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Managing CCP Risk Globally

George Bollenbacher

Turtle Bay Advisory Services

The US View

 Recent white papers by the CME (Clearing – Balancing CCP and Member Contributions with Exposures) and ISDA ( CCP Default Management, Recovery and Continuity: A Proposed Recovery Framework) bring into sharper focus a global debate that has been raging under the surface of the markets, about whether the introduction of mandatory clearing for swaps has 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 might help to clarify our thinking on this important topic.

Once we require swaps to be cleared, the crux of the debate becomes how to ensure the safety of the cleared swaps market, and who bears that responsibility. Capital is one way to promote safety, and 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. And that just about sums up the capital debate.

There are, of course, 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,” they go 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, where 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. They conclude that, “The discussion of skin in the game should focus largely on the amount of skin in the game that each clearing member must contribute to the waterfall, including IM, concentration margin, default fund, and assessments. A clearing member’s skin in the game should scale with the exposures they bring to the CCP.”

ISDA, on the other hand, says that “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).” One of its footnotes postulates that, “Any calls to CMs should be pre-defined, limited, reasonable and quantifiable. Without certainty regarding exposures, clearing as a business becomes problematic because CMs would be deprived of the ability to quantify their risk exposures. Also, multiple assessment calls on non-defaulting CMs at a time of stress could become a significant source of pro-cyclicality with systemic consequences that could threaten the viability of remaining CMs.”

So, while the CME is focused on building a capital cushion, ISDA is focused on the auction process for moving the customer positions from a defaulting CM to a solvent one, with neither providing much focus on default prevention. So maybe these two documents won’t help to clarify our thinking.

The European View

A recent report by the European Commission on the use of CCPs by pension funds brings another aspect of risk management to light.

First the report points out that, “Under EMIR, OTC derivatives that are standardised (i.e. that have met predefined eligibility criteria), including a high level of liquidity, will be subject to a mandatory central clearing obligation and must be cleared through central counterparties (CCPs).” Then it says that, “Pension Scheme Arrangements (PSAs) in many Member States are active participants in the OTC derivatives markets. However, PSAs generally minimise their cash positions, instead holding higher yielding investments such as securities in order to ensure strong returns for their beneficiaries - retirees. The inability of CCPs to accept non-cash assets as collateral to meet [variation margin] VM calls means PSAs would need to generate cash on a short term basis either by borrowing cash or selling other assets in order to meet the CCP margin calls.

After observing that PSAs can post non-cash margin in the bilateral world, the report notes that a transition period was, “explicitly provided for under EMIR in order to provide further time for CCPs to develop technical solutions for the transfer of non-cash collateral to meet VM calls.” The solution envisioned was for PSAs to repo securities owned free and clear to generate the cash needed for VM. On its face, this would be a workable solution, since there is an active market for repos in Europe, with several clearinghouses, like LCH RepoClear, providing those services. If the derivatives were cleared at LCH, for example, it doesn’t seem to be too much of a stretch to imagine a linkage between RepoClear and SwapClear, where VM requirements would trigger a repo of securities held at LCH, and excess VM would trigger an unwind and return of the securities. Sounds like a good business model to me.

 However, the report points out an immediate concern. “The baseline study indicates that the aggregate VM call for a 100 basis point move would be €204–255 billion for EU PSAs. Of this, €98–123 billion (£82–103 billion) would relate to UK PSAs, and predominantly be linked to sterling assets, and €106–130 billion would relate to euro (and perhaps other currency) assets. Even if PSAs were the only active participants in these markets, the total VM requirement for such a move would exceed the apparent daily capacity of the UK gilt repo markets and would likely exceed the relevant parts of the EU Government bond repo market — i.e. primarily that in German Government bonds (bunds).

In other words, as I pointed out last July, the swaps markets are so large that a 100 bp move in short rates would create an enormous VM requirement. Given that risk, the report says that, “The Commission therefore intends to propose an extension of the three-year period referred to in Article 89(1) of EMIR by two years through means of a Delegated Act. The Commission shall continue to monitor the situation with regards to technical solutions for PSAs to post non-cash assets to meet CCP VM calls in order to assess whether this period should be extended by a further one year.”

To clarify, then, on the one hand, the VM requirement for European pension funds in the event of an upward move in rates is so large that the repo market couldn’t handle it. On the other hand we’re all comfortable that the risk could be handled in the bilateral market. Really? Well, if all the PSAs are doing with swaps is hedging the risk of owning fixed rate debt, then we would expect them to be paying fixed and earning floating. Then, if rates rise, they will be receiving VM, not posting it. However, if they own floating debt, why would they be hedging against a rate rise? Unless, of course, their whole motivation is higher yield.

As it turns out, the management of this risk, as with all investment risks, doesn’t depend on whether the positions are carried in a CCP or not. It depends on whether the swaps positions are hedges and, if so, what risk they are hedging. If the PSAs are using swaps as a hedge, then the VM requirements would not be insurmountable, since the size of the positions would be commensurate with the size of the bond holdings. Thus the repo problem would solve itself. If they are not hedges, then someone should be asking what they are used for. A good reporting system would help us assess this risk, but, as we all know, swaps reporting has been a disaster around the world. Thus we have very little chance of knowing how big the risk is, how well it has been managed, and when it will re-emerge. Instead, we’re focused on whether PSAs are required to clear their positions.

The Inside View

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 who 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.

One implication of this scenario is that, as vigilant as a counterparty may be, they might not see the cracks in the façade until the edifice is already falling down. In the bilateral world firms deal with this risk by limiting their exposure to any party to only what they would be comfortable losing. Obviously, customers can open accounts with multiple counterparties and thus build up gargantuan positions, but at least the risk is spread out, based on each firm’s risk appetite.

Clearing adds a few wrinkles to this scenario, but some aspects remain the same. Assuming the customer opens accounts at several clearing firms, and each of them independently does its own due diligence, the same opportunity for a market meltdown exists. And it is likely that the distant rumblings of trouble would be as muted as in the bilateral world, until it all comes out. So far, no difference.

The big question is, what happens when it does come out. Supposing that this one customer represents, say, 70% of the positions on the losing side, everyone would immediately ask, “Where were those positions cleared?” Now, instead of having them spread out amongst many firms, they all appear in one place, the CCP. And the resolution plans of many CCPs indicate that they could use the VM expected to be paid on the winning positions to cover the losses.

Knowing that, customers would rush to withdraw their seg balances from the clearing members, and the clearing members from the CCP, and we start to have lines around the block. It all looks worse, though, if the culprit is a clearing firm itself. In that case, one would be sure that they would have already accessed all their IM, default contributions, and any other cash, and possibly their customers’ cash as well.

As grim as this scenario is, it has already happened on a minor scale. But the point here is that the swaps markets are huge. The fixed-float outstanding notional is still around $400 trillion, as far as I can tell, so a 100 bp move in short rates represents a full fledged earthquake in terms of VM. Who actually holds all those positions? Nobody knows; not the regulators, not the CCPs, not the clearing firms, nobody. To top it off, the CCPs are global businesses that are regulated nationally. That means, of course, that we have either multiple regulations on a single business, or none, or confusion.

In the end, then, skin in the game may give some folks comfort, but not me. The only way to guard against the dreaded creeping, mushrooming CCP default is transparency and good business practices on the part of both the CCPs and the clearing firms. In some ways, the CCPs may simply be very interested bystanders, and then everyone’s skin is in the game. So maybe everyone is responsible for CCP risk management. But we know that making everyone responsible means nobody is responsible. Then the risk doesn’t get managed at all, and that appears to be where we are.