Category / Clearing and Collateral

Collateral crises February 18, 2014 at 12:22 pm

From the abstract of Collateral Crises, by Gary Gorton and Guillermo Ordoñez:

Short-term collateralized debt, private money, is efficient if agents are willing to lend without producing costly information about the collateral backing the debt. When the economy relies on such informationally insensitive debt, firms with low quality collateral can borrow, generating a credit boom and an increase in output. Financial fragility is endogenous; it builds up over time as information about counterparties decays. A crisis occurs when a (possibly small) shock causes agents to suddenly have incentives to produce information, leading to a decline in output. A social planner would produce more information than private agents but would not always want to eliminate fragility.

Personally I think this approach is interesting but insufficiently epistemic. It’s easier to explicitly model lender’s beliefs about borrowers, and about collateral. Still, it’s nice to see a formal model of the run on repo insights.

A trillion dollars less February 15, 2014 at 10:32 am

From the New York FED’s latest Update on Tri-Party Repo Infrastructure Reform:

[Due to reforms] the two clearing banks are providing over a trillion dollars less in intraday credit to market participants on a daily basis today than in February 2012.

(Emphasis mine.)

The FED’s collateral policies during the crisis January 21, 2014 at 7:43 pm

I can’t believe that I missed this two years ago when it came out, but I did, so herewith find Bloomberg’s carefully-researched and probably not at all conjectural expose of the FED’s collateral policies in the crisis:

Last week the Federal Reserve bravely released 894 PDF files containing 29,346 pages that detailed its heroic actions during the financial crisis.

These documents revealed how open-minded the Fed can be when it needs to be. Local governments in Belgium, Japanese fishing cooperatives, the Libyan government and many other unlikely parties received the Fed’s financial aid. Failing U.S. banks, such as Citigroup and Morgan Stanley (MS), were of course handed whatever they wanted, and permitted to post as collateral pretty much anything they could get their hands on: junk bonds, defaulted debt, volatile equities…

A team of Bloomberg investigative reporters, led by Kram Namttip, was allowed to spend a day examining what remains of the collateral collected by the Fed during the crisis. What follows is a brief summary of their findings. To wit:

– A vault in the Fed basement filled with young women, who claimed, in broken but excited English, they had been repo-ed by the Italian government.

If Italy has weathered Europe’s sovereign debt crisis so much better than its fellow deadbeats, here is why: the Fed’s nervy decision to extend credit to the Italian government against its prime minister’s social assets…

Liquidity, innit? December 1, 2013 at 2:46 pm

The ongoing debate about CCP collateral is interesting. The claim at its simplest is that even very good quality bonds – US T-bills for instance – are not perfect collateral because they cannot be turned into cash immediately. As Reuters reports:

Lawrence Sweet, senior vice president at the New York Fed, said last week that Treasuries could still pose risks to clearinghouse liquidity because payment for sales of Treasuries is not settled until the next day.

The idea, I think, is that if margin is 100% USTs, and a default happens, the CCP could absent other mechanisms (like lines of credit) find itself solvent but not liquid for a day. Market maker of last resort function anyone?

Fire sales in securities financing markets October 31, 2013 at 9:22 am

Jeremy Stein, Governor of the NY FED, gave an interesting speech at their recent workshop on Fire Sales as a Driver of Systemic Risk in Triparty Repo and other Secured Funding Markets (HT FT Alphaville). He gave two examples of the kind of situation that worries the FED.

Example 1: Broker-dealer as principal

In this first example, a large broker-dealer firm borrows in the triparty repo market–from, say, a money market fund–in order to finance its own holdings of a particular security. Perhaps the broker-dealer is acting as a market-maker in the corporate bond market, and uses repo borrowing to finance its ongoing inventory of investment-grade and high-yield bonds. In this case, the asset on the dealer’s balance sheet is the corporate bond, and the liability is the repo borrowing from the money fund.

