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… 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.


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