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Do Central Clearing Parties (CCP) reduce risk or concentrate it? And how do laws and regulations need to change? Those were among the topics that executives of leading clearers addressed at FIA Expo last week.
Regulators see high concentration on the clearing side, noted Matthias Graulich, chief client officer at Eurex. Is the simple answer to water down the capital rules, probably not the desired outcome for regulators as market structure would stay the same. Regulators should modify capital rules and take netting effects into account.
Edward Pla, managing director and global head of clearing & execution at UBS, asked if the system would be more resilient in the next crisis.
“We are having conversations with end user clients who have been asked to take their business elsewhere,” said Trevor Spanner, CEO at LME Clear. “More risk in the system drives more capital. What are we solving for — the last crisis or the next?”
“We have been dealing with this issue for almost 18 months and not making much progress,” said Thomas Hammond, president & chief operating officer at ICE Clear U.S. “If you look at a default situation in a market and you are looking at a market contracting because of capital requirements in the proposed leverage ratio, it will be difficult when you have to port exposures; people simply won’t have the capital.”
Participants said that some modification to the regulations is needed. One problem is a big gap between regulators and the people in the marketplace.
“The regulations were meant to de-lever banks and derivatives got sucked in” with unintended consequences, said Mike McClain, president & chief operating officer at OCC. You can have two options that are the opposite of each other and both require risk capital charges, he added.
“No one can afford to get into options positions for a long period of time — it’s too expensive. Regulation means well but you have to look at unintended consequences and tweak the legislation and regulation.”
“The goal was to drive more OTC opaque exposures into clearing and collateralized at all times,” said Sunil Cutinho, president of CME Clearing. “The other goal is to reduce concentration, too big to fail — reduce TBTF and try to get as many broad participants to enter the market and transact directly through the market. Perversely these rules are actually achieving the opposite.”
Porting a client from a defaulting agent to a solvent agent, raises the issue of concern going forward of who would be willing to take on a book of clients, even if fully collateralized. Who would be willing to step in if they have to deal with these capital costs?
In a crisis, what will happen?
Some porting is automated, said LME Clear’s Spanner. “Some CCPs have short porting windows, ours is 4 hours, Unless you have placed your instructions with a clearing house you will struggle to get your positions away on time.”
There is also concern about business continuity said McClain.
“Harmonized risk relies on the same institutions to provide access, and should they wobble or fail, you lose your source of continuity.” The FCMs and broker dealers providing access are the same ones clearing houses rely on for liquidity
“We have looked at our reliance on clearing member and tried to diversify that. Some people were curious why we broke out a third of our liquidity facility to CalPERS.”
In March the OCC announced a one-year agreement under which the $296 billion public employees pension fund will provide cash and U.S. Treasuries as collateral the clearing house can tap in the event of a default.
“We get the diversification we wanted and it is prefunded so we can get cash in minutes. We also have started looking at banks who custody collateral and try to move that collateral to other utilities like DTCC and make sure we aren’t overly reliant on one bank.” Clearing houses should try to get more Tier II banks participating, he added.
Pla asked what role the central banks should play.
“Access to the window is something we have asked about,” said McClain. “We are trying to give the U.S. government their own notes haircutted in exchange for cash for a few days. That kind of access is good as a last resort. We think the clearing house should do everything it can not to rely on that, but at least put a structure in place so there are pre-defined set ways to get that access.”
In Germany Eurex is registered as a bank, said Graulich, and has access to the central bank.
“We don’t want insurance companies sitting on piles of cash; we want to use securities collateral. The CCP must be able to liquidate these securities to run liquidation. If this is a large directional client and you liquidate collateral, you have a fire sale on securities which is in no one’s interest. If you can go to the central bank with German bonds and get cash to run liquidation, and then as the market calms down you can sell securities step by step into the market. That is in the interest of everyone because it helps smooth out the process.”
Cutinho agreed on the importance of a variety of collateral in addition to a committed liquidity facility. CME Clearing uses, by way of example, Australian debt, Canadian provisionals, debt from Singapore with limits and haircuts.
“It’s important to have that diversity.”
Spanner said LME Clear accepts European cash, govvies, gold and, since summer, off-shore renminbi.
“You can innovate in this space. If people are long on metal, why not let them put up warrants for warehouse stock as collateral?”
Eurex accepts 25,000 ISINs, govvies from around the globe, high quality corporates and equities.
“Make sure you have concentration limits in place, and that you don’t have wrong-way risk policies in place,” said Graulich. “The key investment principle is to diversify risk.”
The CCP executives are, of course, paid to think about the unthinkable. And they do.
Hammond at ICE Clearing looks at a scenario “where we need liquidity and [the need] will be large with large banking participants. All my facilities are probably going away. When I run up and say we have this agreement, you have to provide me with liquidity, and they say ‘This place is on fire and i have to get past the next hour.’ Missing in all this discussion is that we can build these things in a way that is comfort. Scenarios and role playing have been the activity of two years, but when you realistically apply it you are going to be in trouble even if you have the piece of paper in your hand. You certainly don’t want to be in cash, Treasuries have always proven to be a safe haven, they have always stayed liquid, so they seem to be a logical solution for providing some relief. I would much rather have that than a piece of paper.”
Are regulators around the globe coordinating? asked Pla.
“We have seen some real progress,” said Martin Pluves, CEO at LCH.Clearnet. “Increasingly we are very real global entities with membership all around the world and large volumes of major international currencies. The Bank of England (BOE) pulled together international regulation crisis management teams,.”
The BOE have all the international regulators look at it and a discussion earlier this week (before FIA EXPO) at the Chicago Fed looked at regulatory and solvency regimes.
“We have done fire drills with BOE, firedrilled things that look impossible but look possible at the bottom of the waterfall.”
“What clearing CCPs are doing is to get the probability of a waterfall to be small,” said OCC’s McClain. “We have default management staff, we test draw liquidity from banks, have emergency rule process, transfer positions and test all our link relationships. We test a custody bank going out or the head of our liquidity facility goes out. We do it with the participants and we have sophisticated auction process with a stable of bidders who have to bid in and show they can bid in an hour.”