Example 2: Broker-dealer as SFT intermediary

In this second example, the ultimate demand to own the corporate bond comes not from the dealer firm, but from one of its prime brokerage customers–say, a hedge fund. Moreover, the hedge fund cannot borrow directly from the money market fund sector in the triparty repo market, because the money funds are not sufficiently knowledgeable about the hedge fund to be comfortable taking it on as a counterparty. So instead, the hedge fund borrows on a collateralized basis from the dealer firm in the bilateral repo market, and the dealer then turns around and, as before, uses the same collateral to borrow from a money fund in the triparty market. In this case, the asset on the dealer’s balance sheet is the repo loan it makes to the hedge fund.

The problem is that in both cases if the counterparty fails to perform, the broker/dealer will have to sell the bond, and that ‘fire sale’ could force down prices.

Clearly, there is the potential for fire-sale risk in both of these examples. One source of risk would be an initial shock either to the expected value of the underlying collateral or to its volatility that leads to an increase in required repo-market haircuts (e.g., the default probability of the corporate bond goes up). Another source of risk would be concerns about the creditworthiness of the broker-dealer firm that causes lenders in the triparty market to step away from it.

In either case, if the associated externalities are deemed to create significant social costs, the goal of regulatory policy should be to get private actors to internalize these costs.

Stein then mentions three regulatory tools for addressing this, but I’d add a fourth: a market market of last resort function. Someone – perhaps the central bank or a CCP (who can via their rules strongly incentivise members to bid in an auction) or another market stabilisation body – needs to be able (1) to bid on these collateral portfolios and (2) be credibly capitalised and funded so that it can hold them until the concern of a fire sale no longer pertains.

One might for instance imagine – hypothetically – a fund being set up which was capitalized by fees paid by SFT market participants and which had suitable committed credit lines (ideally with retail rather than wholesale banks) that it could drawn down substantial extra funds. In ordinary times this fund would do nothing, but in crisis it would undertake to bid on and hold defaulter’s collateral pools. The right fees to charge – the internalization of the externality – would be the ones needed to (a) get a AAA rating for the fund and (b) pay the commitment charges on the credit lines in a suitable size (at least $50B, I would guess). The point is that even if you don’t do this, thinking about what it would cost to do it is a way of estimating the cost of the externality.

Increasing credit risk, um, increases credit risk (clearing edition) October 30, 2013 at 8:15 am

Yeah, it’s not surprising is it? But you might be forgiven for thinking that there’s something here if you read a post by the Streetwise professor on clearing. To save you time, here’s the short version:

  • IM is, by design, bigger than the expected exposure on a portfolio of cleared derivatives.
  • If you trade the derivatives bilaterally without collateral (which, soon, you probably won’t be able to do), then roughly your credit risk is the expected exposure, but
  • If you trade act as clearing member and lend the margin required to the counterparty, you have lent more, so you have a bigger exposure.
  • So clearing is riskier than not clearing, right?

Well, kinda. It depends on whether you think the margin is incremental extra liquidity that the counterparty has to raise and which therefore creates extra unsecured borrowing or not. It also assumes that there are no netting benefits (and thus exposure reductions) for the counterparty in using a clearing house. Finally of course it assumes that the excess margin posted to the clearing house is not accessible to the clearing member (i.e. that the margin returned after the default goes straight back to the defaulter’s estate and cannot be netted with the clearing member’s loan). Now all of those things are true sometimes, but not all of the time. In particular if the client borrows funds to post as margin on a secured basis – which it typically will – then the analysis is rather different. Just FYI.

A milestone in European CCP policy October 25, 2013 at 10:14 am

News point of the day, from Eurex:

On 11 October 2013, Eurex Clearing received confirmation from its competent national authority BaFin(Federal Financial Supervisory Authority) that Eurex Clearing’s application under Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (EMIR) has been determined to be complete.

Why did it take so long? October 22, 2013 at 6:41 am

Risk magazine (HT the OTC space) reports that dealers are posting illiquid assets as initial margin against OTC derivatives portfolios to reduce capital requirements. Such assets require large haircuts, of course, but the dealers have plenty of them, so that’s OK. My only question is why it took so long for them to figure this out.

Mary Jo addresses the oxymoron October 4, 2013 at 11:06 pm

From SEC chair, Mary Jo White:

Equity exchanges today operate fully electronic, high-speed trading systems using a business model that mostly was developed by electronic communications networks, or ECNs… Exchanges differ from ECNs, however, in significant respects. Exchanges, for example, continue to exercise self-regulatory functions, even as they operate as for-profit entities.

