Financial reform: Conduits of contention
By Jeremy Grant
Published: June 15 2011 22:02
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To this day it remains a footnote in the story of Black Monday, as the September crash became known. But the lessons of the Hong Kong events are reverberating anew around financial capitals as Greece teeters towards possible default, stock markets pull back on worries about slowing global growth and regulators struggle to implement reforms aimed at clearing up after the latest crisis of 2008.
In Hong Kong 24 years ago, authorities and local banks were forced to bail out the territory’s clearing house after it became clear that it would not have the resources to deal with possible mass defaults among traders on the futures exchange as their bets on the Hang Seng index turned sour. It was a rare example of the near-failure of a clearing house.
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Although they have existed in close to their present form since the coffee and cotton markets of the French port of Le Havre in the late 19th century, clearing houses have rarely made news. That is because they handle the arcane “plumbing” that takes place after trades are agreed, such as a share deal between two parties on the New York Stock Exchange, a futures contract changing hands in Chicago’s dealing rooms or when a Spanish government bond is traded in London.
Although they have existed in close to their present form since the coffee and cotton markets of the French port of Le Havre in the late 19th century, clearing houses have rarely made news. That is because they handle the arcane “plumbing” that takes place after trades are agreed, such as a share deal between two parties on the New York Stock Exchange, a futures contract changing hands in Chicago’s dealing rooms or when a Spanish government bond is traded in London.
But they have shot to prominence amid reforms initiated by the Group of 20 leading industrialised and developing countries in the wake of the defaults of AIG, the big American insurer, and Lehman Brothers, the Wall Street investment bank. This overhaul, enshrined in the Dodd-Frank act in the US and similar European proposals, will among other things force over-the-counter derivatives – which were central to the AIG debacle – on to exchanges and through clearing houses to make such markets safer and more transparent.
Craig Pirrong, professor of finance at Bauer College of Business at the University of Houston, says the changes “will represent a seismic shift in the financial markets”.
That shift is set to concentrate new risks in the clearing houses, since it will create systemically important institutions that could become “single points of failure”.
That raises the uncomfortable possibility of another taxpayer bail-out – the very outcome that the post-crisis clean-up is aimed at avoiding.
Regulators have long been aware of the systemic importance of clearing houses, brought into sharp focus not only in 1987 but also when rogue trades by the Singapore-based Nick Leeson triggered the collapse of the UK’s Barings bank in 1995. Yet clearing houses withstood the impact of the 2001 terror attacks on the US and, arguably their biggest test so far, the 2008 crisis. In the weeks that followed the Lehman collapse, LCH.Clearnet in London and The Depository Trust & Clearing Corporation in New York managed the orderly unwinding of the bank’s vast portfolio of trades, with barely a further ripple in the markets.
But the spectre of Hong Kong is back. Regulators are anxious to ensure that clearing houses, also known as central counterparties (CCPs), are robust enough to withstand the default of one or two big members, without triggering a domino effect that could bring down not only the CCP itself but the rest of the financial system as well.
Ben Bernanke, chairman of the Federal Reserve, said in April: “Clearing houses around the world generally performed well in the highly stressed financial environment of the recent crisis. However, we should not take for granted that we will be as lucky in the future.” Standard & Poor’s, the credit rating agency, warned this week: “We believe the financial and business risk profiles of exchanges and clearing houses are increasing.”
A CCP acts as buyer to every seller and seller to every buyer in a transaction. It uses funds posted by its members – known as margin, or collateral – to ensure deals are completed in the event of default. It helps reduce risk in the financial system by simplifying a web of multiple exposures through a process known as “netting”.
The heightened concern stems from the very reforms that sprang out of the 2008 crisis and the size of the OTC derivatives markets they address. The notional value of OTC derivatives trades outstanding is about $600,000bn, according to the Basel-based Bank for International Settlements – seven times larger than exchange-traded futures markets. Of that, estimates of how much will shift on to CCPs vary from 60-80 per cent, depending on the extent to which contracts are deemed “standardised” and thus eligible for clearing.
“These regulatory steps seem unlikely to adequately reduce systemic risk from OTC derivatives and the likelihood of future taxpayer bail-outs appears to remain significant,” says Manmohan Singh, senior economist at the International Monetary Fund.
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Work is under way among global standard-setters to try to ensure that functions such as risk management policies and those that set levels of margin are robust to tackle new risks, and as far as possible standardised across CCPs globally.
But a host of uncertainties over how CCPs will function in this new era mean there is scant confidence that problems will be avoided. Complicating matters, the clearers are under competitive pressure to be first to market. LCH.Clearnet in February launched clearing in the US of interest rate swaps – the single biggest OTC derivatives market by value traded – in competition with CME of Chicago. Singapore’s exchange has already started clearing Singapore dollar swaps, highlighting how some Asian financial centres are muscling in on the new opportunities.
The proliferation of initiatives has led to concern that there could be too many CCPs. Some of the biggest banks warn against having numerous pools of liquidity, which make it hard for watchdogs to see what is going on across multiple venues and time zones. Urs Rohner, vice-chairman of Credit Suisse, says: “A fragmented approach will lead to weaker institutions and greater risk.”
