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28 February 2019

John Dizard: A clearing house crisis will pose a particular threat to Europe

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The author offers a suggestion for how "the banking system (including grandma’s money) will be called on to participate in the next set of massive “gambling” losses. There are many indications that those losses will have the most serious effect in Europe."

[...] Actually, Ms Warren and her fellow reformers of the global financial system helped create the next big opportunity when they used the Dodd-Frank law to push derivatives (usually “risky derivatives” or “gambling”) off bank balance sheets and into standardised forms which require collateral to secure holders against loss of principal. These are now mainly traded through market clearing houses, or central counterparties.

The same reform push swept through Europe. Great. Problem solved. New problems created. Along with financial derivatives reforms, central banks sedated risk markets, in part by buying large amounts of high quality liquid assets. That meant market participants became accustomed to a long period of lower volatility, and that the liquid assets that would be needed as collateral for cleared derivatives would be locked up in central banks.

The reformers and politicians could congratulate themselves for recapitalising banks and making sure that risky assets were not directly underwritten by that money of grandma’s that was in deposit accounts.

Rather, grandma had been persuaded to put her money with asset managers. They promised her a sad little premium of a few basis points in return for giving up the state guarantee. They did, though, have to ensure that premium with interest rate and currency hedges cleared through CCPs.

By now, everyone knows that if a bank gets into trouble, the taxpayers of its home country will wind up having to put new money into the bank’s capital structure to keep the system working. No one likes that but at least it is a plan.

If, on the other hand, a large CCP fails, and there are trillions of interest rate or currency derivatives gushing through a “waterfall” of losses, the path to resolution — that is, reorganisation — of that CCP is not clear. Such an event is most likely to happen where there is some ambiguity between national and multinational regulation of CCPs, as is the case in Europe.

As one official clearing expert says: “Nobody has any appetite to put closure on this question of resolution.” There are technical fixes to how losses in a capital-light CCP could be allocated, such as what is called variation margin gains haircutting, which means those who made money on trades must give up some of those profits to bail out the clearing system as a whole. Our expert says: “The big buyside firms don’t want VMGH because they might be the ones who get the haircut.”

There are periodic cries for help from the geeks inside multilateral financial institutions. These come about every six to nine months in the form of academic journal articles published at places such as the IMF or the Bank for International Settlements. The most recent of these was a December article published by the BIS called “Clearing risks in OTC derivatives markets: the CCP-bank nexus”. CCP-bank nexus?

Squabbling counterparties in a failed CCP may not agree on haircuts. Only limited capital calls on clearing members, ie, bank shareholders, are possible. Then the taxpayers are hit. Grandma loses, either on her asset managers’ statements or on her tax bill.

At least in the US, the Dodd-Frank law as amended has section 13-3, which allows for Federal Reserve/Treasury support of what is known as “market plumbing” if at least five non-banks support an application. In the circumstances, people at bailed-out institutions can expect Inquisition-like punishment but at least there is a plan.

Not quite so in Europe, which, as another multilateral clearing expert says, “is the land of moral hazard”. Just to make a European liquidity crisis more challenging, there seems to already be a shortage of high-quality liquid assets that represent collateral of the sort that will be required in carloads in the event of a real financial crisis.

According to an IMF paper last October by Dermot Turing and Manmohan Singh, “ . . . in Europe HQLA may remain in short supply (although asset purchases will soon stop), the opposite is true in the US.” The title of the paper, “The morning after: the impact on collateral supply after a major default”, apparently is meant to be taken as a warning. [...]

Full article on Financial Times (subscription required)

© Financial Times

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