Unseen Danger: What Might Go Wrong for CCPs?

By Thomas Krantz, Thomas Murray

Originally published on TABB Forum 

In response to the events of 2007-2008, G20 leaders determined at their 2009 Pittsburgh Summit that one of the solutions to the over-the-counter (OTC) contract problem was to make these instruments more transparent to the marketplace by having the “standardised” variants centrally cleared. This would add some certainty in terms of counterparty risk for settlement of the contracts, and generate better information as to their value and quantity.

Or so it was thought.

That policy response was followed by legislation and regulation at the global and national levels. This, in turn, has led to a reconfiguration of clearing houses, once a small, quietly effective corner of market infrastructure. Their capital bases have been considerably deepened, and far more attention has been paid to their risk management models. The introduction of OTC contracts into the mix changes the work considerably.

We will not comment on the appropriate and effective use of regulated clearing houses to rein in the unregulated OTC environment – with implementation of this policy, that is a moot point. Five years after the Pittsburgh Communique, Thomas Murray believes that clearing house managers are now acutely attuned to the changing environment, and have had some years to plan for it. They have been made subject to complex Basel III capital requirements, in order to post a ‘Q’ qualifying status, and so reduce the capital costs to their members. They have had to begin writing detailed self-assessments that describe how they comply with the CPMI-IOSCO Principles of Financial Markets Infrastructures (‘PFMIs’). In another year or so, they will become subject to quantitative disclosure requirements specifically written for clearing houses by CPMI-IOSCO under these same PFMIs. They have not been lacking for attention in what has been an upheaval in their institutional lives.

We will instead turn to other actors in this story.

We sense a change in tone and focus in the discourse amongst clearing houses and their clearing bank members, which contribute capital to the guarantee funds, and so have a stake in the successful handling of business after trading. Until just a few years ago, with asset-by-asset, contract-by-contract novation, clearing was a more straightforward process. Failure rates were extraordinarily low over long periods of time, certainly low enough to engender market confidence, so much so that trades were more or less just handed off to a CCP without much more thought. Clearing was in the background. Today, it has moved to the foreground.

What we find nowadays is a realisation that handing-off is not so simple. After all, this is an environment where risk is mutualised amongst the CCP and all its members. They are at the same table; everybody has money at stake. With more kinds of products being traded and cleared, scarce collateral, and sometimes tight liquidity moments, we see clearing banks eyeing one another to see what they are introducing into the common pool – do the neighbors master clients’ trades, and the value of them? Are they all good at managing in this more complex environment? Each may think it has a firm grasp of what it is introducing to the CCP, but does everybody else?

There is reason to pause here; when we read the IOSCO public consultation of September 2014 that would set basic standards for administration of uncleared OTC contracts [“Risk Mitigation Standards for Non-Centrally Cleared OTC Contracts,” a public consultation by IOSCO, September 2014], we see that sloppy administrative practices are still common. Assuming that the “standardised parts of OTC” are now well administered, given the unknowns about the pure bespoke, there remains a considerable risk information void. Some closely related positions between the same counterparties may be centrally cleared, others not. How does this affect monitoring of position limits? How effective can counterparty position limits be if some – perhaps considerable – contracts are entered into out of sight? A mass of instruments of unknown value and complexity with these same counterparties is hovering in the void just on the other side of the regulatory perimeter. Data on OTC arriving in trade repositories in diverse forms remains unhelpful if the objective were to get a holistic picture of the marketplace.

Let us return to the question of events and what might go wrong for CCPs: Have we been looking in the right direction? If we recall the Great East Japan earthquake of March 2011, the building engineers truly had solidified structures, enabling them to withstand tremendous shaking. And although much planning had been put into anticipating and mitigating the effects of the ancient Japanese nightmare of tsunamis, it was this collateral damage that proved to be the horror. In parallel, in the April 1906 San Francisco earthquake, there was considerable building damage, but far fewer victims and less destruction than in the subsequent fires that raged. Again, the collateral damage proved worse than the violence of the initial event.

In the post-2009 financial environment, the equivalent of the building engineers has been solidifying the construction of CCPs. New foundations have been laid, and what we might term the “building norms” have been rewritten. The CCPs have been subjected to intense scrutiny: So from where else might the damage come?

One concern would be with the members of the clearing house, the other parties in the mutual environment. It is in their interest for everyone to behave well, for the instruments being passed onto the CCP’s books to be managed till settlement. But it is also in their interest to please their clients, who are under pressure to get OTC derivatives centrally cleared. By inadvertence or otherwise, what might get passed into the pool? Many banks have been publicly advising CCPs that they must do this or that, but what about them? Are they protesting too much?

Another would be an event of some kind that disrupts “normal” trading, be it technical or political or indeed even geological. With so much about the financial markets amounting to leveraged opacity, a rush to the exits in these times of thinner liquidity would be highly disruptive to establishing valuations. This is the core mission of a CCP, and the danger always lurking is securities related to margin being dumped in a fire sale, depreciating suddenly the value of what has been on hand to cover risk.

The CCPs and their regulators are aware of the matter. Clearers have been obliged to simulate the effect of one or two of their largest members defaulting on their obligations. They are now being asked to provide for recovery plans, and the battle is engaged over who will have to put up what proportion of capital for this – the CCP alone, or the group [“Recovery of financial market infrastructures, final report issued by CPMI-IOSCO,” Oct. 15, 2014]?

Before – and especially during – an “event,” clear corporate communications are essential for restoring confidence. It is good that more about central clearing is known and in the public domain. What remains unknowable is the interaction between derivatives from both sides of the regulatory perimeter and their compound effects on counterparties – communication on that point during a crisis will have to be artful.

There is the beginning of an intriguing debate being played out within the clearing community, which will come to have its effect: portfolio risk valuations, and whether the number should be a total figure equal to margin held [this is the most commonly used methodology to arrive at a total number for VaR (Value at Risk)], or something more dynamic that would enable the clearing house risk manager with some confidence not to race to the exit by closing out positions as if in a fire-sale.

Several risk managers working together at BVMF, the Brazilian exchange group, have published a new framework that they believe would give such confidence to risk managers [“Managing risk in multi-asset class, multimarket central counterparties: The CORE approach.” L.A.B.G. Vicente, F.V. Cerezetti, S.R. De Faria, T. Iwashita , O.R. Pereira. Journal of Banking and Finance, available online as of Sept. 6, 2014], and enable them to slow down the close-out periods for positions held. The value of this framework is two-fold: greater confidence in the management of positions to start with, and also the promise of attenuating the pro-cyclical problem of forced sales of positions across asset classes at once at the worst possible trading moments. One can envisage serious debates amongst risk managers, their clients and public overseers, as to the merits of these very different approaches.

All this results from concentrating risk in CCPs: In their majority, clearers did not ask to take on OTC; it was thrust upon them. Underlying it all, what is at stake is nothing less than the great game of who takes the profits from market position risk, who has to put up capital to attenuate that risk in a clearing house, and finally also who might have to cover the losses of others in the mutual structure.