The $5 trillion dilemma facing banking regulators

By Felix Salmon
December 3, 2013

Last month, I wrote about bond-market illiquidity — the problem that it’s incredibly difficult to buy and sell bonds in any kind of volume, especially if they’re not Treasuries. That’s a big issue — but it turns out there’s an even bigger issue hiding in the same vicinity.

The problem is that there’s only a certain amount of liquidity to go around — and under Dodd-Frank rules, a huge proportion of that liquidity has to be available to exchanges and clearinghouses, the hubs which sit in the middle of the derivatives market and act as an insulating buffer, making sure that the failure of one entity doesn’t cascade through the entire system.

Craig Pirrong has a good overview of what’s going on, and I’m glad to say that Thomson Reuters is leading the charge in terms of reporting about all this: see, for instance, recent pieces by Karen Brettell, Christopher Whittall, and Helen Bartholomew. The problem is that it’s not an easy subject to understand, and most of the coverage of the issue tends to assume a lot of background knowledge. So, let me try to (over)simplify a little.

During the financial crisis, everybody became familiar with the idea that a bank could be “too interconnected to fail”. The problem arises from the way that derivatives tend to accumulate: if you have a certain position with a certain counterparty, and you want to unwind that position, then you can try to negotiate with your original counterparty — but they might not be particularly inclined to give you the best price. So instead you enter into an offsetting position with a different counterparty. You now have two derivatives positions, rather than one. The profits on one should offset any losses on the other — but your counterparty risk has doubled. As a result, total counterparty risk only ever goes up, and when a bank like Lehman Brothers fails, the entire financial system gets put at risk.

There are two solutions to this problem. One is bilateral netting — a system whereby banks look at the various contracts they have outstanding with each of their counterparties, and simply tear them up where they offset each other. That can be quite effective, especially in credit derivatives. The second solution is to force banks to move more of their derivatives business to centralized exchanges. If there’s a single central counterparty who faces everyone, then the problem of ever-growing derivatives books goes away naturally.

Of course, if everybody faces a central counterparty, then it’s of paramount importance to ensure that the clearinghouse in question will itself never fail. Naturally, the clearinghouse doesn’t own any positions, but on top of that it has to be able to cope with its own counterparties failing. Typically, the way it does that — and we saw this during MF Global’s collapse — is to demand ever-increasing amounts of collateral whenever there’s a sign of trouble.

Such demands have two effects of their own. The first, and most important, effect is that they really do protect the central clearinghouse from going bust. But the secondary effect is that they increase the amount of stress everywhere else in the system. (MF Global might have ended up going bust anyway, but all those extra collateral demands certainly served to accelerate its downfall.) Pirrong calls this “the levee effect”:

Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a central counterparty (CCP) can redistribute shocks elsewhere in the system in a highly destabilizing way. CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects. Indeed, greater reliance on CCPs increases the tightness of the coupling of the financial system, which can be highly problematic under stressed conditions.

Essentially, when markets start getting stressed, liquidity and collateral will start flowing in very large quantities from banks to clearinghouses. Indeed, to be on the safe side, central clearinghouses are likely to demand very large amounts of collateral — as much as $5 trillion, according to some estimates — even during relatively benign market conditions. That is good for the clearinghouses, and bad for the banks. And while it’s important that the clearinghouses don’t go bust, it’s equally important that the banks don’t all end up forced into a massive liquidity crunch as a result of the clearinghouses’ attempts at self-preservation.

The banks, of course, will look after themselves first — especially as the new Basel III liquidity requirements start to bite. If they need to retain a lot of liquid assets for themselves, and they also need to ship a lot of liquid assets over to clearinghouses, then there won’t be anything left for their clients. Historically, when clients have needed to post collateral, they’ve been able to get it from the banks. But under Basel III, the banks are likely to be unable or unwilling to provide that collateral.

