One Great Big Risk? To Clear or Not to Clear
By Miles Reucroft, Thomas Murray
Originally published on TABB Forum
There is a prevailing attitude among global regulators that central clearing is the silver bullet to the previous financial woes. But concentrating risk from around the markets in one place could lead to a disaster. Deciding which products should and should not be cleared, and what collateral can be posted against those trades, is key to avoiding a crisis, says OpenGamma’s Mas Nakachi.
This is the second article in a series based on Thomas Murray’s exclusive interview with OpenGamma’s Mas Nakachi. Part 1 can be viewed here.
Mandatory central clearing has been a globally unanimous regulatory response to the financial crises that hit post-2008. Positioning a buyer to every seller and a seller to every buyer at the centre of financial markets is the route to ensuring that all trades are completed efficiently and safely. It encourages competition and new market participants, and places a layer of unanimity into the trading space.
These clearing houses, or CCPs, will also act as risk concentrators. Risk is being taken from around the markets and placed into one location. This in itself creates one great big risk. So is this the right way to go?
“You are taking risk from everywhere and putting it into a few places and ideally watching those places very closely,” says Mas Nakachi, CEO of OpenGamma. “The problem, of course, is if anything goes wrong at any of those ‘few’ places, then we will have to get automatic weapons and gold bars and run into the forest! It would be a very different world very quickly.”
In short, CCPs are ‘too big to fail.’ If one were to fail, then government bailouts would be essential, which is a direction that everyone was keen to move away from. “There is no danger currently, so any failure would be down to unforeseen consequences,” says Nakachi. “It is very difficult to predict, longer term, what will happen. We are concentrating a lot of risk and monitoring it closely, but what happens in a time of market stress is still somewhat unknown.”
It is the unknowns that have left many questioning the wisdom of concentrating so much risk into CCPs. It is, after all, rarely the foreseen consequences that cause financial crises.
The other fear is the handling of certain types of derivatives trades through CCPs. “No one should be pushing bespoke trades through a clearing house,” explains Nakachi. “Clearing houses should only trade highly liquid, highly fungible products that can be unwound in times of market stress. The clearing members or clearing member pool also has to be sufficient to take down the risk when one or two firms default. That is the whole point around not taking in certain types of trades.
“There has been a lot of debate around swaptions, for example. Certain dealers are adamant that clearing them should never happen, whereas other firms say that, if it is done correctly, it should happen right away. The point is that either way, there is a spectrum of financial products at which point you draw the line. Where that line should be varies according to the individual, but there is some line somewhere that needs to be drawn that says, ‘This product is too illiquid.’ It’s clear: Certain products should never go through a clearing house.”
The regulatory appetite for central clearing, however, is large. Whilst no one would ever put it so, there is a prevailing attitude that clearing is the silver bullet to the previous financial woes. Which products to put through clearing is a big issue and, as Nakachi points out, opinion is divided as to what should be excluded from clearing. It is the unwinding of trades that is the central point here. If a trade is too complex to be simply unwound, then losses will continue to mount.
In short, central clearing is the right way to go, but only for the right products. Some products are too complex and too bespoke and, therefore, carry a larger inherent risk that CCPs and their clearing members simply should not be exposed to. Deciding which products should and should not be cleared, and what collateral can be posted against those trades that are to be cleared, is another regulatory challenge and another risk in the space.