360° Coverage : It's Not Just Banks That Are Too Big To Fail

2 Updates

It's Not Just Banks That Are Too Big To Fail

Apr 30 2014, 9:17pm CDT | by

Following the financial crisis, worries about failures in over-the-counter (OTC) derivatives trading causing destabilizing runs and market crashes have led regulators to force most OTC trades to be...

Filed under: news

 
 
 

24 weeks ago

It's Not Just Banks That Are Too Big To Fail

Apr 30 2014, 9:17pm CDT | by

Following the financial crisis, worries about failures in over-the-counter (OTC) derivatives trading causing destabilizing runs and market crashes have led regulators to force most OTC trades to be cleared through central counterparties (CCPs). CCPs act like clearing banks, taking on their own books the risk of the seller defaulting. Sellers clearing OTC trades through a CCP can (in theory) default on payment without risking the entire system unravelling.

But this creates a problem. What happens if a CCP fails? Of course, the way CCP-cleared OTC trades are structured should minimize this risk. CCPs require sellers to post initial margin in the form of cash or government bonds to cover expected volatility during the lifetime of the trade, and they also require posting of variation margin in cash to cover daily price movements. As everything is fully margined in liquid safe assets, there should in theory be no shortfalls and no defaults.

But…..cash margin requirements don’t necessarily make the system safer. Firms with largely illiquid balance sheets, such as large insurance companies, can have difficulty raising the cash to meet large increases in variation margin. The principal cause of the failure of AIG in 2008 was cash margin calls on OTC credit default swaps that it was unable to meet. And this brings me back to the question – what happens if a CCP fails? Yes, a large insurance company unable to meet cash margin calls could perhaps be allowed to fail safely. But that doesn’t solve the CCP’s problem. If margin isn’t posted and the seller defaults, the CCP itself is at risk of failure – and that could have disastrous effects across wide swathes of the market. Far from making the system safer, clearing all OTC trades through CCPs could actually make it riskier.

When a CCP is placed at risk by a large seller defaulting on a trade for which it has failed to post margin – a scenario which is not as unlikely as it sounds – the CCP may call in resources from other CCP member firms of the CCP. This is called a “default waterfall” model and is not unlike the system whereby claims on deposit insurance when a bank fails are met from levies on the surviving banks. In the case of CCPs (and increasingly for bank deposit insurance, too) the levy is charged in advance and goes to create a “default fund”.

Regulators have also insisted that CCPs must have their own capital buffers to absorb losses due to member firm default.

But even this may not be enough. The scale of AIG’s losses, for example, would quickly have drained any default fund and wiped out most CCPs’ capital. In 2013, therefore, the Bank of England produced a paper discussing alternatives for resolving failed CCPs. In this paper, for the first time, the possibility of the buy-side sharing in the losses of a failed CCP was raised.

On the face of it, this seems wholly unreasonable. If a sell-side firm defaults, why should buy-side firms not involved in the trade take losses? The whole point of a CCP is to avoid generalised losses across the whole industry. This seems like a dilution of the purpose of CCPs.

And yet Risk magazine reports (paywall) that two asset management firms, Blackrock and Citadel, have endorsed the idea that the buy-side should share CCP losses, perhaps by taking a haircut on margin payments to them from the CCP – which was one of the suggestions in the Bank of England paper. The firms say that it is unreasonable for clients in CCP-cleared OTC trades to expect to bear no counterparty risk:

Taking the risk away completely could itself be dangerous, argued Athanassios Diplas, senior advisor to the board of the International Swaps and Derivatives Association and principal of Diplas Advisors. He said a government backstop for CCPs would present a moral hazard, allowing people to behave improperly with the guarantee that they will be bailed out in the case of a default. For this reason, Citadel’s Mazzella emphasised any backstop should come after all other market participants had taken some share of the losses.

“I do think we should have some skin in the game and that should come before any government backstop,” he said.

So CCP clearing with cash margin creates a form of moral hazard similar to that created by deposit insurance and implicit government guarantees in banking.

Mazilla’s suggestion that buy-side firms should accept haircuts to prevent a CCP failing, and that government bailout should be absolutely the last resort, is not unlike the EU’s European Bank Resolution Directive, which will formally endorse large depositor haircuts ahead of government bailout of banks. But this raises an interesting point.

Not all counterparties to OTC trades are too big to fail – indeed it is probably true to say that the majority are not. But CCPs are unquestionably too big to fail. In seeking to end “too big to fail” in OTC derivatives trading, we may actually have made the problem worse.

