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Six years after the financial crisis exposed the systemic dangers of derivatives, the industry faces questions as to whether risk management systems will contain the next major bout of market turmoil.
On May 5 FIA Global, the futures industry trade association, will add its voice to a growing debate about the role of clearing houses, the centralised risk managers charged with bolstering market stability.
Uneasiness pervades this fundamental market shift, with some worried that global regulations have not created a resilient framework that could function in the event of a major financial institution failing. While the risk associated with derivative trades is being collected in one place, via clearing houses, the potential for systemic pressure, however remains in place. The Bank of England has expressed concerns that clearing houses are being asked to take on risk management for market liquidity, when they were built for managing counterparty credit risk.
The Bank of England, for one, has expressed concerns that clearing houses are being asked to take on risk management for market liquidity, when they were built for managing counterparty credit risk.
“It’s largely the reshuffling of risk — it’s not gone away,” says Craig Pirrong, an academic at the University of Houston in the US. “Regulators have not taken a truly systemic approach to analysing risk.”
Market participants say that clearing houses’ differing and opaque risk models mean risks cannot be consistently compared. Chief among them is that clearing houses’ risk models are “procyclical” — meaning they require more margin for derivatives portfolios during times of market stress, which is also the most difficult time for traders to find more stable liquid assets. To insulate themselves against the next financial meltdown, two issues persistently dominate industry debate — greater financial participation by clearing houses and more transparency in their risk management models.
“Clearing house skin in the game is generally a negligible percentage of the overall default fund,” says Mariam Rafi, US head of OTC clearing at Citi. “However clearing houses are for-profit entities. They decide the risk model, they determine what new products are going into the clearing houses. It brings up the question of misalignment of incentives.”
Regulators are beginning to address concerns. Next year the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions will require clearing houses to publish their models for calculating their users’ risk, in the hope it will assuage customers’ worries.
Full article on Financial Times (subscription required)