Are CCPs Increasing Risks? Part I

The title of this post is the title of a debate being hosted Post-Trade Forum next month:

Post Trade operational risk: Are Clearing Houses increasing risks?

Gary Wright of B.I.S.S. Research has kindly asked me to give the key note.  I'm also on a panel next week at the RISK Annual Summit on Collateral Trends for Corporates which will cover some of the same ground.

In reflecting on the topic I realised that I have been studying the risk mitigation implications of swaps clearing for nearly 25 years, since the very first swap clearing house was proposed by the Board of Trade Clearing Corporation in the late 1980s while I was on the Settlement Systems Studies Group at the Federal Reserve Bank of New York.  I was co-inventor of the first global, real-time, ISDA-CSA compliant OTC derivatives margin system for Clearstream in the late 1990s.  I've written and thought about the clearing and margining of OTC derivatives for longer than almost any of my contemporaries.

So here's Part 1 of what I'm going to say about the risks of CCPs being rolled out globally later this year:

1. As someone who has supervised and built clearing and settlement systems for a long, long time, let me first observe that the single surest sign of system failure is pre-mature specification before the requirements and regulations are complete.  This always leads to cost overruns, delays and often complete abandonment of a half-completed system.  Since complete regulations have yet to issue in US, UK, EU and Asia, and since all these regulations will be inconsistent to some degree, the risks of project problems for CCPs are very high.  (Disclosure: Granularity has a great track record of problem project remediation so I consider this potentially good for business.)
   
2. CCP clearing will become mandatory for all "standardised" OTC derivatives.  One of the things that isn't yet defined is what "standardised" means in OTC derivatives.  In the broad array of financial instruments where two parties exchange cash flows based on fluctuations in reference indicators, the contract terms which must be common or configurable to be standard has never been completely described.  While standardisation has progressed quite a bit in the last decade with ISDA standard agreements and FpML, especially for products that are designed to clear through Swapclear and other facilities, there is a long way to go in establishing certainty as to which products must and can't be CCP cleared.  A side note to make here is that the regulators will try to force more standardisation by requiring bilateral exchange of intial margin for all swaps dealers and unilateral initial margin for end users for all instruments not cleared through a CCP.  The pressures both ways should create some interesting chaos as the industry grapples with a changed cost base, collateral demands, CSA amendments, tri-party collateral facilities, and CCP integration.  It should be noted that an end user will have increased exposure to his bank/counterparty for any initial margin provided in the event of the bank/counterparty's default, unless a tri-party agent is used for custody.
   
3. CCPs will have to provide daily valuations of cleared derivative instruments and portfolios in calculating variation margin.  This is not as straightforward as it sounds as there is a diversity across the industry in the modelling of valuations for OTC derivatives.  There is scope for some serious game playing in seeking advantage in steering the portfolio valuation methodology toward more accommodative models, especially as liquidity tightens or volatility increases.  Given that there has been tremendous concentration in the ownership of demutualised clearing houses in the past decade, there is a serious risk that owners/incumbents that dominate OTC dealing and clearing house risk committees could rig the system to their benefit.  Perhaps I'm being cynical in thinking this would ever occur to them, but let's face it, fiduciaries are harder to find than predators in the current market climate.
   
   On the operational side, daily valuations of OTC derivatives portfolios are standard for all financial institutions regulated under Basel Capital Accord principles, and for many investment banks who need to tightly manage their treasury operations.  Daily valuations are not standard for a very broad swathe of hedge fund, institutional and corporate counterparties, some of whom have very modest means and very few OTC derivatives.  Many businesses were forced by their banks to take interest rate swaps as part of a commercial loan origination.  These end-users are not going to benefit from CCP clearing as there will be little scope for netting gains and/or little improvement in their risk profile from CCP credit interposition relative to their bank. 
   
4. Besides the portfolio, the CCPs will have to provide daily valuation of collateral.  One of the challenges in building the Global Credit Support Service in the late 1990s was providing the valuation methodology for 54 currencies and over 180,000 securities in a manner which would allow the users to have real-time transparency of margin positions.  While systems have come a long way since then, collateral valuation remains a non-trivial challenge, not least because few models accurately capture the volatility and liquidity conditions which follow a default.  Because valuation is difficult, particularly for less liquid securities and currencies, the CCPs will tend to require high quality assets as initial margin.  Even there, we have seen huge volatility for sovereign debt in the past few years, and there is little sign that this will diminish going forward.  If a CCP is too restrictive on initial margin assets, it will be difficult to attract users, so there will be pressure to take lower quality assets at more generous valuations. 
   
5. Variation margin must be paid in the currency of the underlying swap obligation.  This sounds straightforward, but will prove an operational nightmare.  The practical implication is many times more payment confirmations to be reconciled in many more currencies.  Instead of one net payment in one currency, counterparties will have to track, confirm and reconcile payments in a range of currencies.  The costs and complexity will probably drive renegotiation of many existing derivatives to reduce the operations costs and burden.
   
6. The CCP drive comes in parallel with an initiative to standardise reference data, and in particular Legal Entity Identifiers (LEIs).  The standard has yet to issue though expected in June, so the CFTC is now proposing that US-based CCPs use a CFTC Interim Counterparty Identifier (CICI).  This may sound a small thing, but believe me the standardisation of reference data is a major headache. If it were an easy thing to do, it would have been done decades ago.  While I'm generally in favour of LEIs, the tight time frame for implementing such a radical reform which must then be integrated into multiple existing and new systems to accurately ensure mapping across internal and external reference data is a major technology and operations challenge. 
   
7. Finally (for this installment), CCPs will be subject to supervisor stress testing and scrutiny of Default Guarantee Fund arrangements.  It is expected that owners/members of the CCP will have to absorb some contingent liability for CCP losses as an alternative to the massive capitalisation that would otherwise be required to cover difficult to measure losses on OTC derivative portfolio defaults under stress conditions.  Again this is an area where regulators have yet to provide a detailed picture of what they want or what they will expect or what they will accept as sufficient.  The capital and liability-sharing arrangements will have implications for members as well as CCPs, so could become an element in CCP evaluation and competition. 

More to follow!