Sometimes the solution to a problem-such as the current dangers inherent in the over-the-counter derivative trade-is as bad as, or worse than, the problem.
The use of the clearinghouse, or central clearing counterparty (CCP) has been anointed by lawmakers as the way to prevent a repeat of the disasters that sprung from OTC derivatives trading in 2008. This market is huge-a few years ago, it was pegged at around $600 trillion in notional value, according to the Bank for International Settlements. But now some regulators and market observers want to examine the supposed solution, the clearinghouse/CCP. And these are institutions, like dealers, that haven’t always been 100 percent foolproof-in one instance, one Hong Kong clearinghouse went under during the 1987 crash.
So what is the case for the reform of the OTC derivative trade going through the exchange instead of on a bilateral, dealer-to-dealer basis?
"Clearinghouses are designed to mitigate risk. Day to day, they plan for the worst-case scenario and how it can be managed, all within a highly regulated structure," said Chris Jones, executive director and head of risk management for LCH.Clearnet.
Jones adds that clearinghouses are better equipped to handle market shocks than dealers.
His proof? LCH.Clearnet lived through the disasters of 2008.
"We were the first clearinghouse to manage an OTC default when we managed Lehman Brothers’ $9 trillion interest rate swap portfolio," Jones said.
Factors
Several factors, he said, allow the clearinghouse to weather the worst storms of the market. Among these are the pooled risk feature of the clearinghouse and the open nature of clearing OTC derivative trades through public exchanges.
Left unsaid by Jones: The clearinghouse model is much safer and more transparent than the opaque quality of privately transacting these trades. It is less dangerous than the dealer-to-dealer model. Indeed, this was the language used by lawmakers in the Dodd-Frank Act of 2010.
See Sidebar: See How They Clear
"Clearing more derivatives through well-regulated central counterparties will benefit the public by reducing costs and risks to the American taxpayers, the financial system and market," Dodd-Frank reads. The huge financial reform law, which numbers around a thousand pages and is in the process of being interpreted by various regulators, also calls for "a fair and open access to clearing."
In the wake of the market disasters, the clearinghouse and the CCP became "the in-vogue solution because there was a rush to a mediation infrastructure system so politicians could say, ‘We’re not asleep at the wheel. We’re going to do something about the problem,’" said an official at a clearinghouse who didn’t want to be quoted by name.
The official, who provides risk management analysis for an exchange, said there was little consideration of the problems of the clearinghouse/CCP. Most clearinghouse officials, unsure at this point of how the Dodd-Frank Act will be translated into rules, declined to comment on how their institutions will become more important in the use of OTC derivative contracts and which models will be used.
Yet it is indisputable that the widespread use of the clearinghouse is the reform that is designed to prevent a repeat of the problems of the 2008 market meltdown. At that time, the use of OTC derivatives-often bypassing clearinghouses and trading on a dealer-to-dealer basis-confused many market participants. Market participants weren’t sure how to price many of these complex contracts due to the lack of price discovery in a central market. The market became locked in confusion.
European regulators are also now armed with similar laws favoring the CCP and the clearinghouse. And clearinghouses and CCPs are hungry for the expected business that the lawmakers and now the regulators are pushing their way, a swaps business that registers in the trillions of dollars. They have been tinkering with their exchange models to accommodate the new era of OTC derivative trading and clearing.
In the exchange model trading arrangement, "firms trade, but face the exchange as well. The exchange also guarantees the performance of every open contract traded in the exchange," according to the Aite Group paper "Credit Default Swaps: Counterparty Risk and Industry Initiatives" (see illustration). However, in the same sentence, the paper further notes that the exchange model "also concentrates participants’ exposure to a single entity."
Here is the nub of the debate over whether the reform is better or worse than the problem: What if the reform also has its own problem? What if a clearinghouse or a CCP fails?
Prevent a Meltdown
That’s what some in the clearing industry are wondering as regulators and lawmakers over the last few years have relentlessly pushed clearing houses and CCPs as the safe way of trading OTC derivatives. They have also implied that these public institutions, if more widely used, would prevent another 2008 market meltdown.
But it’s time to consider if the solution is better or worse than the problem. The clearinghouse record, say some observers of the recent MF Global problems, is not without its own failures.
And what happens if the clearinghouse itself is contaminated by the problems of a financial troubled customer or a member? Can’t they, the same as brokerages such as MF Global and Lehman Brothers, also fail?
They can and they have.
