Repo and derivative clearing houses concentrate the risk

A critical look at post-crisis efforts by regulators to move privately negotiated, or over-the-counter, derivatives to clearinghouses to reduce systemic risk has unspoken lessons for the tri-party repo market as well.

A March 2011 International Monetary Fund paper, “Making OTC Derivatives Safe―A Fresh Look” by economist Manmohan Singh, raises concerns about the plan to move many derivatives to central counterparties, or clearinghouses.

The clearinghouses themselves may become hot spots for systemic risk and taxpayer bailout, just as the mega-banks were in 2008, Singh says. They may become additional too-big-to-fail financial institutions that regulators must oversee.

RepoWatch suspects something similar could be said of JP Morgan and Bank of New York Mellon, who are clearing banks for the tri-party repo market, which handles about one-fourth of all U.S. repo transactions.

As Yale University professor Gary Gorton said, “I don’t think we want to force all repo into the tri-party system. It’s only two banks. That’s a lot of risk in two banks in lower Manhattan,” Gorton said.

The safety of the tri-party market, and the two giant banks that serve as middlemen to the transactions there, was the primary driver behind the taxpayer bailout of the financial markets in 2008, regulators have said. Their main concern was that the mechanics of tri-party transactions required JP Morgan and Bank of New York Mellon to extend credit to the repo borrowers during the day. An industry task force has recommended eliminating the intraday credit by October 2011.

In the case of JP Morgan, the risk is intensified by Morgan’s important role in both the repo and derivative markets. The key financial institutions active in over-the-counter derivatives are Goldman Sachs, Citibank, JP Morgan, Bank of America, and Morgan Stanley in the U.S., Deutsche Bank, Barclays, UBS AG, Royal Bank of Scotland, and Credit Suisse in Europe, says Singh.

Singh thinks taxing the under-collateralized risk – which has been estimated at $2 trillion for the 10 largest financial institutions – is one way to lessen systemic danger and taxpayer bailouts from over-the-counter derivatives.

His other idea is to set up one central government-run clearinghouse that clears all derivatives, performs like a utility, can interact internationally and taxes its members to cover the risk. The clearinghouse could require ample collateral and in times of trouble it could unwind derivative trades and lessen impact by requiring net, not gross, payouts.

Singh worries that the current plan, where only perhaps two-thirds of derivatives are moved to a number of private clearinghouses owned by the giant banks, will simply move the taxpayer guarantee from the global banks to the clearinghouses.

From the paper:

Regulators are “forcing” en-masse sizable over-the-counter derivatives to centra counterparties. This is a huge transition, primarily to move this risk outside the banking system. If the intended objective(s) are achieved, these new entities should be viewed as “derivative warehouses,” or “risk nodes” in financial markets, and not under the payment/settlement rubric.

Just as there was a run on the repo market in 2007 and 2008, there can be a run on the derivative clearinghouses, Singh says.

A central counterparty may face a pure liquidity crisis if it is suffering from a massive outflow of otherwise solvent clearing members, in which case the risk is that it will have to realize its investment portfolio at low prices.

Assume an external shock where everyone is trying to liquidate collateral simultaneously. This will lead to a problem if the central counterparty has repo’d out the collateral it has, cannot get it back, and for whatever reason does not want to pay cash to the members (i.e., effectively purchasing the securities at that price).

In these circumstances, a central bank would be repo-ing whatever collateral the central counterparty would ultimately get back. In such instances, it would be more sensible to require the bank members (e.g., JPMorgan, Credit Suisse) of the central counterparty to access the central bank and then provide the central counterparty with liquidity.

The central counterparty may also need central bank support if it has suffered a series of member defaults and is subject to a run because of credit concerns. In this case, the central counterparty’s book is not balanced (since the trades of the defaulting members have fallen away) and if the central bank provides liquidity support it will be taking credit/solvency risk on whatever the net central counterparty position is. A central counterparty failure should not be ruled out.

As central counterparties begin to clear more complex, less liquid, and longer-term instruments, their potential need for funding support in extremis will rise. In the most extreme scenario, where a temporary liquidity shortfall at a central counterparty has the potential to cause systemic disruption, or even threaten the solvency of a central counterparty, it is likely that a central bank will stand ready to give whatever support is necessary. However, such an arrangement would create moral hazard. …

The recent (draft) European Union framework for Crisis Management in the Financial Sector
acknowledges that central counterparties are potentially too-big-to-fail and will be an integral part of any resolution arrangements. …

Regulators will have to supervise more systemically important financial institutions, as central counterparties will effectively be systemically important financial institutions. Furthermore, existing systemically important financial institutions (i.e., large banks/dealers) will retain over-the-counter derivative positions since nonstandard contracts will stay with them. End-user exemptions and (likely exempt) foreign exchange contracts will not migrate to central counterparties. …

With a central bank providing a lender-of-last-resort, we are shifting the potential tax-payer bailout from Wall Street to entities such as ICE Trust (U.S.), or ICE Clear (U.K.), or LCH.Clearnet/Swapclear (U.K.) or CME (U.S.). …

This transition is increasingly opaque to the ordinary taxpayer, especially since moving derivatives from systemically important financial institutions’ books to those of central counterparties is mired in convoluted arguments and impenetrable technical jargon. …

Many end-users of over-the-counter derivatives (Pimco, Blackrock, etc.) are reluctant to post collateral with certain central counterparties that do not have central bank backstopping. …

Singh says financial institutions likely will not move a good portion of their over-the-counter derivative transactions to clearinghouses:

The financial statements of the 10 largest systemically important financial institutions suggest that under-collateralization has been on average about $1.5–$2 trillion in recent years. At present, there are many derivative users such as sovereigns, quasi-sovereigns, debt management
offices, U.S. municipalities, privileged clients of systemically important financial institutions such as high rated corporates, AAA insurers, pension funds, etc., who do not post full (or any) collateral to systemically important financial institutions. Market sources confirm that at present, derivative users such as some European sovereigns or U.S. municipalities are unlikely to post their full share of collateral. This, along with exemptions
for end-users, nonstandard contracts that cannot be cleared, and perhaps a waiver for the foreign exchange market, will result in a non-trivial share of the over-the-counter derivative books staying with the systemically important financial institutions.

Singh offers the following scenarios for how the U.S. could handle the failure of a clearinghouse:

The Dodd-Frank Act allows the Fed to provide secured lending only, and not unsecured lending. Thus, central counterparites can benefit from the Fed discount window via an account only to the extent of a central counterparty’s non-cash collateral at the Fed.

If a central counterparty fails and there is insufficient collateral among all central counterparties to cover the losses, then one could consider an unlimited call on the significantly important financial institutions dealing with the central counterparty to bridge the losses (and thus have “skin in the game” and avoid moral hazard). In the aftermath of the October 17, 1987 crash, the Federal Reserve (Chicago and New York) persuaded banks to lend freely to central counterparties, promising whatever support was necessary. In the case of CME, failure was averted when its bank, Continental Illinois, advanced CME $400 million just minutes prior to the opening bell.

Singh concludes:

These regulatory steps seem unlikely to adequately reduce systemic risks or excess rents from
over-the-counter derivatives, and the likelihood of future taxpayer bailouts appears to remain significant. Taxing derivative payables would be a good alternative (or a complementary solution while regulations are finalized). Explicitly recasting the over-the-counter market infrastructure as a public utility might be another option, although this would need to be accompanied by stronger steps to eliminate cross-border regulatory arbitrage.


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