30 January 2015

Tabb Forum: CCPs - Risky is as risky does

Recent white papers by the CME and ISDA bring into sharper focus a debate that has been raging under the surface of the markets: Has the introduction of mandatory clearing for swaps concentrated risk in the CCPs and made them too big to fail? As with any document published by a participant in a debate, we have to remember who wrote these, but they should help clarify this important topic. The crux of the debate is about how much capital is necessary to ensure the safety of the cleared swaps market, and who should put up the bulk of it. Since everyone is now aware of the extent to which increased capital requirements raise the costs of trading, everyone should expect all the market participants to argue that any additional capital should come from any other class but theirs.

There are compelling arguments on both sides. For the CME’s part, after saying that “CCPs are fundamentally risk managers responsible for ensuring the overall safety and soundness of their markets,” it goes on to say, “Ensuring that market participants and clearing firms have the proper skin in the game is one of the most critical roles of a CCP.” This sets the stage for most of the CME’s argument: that recent financial failures were due to the perpetrators not having the same exposure as their customers or the government – i.e., not having skin in the game. The CME argues that the waterfall approach, in which increasing losses tap into ever more general pools of money – from the customer’s IM to the clearing member’s IM, to the clearing member’s part of the default fund, to the default fund in general, to assessments on members – serves not only to spread the risk appropriately but also to discourage risky behavior.

ISDA says: “Effective default management is predicated on the ability of a CCP to transfer the defaulted clearing member’s (CM’s) positions to solvent CMs in order to re-establish a matched book. The primary tool to re-establish a matched book is a voluntary portfolio auction, which is already built into the default management process (DMP) of many leading CCPs. In trying to achieve this objective, a CCP has loss-absorbing resources available that include the defunct CM’s pre-funded default resources (its initial margin (IM) and its contribution to the default fund (DF)), as well as mutualized resources. Such default resources are organized and consumed in the order of a pre-defined default waterfall (DW).”

So it is appropriate now to take a closer look at how swaps clearing actually works, and see if we can determine how risk is created and then managed. The first thing to understand is that in the omnibus model, the clearing member truly stands between the CCP and the customer that is actually creating the risk. Unless the CCP maintains separate accounts for each customer, it performs no KYC, does no credit checking, and assigns no limits to each customer. It knows which positions and margin are proprietary to the clearing member and which are customer positions, but nothing about which customer has which positions. In other words, the CCP is relying totally on the clearing member’s risk management. No wonder they want the members to have lots of skin in the game.

However, there are several other considerations, at least in the minds of market participants. One is that providing clearing services is very much a volume business, in the same way that custody or payment clearing is. Volume businesses always tend toward concentration, since higher volume leads to lower costs. But since clearing is also about risk, this phenomenon automatically tends toward risk concentration. The second consideration is the typical pattern of financial disasters. The risk always starts out as manageable, and the forecast is rosy. Then a few things start to go wrong, and the victim makes a few “temporary” adjustments to rectify the situation. Then those start to go wrong, and even more questionable measures are taken. All the while, everyone in the know makes sure nobody else knows, because making it public will only make it worse. Then, under further deterioration, some blatantly illegal things are done, just before the wave breaks and everyone finds out how bad things are. Except that the public panic makes it significantly worse.

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