Pins before bubbles June 6, 2011 at 1:47 pm

This is a tale of two links. The first is from the BIS quarterly here. In it, Daniel Heller and Nicholas Vause highlight the current state of OTC derivatives clearing:

At present, central clearing covers approximately 50% of the $400 trillion of outstanding interest rate swaps (IRS), 20–30% of the $2.5 trillion of outstanding commodity derivatives and a little under 10% of the $30 trillion of outstanding credit default swaps (CDS).

They then discuss where this train is going:

We estimate the financial resources that two separate CCPs operating in different derivatives markets and their dealer members would need
if central clearing were expanded in a prudent way to cover the full volume of
IRS and CDS held by the major derivatives dealers… A five-day sequence of large variation margin calls that could be expected with a probability of one in 200 would equate to around 28% of current cash and cash equivalents [for the G14 dealers] in the worst case.

In other words, just as Basel III is requiring banks to hoard more cash and near-cash equivalents to meet its liquidity requirements, so central clearing is posing a risk of large cash outflows. A five day sequence of margin calls could take out nearly a third of the cash in the banking system. And that is not an especially improbably event.

Now all of this would be bad enough if the only effect of CCPs was to suck down liquidity. But they also have credit risk. As Paul Tucker points out in a recent speech:

If CCPs can do a lot of good by simplifying the network of counterparty exposures and imposing standard valuations and margin requirements, conversely it is an understatement that it would be a disaster if a clearing house failed. Commentators have, indeed, been emphasising that CCPs are becoming systemic. To my own way of thinking, they have already been systemic for the markets they clear for a very long time… a clear ex ante framework is needed for limiting disorder if … a CCP does in fact fail.

So we have created systemic institutions with no resolution framework which can create massively procyclical effects in the financial system. And this was done to increase financial stability? Um…

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