A CCP or a clearinghouse can fail, regulators and market observers say. Still, they hope that the new rules will make that unlikely. An industry analyst notes that one principle of Dodd-Frank is that the clearinghouse, standing in the middle of a transaction, will ensure that both parties to a trade will be paid. In theory, this would reduce the risk that the difficulties of how one party failing will affect the other.
But this, notes one clearing industry observer, could actually be more dangerous than two parties conducting a trade privately through their brokerages.
"Clearinghouse and CCPs can and do centralize risk," said John Jay, a clearing industry analyst with Aite Group. "I would say that the inherent risk with the infrastructure is that if the CCP goes under, then everybody suffers."
Jay uses the terms clearinghouse and CCP interchangeably. However, there is a bit of a difference.
Generally, CCPs limit themselves to one kind of swap, such as a credit default or an interest rate swap. That’s unlikely for an exchange or clearinghouse, where a variety of activities take place, including the trading of OTC derivatives. These are contracts that were recently generating hundreds of trillions of dollars a year in activity.
An OTC derivative transaction conducted dealer-to-dealer, without going through a clearinghouse or CCP, might in some cases be less risky, Jay argues. Then, if a trade fails, only the failing counterparty that will be hurt instead of all the members or users of a clearinghouse, he notes.
"That’s the irony of this reform," Jay said. Nevertheless, he still expects that most clearinghouses, if properly structured to withstand market storms, should be able to avoid failure. That’s provided the clearinghouse sticks to popular swaps. By that he means OTC derivative contracts that have big volumes and are easy to clear, and that the clearinghouse stays away from the exotic OTC derivatives with low volumes.
The Good and The Bad
Which ones are good for clearinghouses and which ones aren’t? That is an issue the regulators are still trying to figure out, even though Dodd-Frank was signed into law a year and a half ago.
For instance, as CQ&D was going to press, most of the biggest swaps dealers were lobbying regulators to exempt their overseas swaps from Dodd-Frank regulations. The exemptions were requested in filings with the Federal Reserve Board. Again, the issue is what happens if transactions are no longer conducted privately, but recorded in a public exchange go bad?
Jay asserts that, "if a CCP goes under, everyone who is a member of the CCP is in trouble, because by definition the CCP is the hub and then by definition all the spokes will be in trouble."
How should a strong clearinghouse of CCP be modeled to withstand the worst? What’s a good clearinghouse? And what’s a bad one, one that could ultimately make it into the annals of our woes of clearinghouse history?
See Sidebar: The Woes of Clearinghouses and CCPs
Jay says the most important factors are that the CCP/clearinghouse is well capitalized and that it has rigid requirements for members. This means, he adds, that in an attempt to attract business, the clearinghouse doesn’t cheapen requirements for conducting business. That means a clearinghouse/CCP should not be a stand-alone institution. It should be one backed by a rich parent that will survive bad times, Jay said.
"How much can credit back up a CCP?" Jay asked. "How much can it handle if everything blows up?" It also means that the clearinghouse/CCP should have stringent risk models that will determine the margin levels for members.
A Puzzle
The dilemma, of course, is that the clearinghouse still has to attract sufficient members to be profitable. Set margin requirements too high, and the clearinghouse could turn away business that would allow it to remain competitive. Set margin requirements too low, and the clearinghouse risks becoming another casualty in the infamous history of financial institutions that have not been able to survive market shocks.
So clearinghouses, the supposed savior of the marketplace, can and have had their own problems. That’s what a prominent market participant said recently.
"What happens if they go bust?" asked Paul Tucker, a deputy governor of the Bank of England. He recently addressed European regulators. In his speech, Tucker pointed to several clearinghouse failures in the 1970s and ’80s. He suggests that they happened so long ago that, for some, they have become ancient history.
Therefore, they have been forgotten by some of the current advocates of CCPs and clearinghouses. In the meantime, given that a clearinghouse or a CCP could fail, how does one evaluate a clearinghouse?
LCH.Clearnet’s Jones argues that clearinghouse officials need to make the case that they have "prudent risk management and adequate membership criteria and thorough back testing."
And although Jones contends the clearinghouse is an effective way of reducing risk, he still makes the case for LCH.Clearnet by saying it was "the first clearinghouse to manage an OTC default."
And a clearinghouse/CCP default is something the Bank of England’s Tucker says the market should be preparing for now.
Tucker warns that, if a big clearinghouse fails, it would be worst than the failure of a big bank or brokerage. "I can tell you the simple answer: mayhem," Tucker said.
Clearinghouse failure has happened before, he adds, so why couldn’t it happen again?
Tucker counsels regulators to start preparing for the worst. Now, he adds, "there needs to be a resolution regime" for CCPs and clearinghouses.
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