Derivatives as a Financial Crisis Accelerator

Following links a few days ago led me to a fascinating journal article by Professor Mark Roe of Harvard Law School.  He suggests that the preferential treatment of OTC derivatives and repo collateral transfers in advance of bankruptcy skews incentives to make the financial system much more leveraged and more risky than it would be otherwise.  The top dealers - who have the best overall view of asset portfolios, trading positions and debt structures - can secure cash and assets to themselves through collateralisation, and even fraudulent over-collateralisation, without any risk of challenge in the ensuing bankruptcy.  As a result, they finance much higher levels of systemic leverage and write many more OTC derivatives than they would if they had to actually worry about counterparty failure.  And the failed companies themselves are left with much less of value to satisfy other claimants (employees, pensioners, trade creditors and the government) or to attract investors that might resuccitate the failed firm.  Because repos and OTC derivatives are bilateral and not reported, it is impossible for other creditors of a firm to monitor the exposure of the firm or the pre-insovlency transfers of assets through margin calls to the preferred secured creditors.  The result is that the market economy becomes progressively less transparent, less resilient and less equitable.

Professor Roe's observation is worth seriously evaluating as it accords very nearly with what we have observed in the five years of financial crisis.  It also helps explain why the crisis stubbornly persists in the face of extraordinary fiscal and monetary policies.  Assets are transferred pre-insolvency to preferred repo and OTC derivatives creditors.  (In the case of Lehman Brothers International, the global market liquidations started in March 2008 as available assets - including customer assets - were liquidated globally to make progressively more demanding margin calls to a handful of preferred creditors.)  Losses are socialised to investors, trade creditors, pensioners and taxpayers, while the dominant global banks continue to record healthy profits.  Investors shy from taking on failed firms as they have in previous downturns, because too little is left worth salvaging.

It may be the situation is still getting worse, rather than better.  In the recent failures of Bear Stearns, AIG, Lehman and MF Global, the failures actually reinforced the dominance of the top incumbents and further concentrate dealing, custody and collateral to these same firms.  They have more market power today than ever, and better vantage should they choose to game the system.

Besides indicting the preferences of the Bankruptcy Code reforms, Professor Roe also suggests that the move toward central counterparty clearing will not improve the situation as hoped.  His objections include:

• Poor incentives in exchanges and clearing houses to manage risk as they are competitive and owned by the dominant incumbents;
• Clearing house margining of many OTC derivatives will not fully address credit risk as past experience indicates that many transactions look just fine right up until default is recognised - "jump to default" risk;
• The risks netted in a clearing house are only netted among direct clearing members, resulting in reallocation of the risks to those outside the circle of direct clearing members while concentrating assets in the hands of fewer and fewer dominant players;
• Clearing houses "up the ante" on Too Big To Fail by themselves being too big to fail, and concentrating liquidity and assets in the hands of clearing members and settlement banks.

I'd like to believe the work we are undertaking as an industry to implement CCPs will prove risk reducing, making the financial system stronger and more resilient.  But I also believed the same thing when I helped repeal Glass-Steagall and promoted OTC derivatives in my early career as a regulator.  I believed the same thing when I was involved in driving forward the harmonisation of laws on securities ownership, transfer and pledging globally.  I sincerely believed that deregulation and harmonisation would make the world a safer place for capitalism. Legal certainty of transaction enforceability grows markets, and our success in gaining legal recognition of repo, derivatives and their collateral arrangements underpinned the massive global growth in repo and OTC derivatives dealing that defines today's markets.

But capitalism requires risk if capital is to be allocated efficiently.  If the dominant players in the game never lose, because they can always allocate losses to others at the table, then that isn't really capitalism anymore.  The result will be consistent misallocation of capital and inequitable returns to firms that do not contribute to the overall social welfare and economic prosperity.  In a nutshell, this is what the Occupation movement objects to about the current system.

