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.

2 Responses to “Increasing credit risk, um, increases credit risk (clearing edition)”

  1. The point Craig made that the 99%+ confidence level on IM means that the mutalisation of losses is a rare event is worth noting too.

  2. Yeah, that’s fair. It does as Craig hints rather wreck the argument (which I have been guilty of too, mea culpa) that mutualisation means that there is no incentive for counterparty due diligence.