Bankers say the weakness in such a system would be exposed since one CCP may not necessarily know what financial commitments one of its members may have to multiple others. Athanassios Diplas, head of systemic risk management at Deutsche Bank, asks: “In a world of multiple CCPs, how many contingent clearing liabilities would you have that the CCP wouldn’t know about?”
Equally problematic is ownership and governance, specifically whether ensuring that robust risk management is best served by clearing that is organised as a for-profit business, or as a quasi-utility owned by market participants. A wave of demutualisation among exchanges has transformed many CCPs from dull utilities into businesses integrated into exchanges that are run to maximise shareholder value.
Regulators are anxious that CCPs act as “system risk managers”, as Paul Tucker, deputy governor at the Bank of England in charge of financial stability, puts it. But he adds: “I am not convinced that is sufficiently recognised by clearing houses or standard-setters.”
Indeed, the recent trend has been towards ownership of CCPs as part of a for-profit exchange group, organised in a “vertical silo” with trading and post-trade integrated in one business that is managed to maximise profits. Concerns have surfaced that for-profit operators could be tempted to relax standards – such as on margin levels required of members – in order to attract business. The Bank of England has struck an uncompromising note, saying user-owned CCPs “provide strong incentives for effective risk management”, while those incentives “are weaker among CCPs operating on a for-profit basis”.
Others worry about a concentration of market power at the biggest CCPs. Gary Gensler, chairman of the Commodity Futures Trading Commission, the US regulator that is writing detailed rules on the implementation of Dodd-Frank, insists that membership should be open beyond the handful of big dealer banks that have long controlled OTC derivatives markets – what he has called “exclusive clubs”.
Critics say that while it may be reasonable to “democratise” membership in this way, larger dealer members may find themselves guaranteeing smaller, poorly capitalised ones. Worse, the CCP may have members that have no experience in handling the market auctions that are typically used to wind down portfolios involved in a default like Lehman’s – or where risky products such as credit default swaps are involved.
In a sign that global regulators are still divided on the issue, the UK’s Financial Services Authority wrote to the CFTC in March urging it not to impose its proposed CCP membership rules for derivatives “with complex or unique characteristics” as this “could lead to increased risk in the system”.
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Regulators and central banks have made some strides in addressing these issues. In March the BIS’s Committee on Payment and Settlement Systems and International Organisation of Securities Commissions, which includes national regulators, recommended “new and more demanding standards” for clearing systems, including extra financial resources.
For their part, CCPs argue that decades of experience mean they are well placed to handle some of the new risks associated with clearing an array of OTC derivatives. Chris Jones, the head of risk management at LCH.Clearnet, says: “OTC risk is different. If this is recognised and addressed through appropriate risk management, increased clearing – whilst no panacea – will mitigate systemic risk.”
Yet there is still one unanswered question: if a CCP were to get into difficulties, would the taxpayer be on the hook once again to save the financial system? Peter Norman, author of a new book on clearing, says this puts markets and regulators on the horns of a dilemma. Should CCPs that are “pursuing a public policy goal, while expecting to profit from it” expect to be bailed out by the state, or should their owners “take the financial hit in the new regulatory environment designed to ensure taxpayers are never again liable for a company that otherwise would be too interconnected or too big to fail”?
Most central banks have been coy on the subject, not wishing to make public statements for fear of creating unrealistic expectations. The Bank of England’s Mr Tucker went furthest this month by saying that any CCP recapitalisation “should not come from the public sector”.
Ultimately, central bankers are relying on CCPs to maintain the highest possible risk management standards to help avoid the need for bail-outs. But, as Mr Bernanke said, vigilance remains vital: “As Mark Twain’s character Pudd’nhead Wilson once opined, if you put all your eggs in one basket, you better watch that basket.”
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Substantial sums still to be backed
.The amount of money tied up in clearing houses can be breathtaking. The Depository Trust & Clearing Corporation, which clears all equities trades on exchanges in the US, settled $1.48 quadrillion (million billion) in securities transactions last year, meaning it turned over the equivalent of US annual gross domestic product every three days.
On a more modest scale, the value of trades handled by members of the London-based LCH.Clearnet as logged on its 2010 books amounted to €480bn, still equivalent to a year’s worth of economic output by Switzerland. The amount of collateral tied up at the clearing house run by CME Group, which also operates the Chicago Mercantile Exchange, was $100bn as of March.
In addition to charging fees, clearing houses make money by investing their funds in interest-bearing financial instruments such as overnight money markets.
For some economists, the sums passing through clearing houses will swell considerably because over-the-counter derivatives markets are currently undercollateralised. A March report for the International Monetary Fund estimated that the overall OTC derivatives market was short of $2,000bn in collateral. Assuming about two-thirds of the OTC market moves to being cleared, clearing houses would require about $1,400bn in extra margin cover.
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Copyright The Financial Times Limited 2011
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