 
Update
2

7 weeks ago

Khazanah throws MAS RM6b lifeline

Aug 29 2014 5:01pm CDT | Source: Business Times Singapore

August 30, 2014 1:15 AMKHAZANAH Nasional will inject RM6 billion (SS$2.4 billion) over three years to resuscitate loss-making Malaysia Airlines (MAS) under a recovery plan that includes even an Act of Parliament. Other key moves are migrating its operations, assets and liabilities to a new company (NewCo) and slashing the workforce of 20,000 ...
Source: Business Times Singapore   Full article at: Business Times Singapore
 

 
Update
1

7 weeks ago

MAS posts loss of RM307m for Q2

Aug 28 2014 5:00pm CDT | Source: Business Times Singapore

August 29, 2014 1:13 AMMALAYSIA Airlines (MAS) registered a loss of RM307 million (S$122 million) for the second quarter to end-June, but warned of worse to come in the second half when the "full financial impact of the double tragedies of ...
Source: Business Times Singapore   Full article at: Business Times Singapore
 

 

Don't miss ...

 

<a href="/latest_stories/all/all/30" rel="author">Forbes</a>
Forbes is among the most trusted resources for the world's business and investment leaders, providing them the uncompromising commentary, concise analysis, relevant tools and real-time reporting they need to succeed at work, profit from investing and have fun with the rewards of winning.

 

blog comments powered by Disqus

Latest stories

Indian-origin student named America's Top Young Scientist
Washington, Oct 22 (IANS) Sahil Doshi, a 14-year-old Indian-American student has won the 2014 Discovery Education 3M Young Scientist Challenge for his innovative, eco-friendly battery design that could help lower harmful greenhouse gases.
 
 
Clashes between locals, Ebola team in Sierra Leone, curfew imposed
Freetown, Oct 22 (IANS) A mid-day curfew was imposed in the city of Kono in eastern Sierra Leone after two people were killed in a conflict between local residents and an Ebola team which tried to take a suspected patient for testing, media reported.
 
 
Indians in Gambia contribute to fight against Ebola (Lead, superseding earlier story)
Dakar (Senegal), Oct 22 (IANS) The Indian community in the West African nation of Gambia, has provided 865,000 dalasis ($20,567) to that country's government to boost preparatory strategy against the Ebola virus disease, a gesture that has been highly appreciated.
 
 
Nepal ministries monitor 'third worst airport'
Kathmandu, Oct 22 (IANS) Five Nepalese ministries Wednesday decided to monitor the country's only international airport after it was ranked as the world's third worst airport by a famous travel website, saying the airport resembled a "bus station in an impoverished neighbourhood".
 
 
 

Latest from the Network

European Champions League standings
Paris, Oct 22 (IANS) Following are the European Champions League standings for Groups E to H after Tuesday's matches (tabulated under matches played, won, drawn, lost, goals for, against, points), according to Xinhua...
Read more on Sport Balla
 
Rogerio set to break Giggs world record
Rio de Janeiro, Oct 22 (IANS) Sao Paulo goalkeeper Rogerio Ceni is one victory away from earning his fourth Guinness World Record by eclipsing a mark held by Manchester United legend Ryan Giggs. The 41-year-old will...
Read more on Sport Balla
 
Ryan Reynolds can't keep his hands off Blake Lively
Ryan Reynolds was ''really sweet'' to Blake Lively at the Angel City Ball. The couple, who got married in September 2012, made their first red carpet appearance together in New York City on Monday night (10.20.14) since...
Read more on Celebrity Balla
 
Kris Jenner doesn't know who Bruce Jenner is dating
Kris Jenner has ''no idea'' whether Bruce Jenner is dating her best friend. The 58-year-old reality TV star, who split from the Olympic gold medallist last October after 23 years of marriage, claims she doesn't know if...
Read more on Celebrity Balla
 
When Rihanna dressed like 'Harry Potter'
New York, Oct 22 (IANS) Singer Rihanna was spotted here in a Harry Potter style costume. She wore the wizard-like get-up while heading for a business meal here Monday, reports mirror.co.uk. The 26-year-old combined a...
Read more on Celebrity Balla
 
Germany raises humanitarian aid to Iraq
Berlin, Oct 22 (IANS) Germany has pledged a further 20 million euros (about 25.5 million dollars) in humanitarian aid to Iraq, the foreign ministry said in a statement Tuesday. The additional funds are immediately...
Read more on Politics Balla
 
India calls on Israel, Palestine to resume peace process
United Nations, Oct 22 (IANS) India has called upon Israelis and Palestinians to resume the peace process as "dialogue remains the only viable option" to address the issues confronting the region. In a brief statement...
Read more on Politics Balla
 
Airstrikes help ground forces fight IS: Pentagon
Washington, Oct 22 (IANS) Kurdish forces are in control of the majority of the Syrian city of Kobane despite efforts by the Islamic State (IS) to take the town, a spokesperson for US defence department said Tuesday....
Read more on Politics Balla
 
Palestine, Israel urged at UN to halt unilateral initiatives
United Nations, Oct 22 (IANS) UN Secretary-General Ban Ki- moon Tuesday called on Palestine and Israel to overcome differences and halt unilateral initiatives that fuel mistrust, so as to pursue long-term stability in...
Read more on Politics Balla
 
China urges Israel to create conditions for peace
United Nations, Oct 22 (IANS) Chinese government has called on Israel to create necessary conditions for the resumption of peace talks with Palestine. At an open debate of the Security Council on the situation of the...
Read more on Politics Balla