At its core, an economy requires wages be paid for there to be sustainable wealth creation.  As wages grow, so does broader prosperity.  Industries that create jobs and pay more and higher wages to more people contribute more to the greater social good.  Industries that are insensitive to the destruction of jobs, stagnation of wages and deflation of private wealth are bad for society.

Professor Roe suggests that reforms to bankruptcy laws that removed the risk of loss for repo and OTC derivatives counterparties went too far.  The small cohort of repo creditors and OTC derivatives counterparties that dominate global markets became insensitive to the business rationale or commercial prospects of their counterparties so long as they gained possession of enough quality assets as collateral to comfortably cover any credit risk.  Something is clearly wrong in a system where the dominant incumbents never lose while most of us become progressively more exposed to unemployment, pension devaluation, higher taxes and economic insecurity.

Bankruptcy law usually tells the end of a story.  If Professor Roe is right, we might consider whether the bankruptcy preferences created by a generation of visionary capital markets lawyers are somewhere near the beginning of the story of today's global financial crisis.

Initial Margin: Theory and Practice

The news that the CME CCP will be accepting corporate bonds and that LCH-Clearnet will accept RMBS for initial margin has me thinking about the dangers of demutualisation of clearing houses.  Managements of shareholder owned clearing houses are keen to compete for market share and volume to increase revenues, bonuses and profits (not necessarily in that order).  The interests of their members (and of central banks and taxpayers who may be asked for bailouts) may require more prudence than managements might prefer.

No where is the tension more obvious than in the scope of assets accepted for initial margin.  It is worth remembering that clearing houses only take very short term risk.  One day risk is normal for exchange traded derivatives.  A default will be determined, positions liquidated and final settlement of initial and variation margin made on the same day.  Several days to several weeks risk might be more sensible for OTC derivatives which are less liquid and more difficult to price quickly among a small cadre of dealing firms.

The initial margin the clearing house takes from each member is intended to cover the liquidation costs to the clearing house of disposing of the member's open positions at the time of a default.  As markets come under stress when members default, and members default when markets come under stress, it is quite likely that the clearing house will be closing out positions and liquidating initial margin assets into stressed markets.  The assets taken as initial margin should be of a quality that they are cash equivalent - traded in liquid markets where they can be disposed of for cash as and when the clearing house needs it.

For that reason it has been best practice for clearing houses to only take cash and very liquid government securities as initial margin.  Cash and government securities tend to be counter-cyclical assets in stressed markets, gaining value from their superior credit quality, liquidity and price transparency.  Corporate bonds and RMBS may be valuable assets, but we have seen that prices collapse and market liquidity evaporates under stress conditions.  They are pro-cyclical assets, and the very act of CCP liquidation will further stress already stressed markets against the CCP realising the value it might have projected before the default.

I'm sure that the risk committees at the CCPs are aware of all this, and that there are prudential limits and generous haircuts on the use of either corporate bonds or RMBS as initial margin in their rules.  It still makes me nervous that pro-cyclical assets will be eligible as initial margin.  Rules will tend to be relaxed and exceptions become more normative as markets become complacent and competition intensifies.

The IMF is projecting a huge shortfall in quality, liquid assets driven by record balance sheet encumbrance of banks forced to secured lending markets, immobilisation of collateral assets in margin and CCPs, and downgrading of assets which were once thought quality but now are looking worse and worse.  If clearing houses begin to compete on the scope of accepted initial margin, that will increase the risks already concentrated in the CCPs.

Members who must backstop the capital and default guarantee fund of each clearing house should be paying attention.  So should the central banks that will have to backstop liquidity for a CCP.  And so should treasuries - and behind them taxpayers - who may end up having to recapitalise or bailout a troubled CCP.

There was a reason that market infrastructure was run on mutual principles of membership for most of the last three hundred years.  It concentrated minds on risk management for the longer term - over the business cycle rather than the bonus cycle.