This model for exchanges has encountered challenges. As I noted earlier, for example, the “lit” exchanges no longer attract even one-half of long-term investor orders.

From time to time, equity exchanges have adopted trading models that use different fee structures or attempt to focus on different priorities, such as order size or retail investor participation. These models have been met with mixed success, which raises the question as to whether exchanges have a real opportunity to develop different trading models that preserve pricing transparency and are more attractive to investors.

As is true for all important aspects of our current market structure, the current nature of exchange competition and the self-regulatory model should be fully evaluated in light of the evolving market structure and trading practices. This evaluation should include whether the current exchange regulatory structure continues to meet the needs of investors and public companies. Does it provide sufficient flexibility for exchanges to implement transparent trading models that can effectively compete for investor orders? Does the current approach to self-regulation limit or support exchange trading models?

This evaluation should also assess how trading venues can better balance their commercial incentives and regulatory responsibilities. For example, is there an appropriate balance for exchanges in key areas, such as the maintenance of critical market infrastructure? And are off-exchange venues subject to appropriate regulatory requirements for the types of business they today conduct?

I have in the past, probably unkindly, described the self regulatory model for US exchanges as oxymoronic. What is true, hyperbole aside, is that it is hard to be both a for profit exchange and a regulator of the market you provide, especially as execution mechanisms evolve in ways that potentially advantage one class of market user above another. It is really nice to see the SEC’s chair acknowledging this issue.

Tapering, the exit path, and collateral September 21, 2013 at 10:10 am

Peter Stella has an excellent post on VoxEU on the implications of the central bank exit strategy for collateral. What’s nice about this in particular is that Stella understands modern credit creation:

Most credit in the US is created by nonbanks; virtually all bank lending is funded by the creation of liabilities that are not subject to reserve requirements, and central banks do not ration reserves. In fact they take great pains to provide banks with the amount of reserves they desire. Central banks influence credit not by rationing the quantity of reserves but by altering the interest rate that banks must pay to obtain the quantity of reserves they desire.

Stella then points out that the precise exit mechanism chosen from QE has considerable implications for collateral: in particular “reverse-repo has a portfolio effect that [the offer to banks of] term deposits do not”. Indeedy.

Cash settled repo and funding stress September 14, 2013 at 7:53 am

Cassa di Compensazione e Garanzia is part of the London Stock Exchange Group. It offers, according to its website, a variety of different clearing services on securities (stocks, warrants, bonds, CBs, ETFs), derivatives (futures) and repo. Proudly, CC&G says that it

eliminates counterparty risk acting as buyer toward the seller and vice versa, becoming the guarantor of the final settlement of the contracts.

LCH, another part of the LSE group, interoperates with CC&G. Recently, LCH took what might be described as a different view on the elimination of counterparty credit risk by CC&G, at least as regard to Italian bond repo. Matt King and colleagues at Citi research take up the story:

LCH seems to have become concerned that its exposures [in the event of CC&G's failure] would simply be too great, and/or the correlation of the collateral (which is mostly government bonds) with many of the borrowers is too high, for [its usual default management] process to provide sufficient protection.

One possible response would have been to increase haircuts. Instead, what they have done is to introduce a series of Articles to their rulebook moving to what they call “cash settlement” in the event of a default by CC&G. Rather than standing between repo lenders and borrowers, as is normal, in this case they would instead liquidate the collateral held and reimburse each lender only the “close out value” received for each trade.
In this way they protect themselves, passing on the costs of a default directly to repo lenders.

Matt points out that Italian banks are, unsurprising, the largest private repo borrowers in Europe, and much of that borrowing is done with BTP collateral cleared at CC&G. Without clearing house protection, how many of their funders are going to want to face them? And if they do still want to deal, what haircuts will they require?

If the answers to these questions are not helpful to the Italians, then they will go to the ECB. That works, but remember that the ECB’s haircuts increase precipitously from A- to BBB, and Italy is one step away at DBRS, the relevant ratings agency in this case*. This could cause significant funding stress if essentially all italian bank bilateral repo funding is at the ECB when a downgrade hits.

