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

 
 
 

20 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

2 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 by 30 p ...
Source: Business Times Singapore   Full article at: Business Times Singapore
 

 
Update
1

3 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 MH370 and MH17" hits home. ...
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

Ebola hit countries to lose $809 million by 2015: World Bank
This projected loss will be the medium-term impact of the outbreak of the Ebola Virus Disease (EVD) on these countries, Xinhua reported.
 
 
Russian food ban deals blow to Austrian pork farmers
Vienna, Sep 19 (IANS) Russian import ban imposed in retaliation for Western sanctions over the Ukraine crisis brought down the price of pork in Austria, affecting the farmers in the country.
 
 
Russia seeks to keep out foreigners from media business
Moscow, Sep 18 (IANS) Russia will soon introduce a bill in parliament to restrict foreign ownership in Russian media, a media report said Thursday.
 
 
France to help set up hospital in Guinea to fight Ebola
Paris, Sep 18 (IANS) French President Francois Hollande Thursday said his country would help set up a military hospital in Guinea to assist in the fight against the deadly Ebola virus in west Africa.
 
 
 

Latest from the Network

13 killed in bomb attacks in Iraq
Baghdad, Sep 19 (IANS) At least 13 people were killed in two suicide bomb attacks in the Iraqi capital of Baghdad Thursday evening, a police source said. A suicide bomber drove an explosive-laden car into a checkpoint...
Read more on Politics Balla
 
Scottish referendum polls end, huge turnout reported
London, Sep 19 (IANS) Polling in the referendum to decide whether Scotland should stay in the UK or become an independent country have closed and counting is under way, BBC reported. Counting will be carried out...
Read more on Politics Balla
 
Parliamentarians urges EU to cut off IS resources
Brussels, Sep 19 (IANS) The European Parliament Thursday urged the European Union (EU) to enforce sanctions against business bodies related to the Islamic State (IS) in a bid to cut off its resources. The creation and...
Read more on Politics Balla
 
Sharon Osbourne slit her wrist to prove love
Los Angeles, Sep 19 (IANS) TV host Sharon Osbourne says, back in her rocker girl days, she slit her wrist to prove her love for Ozzy Osbourne. The 61-year-old star has revealed she was hospitalised after cutting...
Read more on Celebrity Balla
 
Ebola hit countries to lose $809 million by 2015: World Bank
This projected loss will be the medium-term impact of the outbreak of the Ebola Virus Disease (EVD) on these countries, Xinhua reported. A statement issued from the World Bank's Ghana office responsible for both...
Read more on Business Balla
 
Russian food ban deals blow to Austrian pork farmers
Vienna, Sep 19 (IANS) Russian import ban imposed in retaliation for Western sanctions over the Ukraine crisis brought down the price of pork in Austria, affecting the farmers in the country. Alarm is growing among...
Read more on Business Balla
 
Nigerian troops capture Boko Haram leader
Abuja, Sep 19 (IANS) Nigeria army have arrested a senior commander of the Boko Haram sect, which is blamed for killing hundreds of people since 2009, the country's defence authority said Thursday. The commander, whose...
Read more on Politics Balla
 
Iggy Azalea sues ex-boyfriend
Los Angeles, Sep 19 (IANS) Rapper Iggy Azalea has filed a lawsuit against her ex-boyfriend. Azalea is suing her ex-lover Maurice Williams for releasing music from her early career without her consent, reports...
Read more on Celebrity Balla
 
Will Smith and Jada Pinkett Smith have garden dates
Will Smith and Jada Pinkett Smith prefer to have date nights at home. The couple, who got married in 1997, believe it's important to spend some time alone with one another in order to keep their romance alive, but they...
Read more on Celebrity Balla
 
Kylie Jenner 'living in shadows' of sister Kendall
Kylie Jenner reportedly feels she's ''living in the shadows'' of her sister Kendall. The 17-year-old star is allegedly starting to feel left out following her older sibling's recent modeling success and believes she's...
Read more on Celebrity Balla