The systematic risks of OTC derivatives clearing October 20, 2011 at 10:18 am

An updated draft of my note can be found here. There are two health warnings: First, I had a hard 5,000 word limit, so it’s a little terse in places, especially if you aren’t sad enough to have spent time on OTC derivatives clearing in the past. And second, this is a draft, so I make no promises about what the final version will say… That said, any comments would be much appreciated.

6 Responses to “The systematic risks of OTC derivatives clearing”

  1. […] draft paper from Deus Ex Macchiato here, not yet for […]

  2. David,

    Excellent paper, I marked up the PDF with some small corrections which I could send if I had an email address for you – just missing letters.

    Page 4, footnote 4: the netting you refer to is of portfolio risk rather than netting or compression of the trades themselves, clarification? Also the wording towards the end of the sentence is broken.

    Page 6, 3.2: Is it always true that less margin is safer? Could it be that a portfolio with balanced risk offsets generates lower IM anyway – what you really mean is that the output of a risk model for the same portfolio can produce varying IM requirements, and that the fundamental modelling needs examination – rather than inferring that less margin is always bad.

    One material point, on page 8, footnote 14 – SwapClear has a ratings based multiplier for IM – if you get downgraded, from memory, the multiplier goes 10%, 50%, 100%, 200% then they are politely ejected. You could ask LCH for the facts.

    Should the regulatory regime for a CCP be much more intrusive than for a bank – given they stand at the confluence of so much ‘risk’ – requiring much closer examination of all aspects of their economic and operational activity.


  3. David,
    While I do not per se disagree with the conclusions of your paper, I see a different direction to solve this problem. Rather then moving OTC clearing to CCP’s, I’d be in favour of standardizing OTC products into exchange traded products. This will make pricing and trading AND clearing of these type of products (for example CDS) far more transparent then they are right now. I’m curious to understand why you do not explore this solution in the paper?

  4. David,

    I have some difficulty with section 4.2 (operational risk). You state “Any entity which turns over hundreds of trillions of dollars of transactions or which manages tens of billions of dollars of investments has substantial operational risk.”.

    Working as an OpRisk modeler for one of those transaction based entities (although on the settlement side), I think you’d be surprised at how low those requirements might end up. Main point is one of liability: under normal circumstances, these type of companies are not liable for second round effects (cascade effects of missing one trade may have an impact on several other trades using the same security). They’re only liable for the delay of execution of the one impacted trade – which usually results in an interest rate driven loss. At the moment, your $500 Mn can cover up to 36000 times that amount (assuming 1% interest rate on 360 days, one day delay in execution) – i.e. $18.000 Billion. I don’t know many trading desks allowed that size of trade.

    The main problem in these kind of transaction based systems is that while an operational error (of any kind) will most likely not have a big impact on the entity itself, it might trigger a credit event on one of its clients (given the amounts involved quickly leading to a liquidity problem). But under Basel II regulations, this is part of the risks taken by the CCP client, not the CCP in itself.

    And that brings us to the core of the issue: when dealing with a systemic institution, we probably want that institution to be well protected, but you’d want also the clients to be extra protected, as a default of that systemic institution may be far worse (with more unexpected side-effects) than the default of another ‘normal’ counterpart. Many banks/traders would do well to check the smallprint to see who’s liable for what in case the CCP defaults and add some capital against that…

  5. Bill – Many thanks for that, especially the swapclear clarification, which was news to me. Re ‘Is it always true that less margin is safer?’, what I mean precisely is that if CCP A offers IM which is always 1/2 that of CCP B, and is otherwise identical to it (rule book etc.), then A is less safe than B.

    Lawrence – What can be standarized pretty much has been. What remains often serves a genuine risk management need. (Implementing a big corporates multi ccy FX and IR hedge using vanilla instruments is typically impossible.) Moreover, given exchanges are often not that safe, why move the risk from big, well capitalized (mostly) banks to small, less well capitalized exchanges which act as concentrated points of failure?

    Hans – I agree with nearly all of what you write, and appreciate the quantitative input. The OR events I was thinking of (e.g. rogue trader in treasury) are somewhere between v. difficult and impossible to model, and probably wouldn’t, to be fair, contribute to OR capital. That’s why I put in the $2B minimum equity requirements – to act as a backstop to OR models not capturing the tail of the OR loss distribution well. You definitely have a good point about CCPs putting the risk back to the clearing members…

  6. >>why move the risk from big, well capitalized (mostly) banks to small, less well capitalized exchanges?

    David — Isn’t it the clearing house capitaliztion that matters instead of the exchange? And surely the concept of well capitalized banks is a bit of a contradictio in terminis these days! Furthermore, why not let the market decide whether it is possible to hedge corporate FX and IR exposure through plain vanilla instruments? I like to think Eurodollar futures have been very succesfull products, why wouldn’t the same be possible for exchange traded IR swaps?
    Maybe the real argument here is that vanilla products will be more transparently and efficiently priced on a public market, resulting in lower hedging/trading costs for end user and (yes) lower profit margins for liquidity providers (ie banks).