*The ECB uses the best of Moody’s, S&P, Fitch and DBRS. Italy is already BBB at the first three.

What is a run on a CCP? September 13, 2013 at 1:21 pm

The term ‘run on a CCP’ has been bandied around a fair amount, but it isn’t entirely obvious what it means. Let me attempt to shine some light onto the idea.

A run on a bank occurs when depositors withdraw deposits quickly. In the days before deposit insurance, bank runs from retail depositors were common as their money was genuinely at risk from bank failure. These runs were damaging as banks which were solvent but not sufficiently liquid (due to demand deposits funding term loans) could fail due to a run. These days, bank runs occur in the wholesale funding market: hence Gorton and Metrick’s influential paper about the run on repo in the 2008 crisis. These repo runs occur if wholesale funders refuse to carry on providing liquidity.

Hence a run on a CCP can happen if the CCP’s counterparties withdraw liquidity quickly, and the CCP cannot liquidate assets fast enough to keep up with the liquidity demands on it (or can only do so at great cost).

What’s different about CCPs is that this can happen in two ways.

  1. If clearing members neutralise their risk quickly, CCPs have to repay initial margin. That initial margin might have been provided as cash but invested by the CCP in securities. Therefore this kind of run – a run on IM – occurs when the CCP cannot liquidate investment assets fast enough to repay IM. CCP investment mandates are designed to reduce the risk of this happening.

    Of course, one way that this can happen is if clearing members move their risk to another CCP. If clearing member house portfolios are regularly compressed, then moving the house account may not be that difficult a matter. Hence the risk of a large clearing member moving its risk from one CCP to another clearing the same products is non-zero.

    (One could imagine this happening for instance because confidence was waning the CCP, or because the CCP’s ‘qualifying’ status was in doubt, leading to the possibility of higher capital requirements for its users.)

  2. A less obvious but equally risky run mechanism (a route for a run?) is collateral substitution. As yield curves normalise over the coming years, the incentive to hold margin in the form of securities vs. cash will change. Term securities may look more attractive, resulting in clearing members substituting securities for cash in margin accounts. This can create liquidity pressure too as the CCP has to liquidate what it has invested the cash in to refund it. There is a case in this context for limiting the speed at which clearing members can substitute non-cash for cash margin.

Time will tell if these risk vectors do indeed threaten CCPs. But until we know more, alertness to potential CCP liquidity risks is vital.

Cheap, cheap September 12, 2013 at 10:22 am

UK readers, and perhaps others (although the postage might be ugly) can get my book at 30% off the RRP, beating Amazon, here. Many thanks to Bill, author of an excellent chapter in the book on the operational aspects of clearing and owner of the OTC space for sorting this out.

The detail of the ESMA equivalence statement on the US September 4, 2013 at 2:10 pm

For real OTC geeks this, from ESMA’s Technical advice on third country regulatory equivalence under EMIR – US:

78. In addition to the legally binding requirements which are applicable at a jurisdictional level, to CCPs in the US, ESMA is aware that some CCPs authorised in the US might, on an individual basis, have adopted (or may in future adopt) internal policies, procedures, rules, models and methodologies which have the effect of subjecting the CCP to standards that are broadly equivalent to the legally binding requirements for CCPs under EMIR. The internal policies, procedures, rules, models and methodologies that some CCPs authorised in the US might, on an individual basis, have adopted, could constitute legally binding requirements for the purposes of Article 25(6) of EMIR where, (a) such internal policies, procedures, rules, models and methodologies cannot be changed without the approval or non-objection of the CFTC and/or the SEC (as relevant) and (b) any departure by the CCP from, or failure to implement, such internal policies, procedures, rules, models and methodologies can give rise to possible enforcement action…

80. Taking into account the legally binding requirements which are applicable, at a jurisdictional level, to CCPs in the US and the other legal and supervisory arrangements present in the US, ESMA advises the Commission to consider that CCPs authorised in the US do comply with legally binding requirements which are equivalent to the requirements laid down in Title IV of EMIR, where such CCPs have adopted internal policies, procedures, rules, models and methodologies that constitute legally binding requirements in accordance with the tests set out in paragraph 78 above and where they incorporate provisions which, on a holistic basis, are broadly equivalent to the legally binding requirements for CCPs under EMIR (i.e. where the internal policies,
procedures, rules, models and methodologies include provisions which, on a holistic basis, address the gaps identified in the relevant section of the detailed analysis set out at Annex III) in the following areas:

