Comments on: The $5 trillion dilemma facing banking regulators A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: AASH Thu, 05 Dec 2013 17:51:55 +0000 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.

By: chrisherbert Wed, 04 Dec 2013 20:09:40 +0000 “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.

By: Gennitydo Wed, 04 Dec 2013 06:06:35 +0000 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?

By: legorf Wed, 04 Dec 2013 00:40:01 +0000 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 déficits 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 (dérivatives, 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.

By: Sechel Wed, 04 Dec 2013 00:08:10 +0000 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.

By: Auros Tue, 03 Dec 2013 18:41:34 +0000 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.

By: Auros Tue, 03 Dec 2013 18:38:06 +0000 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.

By: engineer27 Tue, 03 Dec 2013 17:57:56 +0000 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.