Everybody loves the idea of the central clearing of derivatives. It’s like motherhood, transparency, and honest dealing. The most widely touted take-away from the crisis of 2007-08 is that “central counter-parties strengthen the safety and integrity of financial markets,” as Eurex Clearing put it this summer.
This contention raises an obvious question, as regular readers of this blog will recognize: Won’t the central clearing parties themselves at some point (probably not too far distant) come under stress? And when that crisis comes, won’t they be deemed too big to fail? What happens then? Bail-out? Some front-door or back-door nationalization?
The cheerleaders for the let’s-centrally-clear-everything trend don’t usually take that sort of caution very seriously. They say that it will be different this time. Or, in the calming words of a recent white paper from Eurex Clearing and The Deutsche Börse Group, a CCP “does not take on proprietary risk and reflects the risk exposure by neutral valuation and prudent collateralization.”
Given this, I have to say I was fascinated by Stephen Lubben’s recent paper, (Seton Hall Public Law Research Paper #2458506), with the provocative title “Nationalize the Clearinghouses!”
Lubben acknowledges that there are differences between clearinghouses on the one hand and, say, Lehman Brothers or AIG on the other. But the differences aren’t such as to make the former invulnerable to failure. They will only give the failures a rather different complexion. There are actually three distinct claims in the above quote from the EC/DBG white paper, two stated and the third implicit, and Lubben (without making any specific reference to that paper that I’ve noticed) manages to address each of them.
CCPs don’t have proprietary risk
The boosters say that CCPs don’t have “proprietary risk.” Actually, in a sense they do. They hold (and invest) large sums of collateral, and in principle that could cause losses. It is very unlikely to cause losses large enough to produce an insolvency though. So let’s grant that point.
Still, Lubben says, CCPs can fail either through a massive operational problem or as the result of the failure of a member. In either case, it would be a sudden “jump to default” [analogous to the sort of trigger that can require a payout by the seller of protection in a credit default swap] rather than any slow build-up of losses and gradual increase in the degree of distress.
CCPs follow prudent risk management practices
Ah, but the prudent risk-management practices of CCPs will surely prevent any such failure: right? One of the problems with that, taken as an article of faith, is that the larger members, those with the loudest voice in managing the clearinghouse, may well be tempted over time to push for reduced margin requirements, and reduced default fund contributions as well.
Moreover, the collateral held by a CCP will typically be in the hands of a third-party custodian, and that custodian might well in turn be a member of the CCP: indeed, it could even be the defaulting member. In such a case, as Lubben says, “certain member defaults could be more painful than others.”
Responsible regulators can require sound risk management
Perhaps this one is implicit in the previous claim, though.
As Lubben observes, it isn’t difficult to conjure up scenarios in which the regulators will be part of the problem, part of the risk that could overwhelm the risk managers.
For example, suppose in a crisis one member of a CCP fails, and a second is teetering near failure. The first failure depletes the CCP’s default fund to the point where it calls for capital contributions from the other members. That is, from the point of view of its own solvency, a perfectly prudent measure, and we will presume it is in accord with the relevant documentation.
But … suppose the capital contribution demand is itself a threat to the solvency the teetering member. Lubben asks, “Would its regulator allow the payment?” There may well be cases where one or the other would have to become insolvent, either the second member firm or the CCP that had been serving both it and the first failure.
The hypothetical becomes more compelling if remember that the United States is not alone in the world. A CCP in London or Geneva may well demand capital in such a situation from a systemically important financial institution in the United States. Isn’t it likely that an American regulatory agency would rather block that demand than not? And what of a CCP in the U.S. that demands capital from a SIFI in the U.K. or Switzerland. How would one expect the relevant authorities there to view the situation?
Lubben’s point is that the CCP-ization of everything is creating an environment in which a CCP related crisis is not a matter of “if,” only a matter of “when.” He also would like authorities to be explicit about the nationalization they will impose when that when arrives.
My own reaction is that it would be better not to go down this road at all. A reconsideration of the pertinent provisions of Dodd-Frank is in order. I don’t believe that there is much of a political appetite for the nationalization of institutions as critical as the CCPs are destined to become, and it is better to reverse course than to head down these back roads.
For the lawyers among our readers, I should note – as does Lubben, the following two legal peculiarities. Clearinghouses are treated as “commodities brokers” under bankruptcy law, so they can’t file for reorganization, only for chapter 7 liquidation. Also, clearinghouses are at least arguably excluded from the Orderly Liquidation Authority under Dodd-Frank.