CCPs under the CFTC’s DCO regime

(1) Risk Committee requirements.
(2) Business continuity requirements.
(3) Margin requirements.
(4) Default fund requirements.
(5) Other financial resources requirements.
(6) Liquidity risk control requirements.
(7) Default waterfall requirements.
(8) Collateral requirements.
(9) Investment policy requirements.
(10) Review of models, stress testing and back testing requirements.

CCPs under the SEC regime

(1) Risk Committee requirements.
(2) Business continuity requirements.
(3) Outsourcing requirements.
(4) Segregation and portability requirements.
(5) Margin requirements.
(6) Default fund requirements (except for CAs clearing SBS).
(7) Other financial resources requirements (except for CAs clearing SBS).
(8) Liquidity risk control requirements.
(9) Default waterfall requirements.
(10) Collateral requirements.
(11) Investment policy requirements.
(12) Default procedure requirements.
(13) Review of models, stress testing and back testing requirements.

CCPs under the CFTC’s regime for SIDCOs and Opt-In DCOs

(1) Risk Committee requirements.
(2) Margin requirements.
(3) Default fund requirements.
(4) Other financial resources requirements (except when systemically important in multiple jurisdictions or involved in activities with a more complex risk profile).
(5) Default waterfall requirements.
(6) Collateral requirements.
(7) Investment policy requirements.
(8) Review of models, stress testing and back testing requirements…

ESMA advises the Commission to consider that CCPs authorised in the US are subject to effective supervision and enforcement on an on-going basis and that the legal framework of the US provides for an effective equivalent system for the recognition of CCPs authorised under third-country legal regimes. Although ESMA does note that the US authorities do not use the equivalent system on a long-term basis and ESMA highlights to the Commission that in practice the US authorities require that CCPs authorised outside of the US become subject to the direct jurisdiction of the SEC and CFTC and the application of two sets of rules. ESMA notes that this represents a departure from the third country CCP regime prescribed in EMIR.

ESMA also advises the Commission to consider that the legal and supervisory arrangements of the US ensure that CCPs authorised in the US comply with legally binding requirements which are equivalent to the requirements laid down in Title IV of EMIR in respect of CCPs that have adopted internal policies, procedures, rules, models and methodologies that constitute legally binding requirements in accordance with the tests set out in paragraph 78 above and where they incorporate provisions which, on a holisitic basis, are broadly equivalent to the legally binding requirements for CCPs under EMIR in the areas set out in paragraph 80 above.

84. On this basis, ESMA would only grant recognition to CCPs authorised in the US which have in fact adopted internal policies, procedures, rules, models and methodologies which, on a holistic basis, incorporate provisions that are broadly equivalent to the legally binding requirements for CCPs under EMIR in the specific areas identified above and where ESMA has assessed that the relevant internal policies, procedures, rules, models or methodology do constitute legally binding requirements in accordance with the tests set out in paragraph 78 above.

Estimating the riskiness of OTC derivatives CCPs August 19, 2013 at 1:39 pm

There’s a post on the CDO pricing methodology for estimating OTC derivatives CCP riskiness over on the RegTech blog here. Regular DEM readers won’t find anything new – we just outline how to think of a CCP as a CDO, with collateral assets the derivatives receivables and tranches corresponding to the various amounts in the CCP’s default waterfall.

CDS futures? August 16, 2013 at 6:53 am

Seth Berlin has a useful summary of the potential advantages and disadvantages of CDS futures over at the OTC space. I particularly like his characterisation of a tipping point which, if reached, could result in an avalanche of liquidity – or if not reached, would result in the futures sliding into irrelevance. We’ll see.

