Derivative market reform requires that standardized derivative transactions must be cleared through a central clearinghouse, the central counter party ("CCP") that guarantees performance, reducing the risk of market participants defaulting on obligations.
In the Renaissance, popes often annulled the marriages of Catholic monarchs. The annulment preserved, theoretically, both the authority of the Papacy and the sanctity of marriage. The CCP proposal similarly gives the impression that regulators and legislators are reasserting control over the wild beasts of finance. In reality, the proposal may not work or materially reduce the risks it is intended to address.
The CCP system relies on use of cash or high quality government securities to be lodged as collateral to secure performance under derivative contracts. Margins on cleared contracts will significantly change liquidity and cash flows within the financial system. Derivative traders will need to post initial margin and may experience volatile cash flows as a result of changes in values of positions. As these requirements will have to financed, counterparty risk will morph into liquidity risk.
The risk is not insignificant. Under its bilateral collateral arrangements, AIG's CDS contracts were subject to the provision that if the firm was downgraded below AA-, then the firm would have to post collateral. In October, 2008, when AIG was downgraded below the nominated threshold, this triggered a collateral call rumoured to be in excess of $14-billion. AIG did not have the cash to meet this call and ultimately required government support.
The liquidity risk for industrial companies may be significant. Where a company is hedging, a margin call on its derivative hedge will generally not be matched by an offsetting cash flow on the underlying exposure. Lufthansa claimed that clearing would "cause severe cash and liquidity risks". During the great financial crisis, the company claimed that cash flow requirements from margining derivative contracts "would have erased many corporations with a domino effect reaching every . . . corner of business activity".
CCP clearing of derivatives may increase hedging costs to users of derivatives and their liquidity requirements to support trading. This cost and the risk of liquidity shortfalls may affect levels of hedging, preventing exposures from being hedged. The diversion of liquidity to support risk may also restrict availability of financing for other purposes.
The CCP is designed to reduce systemic risk but in reality, the CCP may become a node of concentration. The clearing arrangement centralizes contracts in a single entity – the CCP.
The CCP effectively changes the structure of markets from a network which can survive one or more failures to a hub and spoke system that is vulnerable to a single failure. This increases risk concentrations within financial markets. The CCP is the ultimate case of "too big to fail".
The credit quality of the CCP is crucial. The CCP's capitalisation and financial resources as well as the risk management systems will be important in ensuring its credit standing. The specific criteria and detailed oversight arrangements are unclear. Currently, private clearing houses are contemplated. Commercial motivation (for market share and profit) may conflict with risk management requirements. It is not immediately apparent how these competing pressures will be accommodated.
Maximisation of benefits of central clearing requires a single clearing house. The CCP will be most effective if all instruments and participants are covered. However, a single CCP covering all products and market participants seems unlikely to be achieved.
Currently, multiple CCP appear likely, as different commercial clearing houses compete for the latest frontier land grab in financial markets. National prejudices, inherent mutual distrust, promotion of national champions as well as feared loss of sovereignty and control of financial markets will mean multiple CCPs located in different jurisdictions. This will require, if feasible, inter-operability, cross margining and clearing arrangements between exchanges and jurisdictions. Instead of decreasing risk, this may create new and complex exposures.
International agreement on clearing and the CCP may prove elusive. It is also not clear who will regulate and oversee the system, especially where it transcends national boundaries.
The CCP is not a comprehensive solution – a magic silver bullet. It is likely to disappoint and create different but equally potent risks. The CCP is consistent with the observation by journalist and columnist Max Lerner: "What is dangerous about tranquillisers is that whatever peace of mind they bring is packaged peace of mind. Where you buy a pill and buy peace with it, you get conditioned to cheap solutions instead of deep ones."
The CCP does not address the real issues of derivatives or the risk they pose to financial markets.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)