So where will clients turn? These are truly enormous businesses which might need to be replaced: Barclays has cleared some $26.5 trillion of client trades, while JP Morgan sees an extra half a billion dollars a year in revenue from clearing and collateral management.

Just as in the bond markets, one option is that the clients — the buy-side investors — will turn to each other for collateral, instead of always turning to intermediary banks. That’s already beginning to happen: some 10% to 15% of collateral trades already involve non-banking counterparties. But it’s still very unclear how far this trend can be pushed:

While corporates and buysiders might be comfortable sharing confidential information with their banking counterparties, shifting to a customer-to-customer model is a big step.

“The problem is that buyside firms have to open up their credit credentials to each other to get a credit line in place. I always felt that was an impediment to customer-to-customer business, but the combined impact of new rules changed that,” said Osborne.

Osborne, here, is Newedge’s Angela Osborne; her job is to start replacing banks in the collateral-management business. Once you adjust for Osborne talking her own book, it’s clear that there’s still a very long way to go before the banks will realistically be able to step back from this market.

After all, it’s not as though the banks’ buy-side clients themselves have unlimited amounts of collateral which they can happily post at a moment’s notice. It’s true that they aren’t as leveraged as the banks are. But they themselves have investors, who can generally ask for their money back at any time — normally, when doing so is most inconvenient for the fund in question. If they tie up assets posting collateral for themselves or others, that makes it much harder for them to meet potential redemption requests.

All of which means that as we move to a system of central clearinghouses, a new systemic risk is emerging: “fire sale risk” is the term of art. If a market becomes stressed, and the clearinghouses raise their margin requirements, then the consequences can be huge. In the bond market, the death spiral is all too well known: a sovereign starts looking risky, the margin on its bonds is hiked, which in turn triggers a sell-off in that country’s bonds, which makes them seem even riskier, which triggers another margin hike, and so on. This can happen in any asset class, but derivatives are in many ways the most dangerous, just because they’re inherently leveraged, and the amount of leverage that the clearinghouses allow can be changed at a moment’s notice.

Do the world’s macroprudential regulators have a clear plan to stop this from happening? Do they have any plan to resolve the inherent tension involved in demanding that banks retain large amounts of ready liquidity, even as they also allow clearinghouses to demand unlimited amounts of liquidity from the very same banks? The answers to those questions are — at least for the time being — very unclear. But the risk is very real, and it makes sense that regulators should do something to try to mitigate it.


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But where does all that magic “liquidity” come from? If it is created by central banks, it should be a simple thing since they are generally speaking the party in charge of enforcing the regulations as well. If “liquidity” is an epiphenomenon of the macro economy, then it probably doesn’t matter if the financial system is healthy or not when the economy is so sick that it can’t provide sufficient liquidity.

Posted by engineer27 | Report as abusive

The follow-on question to engineer27′s point seems to be: OK, it seems likely we can solve this by allowing rapid injections of liquidity from the central bank. But if that’s the solution, then how do we direct such injections to cope with moral hazard issues?

It seems like the point of the CCH is to make sure that none of its derivative-trading smaller counter-parties are “too big to fail”. If one of the banks that faces the CCH has problems, we want them to just go bust, right? NOT receive liquidity from the central bank the way many banks did in ’07-’08.

In the event that one of the CCH’s counter-parties fails, what we really want to have happen is that the CCH itself receives a liquidity injection that helps it cope with the fall-out — it needs to be able to close out positions, even if it’s left with losses after net-positive contracts with the dead counterparty are sold at fire-sale prices or written off.

And this sounds like a relative of deposit insurance, no? We need a Tobin Tax on all of the trades running through the CCH, to fund the pool of money that takes care of winding down dead counter-parties. You could even privatize it — make it a fee charged by the CCH itself, rather than a gov’t-collected tax, if that makes it seem more palatable. The key thing is that there can only be a small number of CCHs, they all have to be maintaining adequate reserves, funded through such fees, and no trading outside of such a system can be permitted — no more shadow banking system, dark pools, etc.

