.

“The CCPs themselves are actually trying to mitigate this, for better or for worse, by expanding the pool of eligible collateral to include securities such as corporate debt. From a liquidity perspective this is good; but again, it impacts the credit side of the equation, as you are expanding into more risky areas that need to have appropriate haircuts applied. You also need to be careful that you do not end up in a situation of market crisis and find that there is not a market for this collateral.”

Liquid, high-quality collateral is a must for CCPs. In the event that a clearing member goes into default, the CCP will need to liquidate their margin quickly and efficiently to make good on its central role as a buyer to every seller and a seller to every buyer.

CCPs, however, are competitive entities. One way of attracting business, obviously, is to accept a wider range of collateral than your competitors, thus opening up your business. “There has been a lot said about the race to the bottom,” says Nakachi of the potential for CCPs to do just this. “It is something that we are currently conducting our own analysis into. What is the reality? There are a number of interesting angles to this, not least discovering what, really, is the cheapest option available to people to margin their trades.

“It’s not up to the clients what they can use in an eligible range of collateral; it is up to the CCPs and their CSA legal agreements that they have with bilateral counterparties. These quantify exactly what can be delivered in certain situations. Within that universe of what can and cannot be delivered is where the optimization occurs. For the smart guys, there is optionality and they can play that. With things like standardization and CSAs, they are trying to narrow that optionality window down so there is no longer any choice and it is what it is.”

The competitive element of CCPs, too, is a risk in itself. “It is one of those very strange questions,” suggests Nakachi. “Some people would say that there are too many CCPs and that, even though it sounds counterintuitive, you would be better off with one CCP where you can net everything. For the dealers, there is a netting piece and there is a governance piece. As there are a lot of CCPs, these challenges add up. Theoretically, the ideal would be to have one or two CCPs globally and that would be it. That, of course, is never going to be the case. Some people view that as a failing of the CCP model.”

To add to the competitive element at CCPs, there is also something of a competition taking place amongst the global regulators responsible for implementing the clearing mandate in response to the 2009 G20 Summit in Pittsburgh where this idea was conceived. “There is no global regulatory harmonization,” asserts Nakachi. “Asia is always going to be different, as is Latin America and Europe. There are all these fractures in the regulatory space where risk can creep in.

“We are introducing all kinds of new risk. This is not necessarily bad, but we need to be aware, from an industry perspective, of the risks in CCPs. For the next few years at least, we are going to be wading through these regulatory changes with a lot of unforeseen consequences.”

The only question that remains is: What next for the CCP space? “There is so much change and so many regulatory pieces that it is very difficult to tell,” says Nakachi. “Finance always has a way, every few years, of blowing itself up. We hope this does not happen with CCPs. Certainly the trading environment will be very different. Some firms will stick to their traditional models while others will get out of the trading space and offer agency services to their clients. Those two camps will be successful and then there will be those in the middle who are neither large nor electronic. They will struggle.”

This has been over recent years, and continues to be, a rapidly changing environment. As such, the risks in CCPs have changed and evolved, too. Be it competition, regulation, margin or liquidity, market participants need to pay very close attention to the CCPs that they use, as well as their own margin calculations.