Not yelling fire August 13, 2013 at 8:13 pm

Bloomberg has a story which might be considered alarmist on a new CPSS-IOSCO consultative report (so not policy) which considers the usefulness of IM haircutting as a CCP loss mitigation tool. It’s worth quoting the full paragraph for context:

Initial margin is likely to constitute a very large pool of assets which would, if it can be used, provide a high degree of loss-absorbency. This loss-absorbency might be considered by market participants as contributing to a robust clearing system. The tool might be considered as effective, since it uses resources in the control of the CCP rather than relying on participants to meet a cash call by the CCP. Since the size of the loss faced by a participant would be capped at the size of their initial margin, this would not be an uncapped or uncontrollable exposure and participants would be able to determine their maximum loss from the use of this tool. This combination of effectiveness and high degree of loss
absorbency could provide important incentives for participation in CCPs that include this tool in their recovery plans, helping the realisation of the G20 goal of expanding clearing of standardised swaps.

How Bloomberg gets from that to ‘Derivatives traders should be prepared to lose the initial margin they post at clearinghouses’ isn’t clear to me.

How mutual should a CCP be? August 12, 2013 at 4:17 pm

The RegTechFS blog has a post of mine highlighting one of the questions Edwin and I ask in chapter 9 of the book: how mutual should a CCP’s default waterfall be? There isn’t a right answer here, but a range of possible solutions, some of which might be explored in ‘second generation’ CCPs. (CCP, the next generation: is there a bald Shakespearean Actor in the house?) Go on over to RegTechFS for the summary, or buy the book for the full argument and so much more besides (well, the Pet Shops boys and Beowulf, anyway).

The book is out August 9, 2013 at 1:22 pm

I can finally confirm that the book has appeared. OTC Derivatives, Bilateral Trading and Central Clearing was published yesterday, and I have a copy in my hands.

The link is here. say that US publication is 4th September, so I am guessing that the books are chugging their way across the Atlantic now: the link is here. Get that rare unsigned copy while you can…

Sun on wood

(PS I love the re-seller market. There are apparently 3 used copies available for a tenner more than the new price on the day of publication. Mind you, if that was the only screwed up thing about the market in books, I’d be very happy.)

A summer daydream, part 2 August 1, 2013 at 6:44 am

When Alice looked up, the White Rabbit had returned.

‘This is a very strange regulation’, said Alice.

‘Not at all,’ replied the Rabbit, ‘it is necessary for financial stability. Too many CCPs are considering interoperation. Why only the other day the Ruritanian equity derivatives CCP proposed an interoperation agreement with the Atlantis credit derivatives CCP, the better to support capital structure arbitrage hedge funds. If we let this kind of thing happen, who knows what kind of economic efficiency might result. CCPs are such a good idea we need to impose a CCP for CCPs.’

‘So a CCPCCP…’ mused Alice.

‘…is a CCP that only clears intra-CCP transactions, yes, do keep up’, said the White Rabbit. ‘Their use will be mandatory in Wonderland from 2014. CCPs will have to post margin to their CCPCCP, and in return the CCPCCP will guarantee intra-CCP trades. It’s a huge boon you know.’

‘To who?’ asked Alice.

‘Why to the financial system, of course,’ replied the White Rabbit. ‘Taking trillions of dollars of derivatives out of well-capitalised banks and putting them into CCPs was so successful that we had to repeat the idea. So we’re taking most of the exposure out of CCPs and putting it into CCPCCPs with wafer-thin amounts of capital. What could possibly go wrong?’

‘Dear, dear! How queer everything is to-day! And yesterday things went on just as usual. I wonder if the financial system has been changed in the night?’ said Alice.

‘I don’t know what you mean I’m sure’ said the White Rabbit snatching up his regulation and walking off.

Suddenly, as if from far away, she heard a new voice.

‘Wake up, Alice dear!’ said her boss; ‘Why, what a long sleep you’ve had!’

‘Oh, I’ve had such a curious dream!’ said Alice, and she told her boss, as well as she could remember them, all these strange Adventures of hers that you have just been reading about; and when she had finished, her boss had a strange gleam in his eye, and said, ‘It WAS a curious and suggestive dream, Alice, certainly: but now run in to your meeting; it’s getting late.’ So Alice got up and ran off, thinking while she ran, as well she might, what a peculiar dream it had been.

DEM is now on summer break: we will return at some point later in August.