Posted by Auros | Report as abusive

I guess then the problem becomes: If the entire system faces an external shock that forces you to decide that the reserve level should be higher, how do you handle the period of transition; if a bunch of counterparties fail simultaneously, before the CCH can accumulate extra reserves, what happens? _That_ seems like the point at which the Fed (or other central bank) steps in and fills the gap, perhaps via a loan facility, or perhaps by buying some convertible preferred shares in the CCH.

Posted by Auros | Report as abusive

I See two problems that right now are working against liquidity. First the Fed owns large chunks of the bond market and very often is the market, one example–mortgages, second banks are going out of their way to create illiquid instruments, because banks love obscure and illiquid instruments for again two reasons( the increased likelihood that clients over-pay and the ability to profit from the bid/ask spread.

Posted by Sechel | Report as abusive

Well I don’t get why this is complicated. The problem stems from the fact clearing houses don’t ask for nearly enough collateral in the first place, when there is no stress in the market. So when stress kicks in, they ask for more and that causes problems.

What’s the worst case scenario for market participants? A 50% haircut? Then the collateral needed should be enough, at all times, to accomodate for such dire market conditions. A bit like the utopist view of the government by keynesians (we all know politicians are the wild card here …). In good times, the governement should run surpluses. When the economy tanks, the governement should allow for dĂ©ficits in order to stimulate the economy. So simple, yet so few actually act that way.

Or maybe I’m just dumb and don’t get how this all works out?

Anyway, I don’t get why the banks are allowed to be market participants in the first place (dĂ©rivatives, stocks, etc …). They should only be allowed to use depositors’ money as collateral. And they shouldn’t be allowed to become too big to fail. Also, we shouldn’t need 100k pages of regulations. And those who fail to follow the rules should be prosecuted.

Else, why do we allow proprietary trading again? Even at investment banks? Because they provide liquidity? But they also cause liquidity to dry up! So they have a pro-cyclical behavior which is dangerous. It good times, they do provide the liquidity. When stress increases, all of the sudden, they no longer provide the liquidity … From my point of view, that’s totally inefficient. Why do we need that liquidity (and the risks that come with it) when all is well? We don’t. Therefore, we shouldn’t allow it.

From my point of view, we trick ourselves trying to find complicated solutions to a simple problem. Hence the problem simply becomes even more complex.

Posted by legorf | Report as abusive

Hi Felix.

I wouldn’t worry too much about liquidity risk. The CCPs mostly hold cash collateral (margin + default fund) and this is all held with the same commercial banks that provide liquidity to everyone else. The CCPs don’t have access to central banks.

The real issue is concentration risk. The forcing of OTC derivatives into CCPs by Dodd-Frank and EMIR means pooling all of the risk for the market into 1-3 entities (primarily LCH). Question is can/will BOE support LCH if it gets into trouble?

Posted by Gennitydo | Report as abusive

“The problem arises from the way that derivatives tend to accumulate: if you have a certain position with a certain counterparty, and you want to unwind that position, then you can try to negotiate with your original counterparty — but they might not be particularly inclined to give you the best price. So instead you enter into an offsetting position with a different counterparty. You now have two derivatives positions, rather than one. The profits on one should offset any losses on the other — but your counterparty risk has doubled.”
Maybe I’m just too retro, but the above system for risk control sounds like a crash just waiting to happen. Oh wait. Already did that.

Posted by chrisherbert | Report as abusive

Maybe I am missing something but this pretty much seems to be a made up risk to me. It would make sense for the banks to push this story so they can keep screwing over their costumers with OTC derivatives.

Is there any example in history of a clearing house causing a financial crisis? Collateral calls add stability to the system by lowering leverage before it gets to levels where systematic default is a danger. If a collateral shortage leads to the credit derivative market shrinking that is a positive in my book.

Posted by AASH | Report as abusive