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

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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...

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13 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
10

7 weeks ago

RM47mil KWSG contributions still unclaimed

Jun 9 2014 7:54am CDT | Source: Business Times Malaysia

KUALA LUMPUR: About RM47 million of contributions in the Teachers Provident Fund (KWSG) still remain unclaimed, the Dewan Rakya ...
Source: Business Times Malaysia   Full article at: Business Times Malaysia
 

 
Update
9

7 weeks ago

Gold shop lost almost RM1mil

Jun 9 2014 3:50am CDT | Source: Business Times Malaysia

KANGAR: A gold shop owner lost almost RM1 million after after the safe on in his shop was broke ...
Source: Business Times Malaysia   Full article at: Business Times Malaysia
 

 
Update
8

7 weeks ago

Motion to debate MAS losses in Dewan Rakyat rejected

Jun 9 2014 3:39am CDT | Source: Business Times Malaysia

KUALA LUMPUR: AN emergency motion to debate the losses incurred by Malaysia Airlines last year, amounting to RM1.2 billion was rejected by t ...
Source: Business Times Malaysia   Full article at: Business Times Malaysia
 

 
Update
7

7 weeks ago

MH370 Tragedy: Hisham: RM27.6 mil spent on 1st phase of SAR

Jun 9 2014 2:11am CDT | Source: Business Times Malaysia

KUALA LUMPUR: Malaysia spent some RM27.6 million in its first phase of the search operations for missing Malaysia Airline flight MH370, said Acting Transport Minister, Datu ...
Source: Business Times Malaysia   Full article at: Business Times Malaysia
 

 
Update
6

7 weeks ago

9.1m litres of diesel seized in a month

Jun 8 2014 1:11am CDT | Source: Business Times Malaysia

PUTRAJAYA: The Domestic Trade, Cooperatives, and Consumerism ministry has seized some 9.1 million litres of diesel and property worth RM58 million since mounting ‘Operasi Diesel Selatan’ in the southern st ...
Source: Business Times Malaysia   Full article at: Business Times Malaysia
 

 
Update
5

7 weeks ago

Girl, 9, awarded RM2.78m compensation for medical negligence

Jun 6 2014 4:56am CDT | Source: Business Times Malaysia

KUALA LUMPUR: A nine-year-old girl who suffered brain damage during her birth at a government hospital was awarded over RM2.78 million in compensat ...
Source: Business Times Malaysia   Full article at: Business Times Malaysia
 

 
Update
4

7 weeks ago

Malaysia's total trade in April up 12pc

Jun 5 2014 11:52pm CDT | Source: Business Times Malaysia

KUALA LUMPUR: Malaysia's total trade in April 2014 rose by 12 per cent from a year ago to RM123.86 billion due to growing trading activities, International Trade and Industry Minister Datuk Seri Musta ...
Source: Business Times Malaysia   Full article at: Business Times Malaysia
 

 
Update
3

8 weeks ago

Works Ministry to spend RM20m for upgrading works at 50 accident black spots

Jun 4 2014 11:35pm CDT | Source: Business Times Malaysia

JOHOR BARU: The Works Ministry will implement upgrading works at 50 accident prone locations in the country that have been identified this year involving an all ...
Source: Business Times Malaysia   Full article at: Business Times Malaysia
 

 
Update
2

8 weeks ago

Najib launches loan scheme for Ramadan traders

Jun 4 2014 10:24pm CDT | Source: Business Times Malaysia

PUTRAJAYA: Prime Minister Datuk Seri Najib Razak today launches RM45 million Ramadan Bazaar ...
Source: Business Times Malaysia   Full article at: Business Times Malaysia
 

 
Update
1

8 weeks ago

Residents bring up objection against Kidex to Suhakam

Jun 4 2014 4:49am CDT | Source: Business Times Malaysia

PETALING JAYA: A group of 20 Petaling Jaya residents held a meeting with the Human Rights Commission of Malaysia (Suhakam) over their objection against the proposed RM2.2 billion Kinrara Daman ...
Source: Business Times Malaysia   Full article at: Business Times Malaysia
 

 

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