 Tony Freeman
Executive Director, Industry Relations
I’ve heard more than a few politicians say that you should never waste a good crisis. Clearly politicians in both Europe and the US are not missing a splendid opportunity to embrace the most obvious forms of populist politics in order to advocate for major reforms in our financial markets. Many have focused in on OTC derivatives, specifically credit default swaps (CDSs), as the main culprit for the “great recession.” While every crisis needs a good scapegoat, the reality is that CDSs did not cause this crisis. I admit derivatives caused AIG’s problems and the bailout that we all paid for (or at least those that actually pay taxes). But we have to remember that AIG was a symptom, not the cause.
Even though CDSs were not the origin of this crisis, we can all agree that they can add to volatile mix of systemic risk when bond issuers begin to default and CDS counterparties are forced to make massive payouts. When looking at post-trade risk management, much of that discussion has focused on the potential benefits of clearing OTC derivatives through a central counterparty (CCP). Conventional wisdom has focused on CCPs as the great hope for managing systemic risk while making OTC markets more efficient and transparent. The problem with conventional wisdom is that is can often be an oxymoron, like the term “free market.”
To be clear, CCPs are a big factor in improving the risk and efficiency of markets. In the equity and exchange-traded derivatives markets CCPs are an indispensible part of the of the infrastructure. It stands to reason that CCP will undoubtedly contribute to the evolution of OTC markets as well. However, many institutions and politician are placing too much expectations on the benefits that CCPs can bring to the CDS markets in the short run.
The reality is that CCPs are not a cure for counterparty risk and given the current state of the market they may not necessarily make it more efficient for participants. This is not due to any shortcomings in risk management by the CCPs themselves but a reality of the competitive nature of clearing and a fragmentation of the whole process. In the current environment where we have multiple CCPs in each region and different CCPs for credit derivatives and interest rate swaps (IRS), the opportunity to efficiently use collateral and reduce counterparty exposure is massively compromised.
In fact, if a buy-side trades multiple types of derivatives in multiple regions they may have 3 different CCPs trying to mange exposures and collateral even if the derivatives contracts were originally executed with the same counterparty. The CCP can net down exposure on a multilateral basis but only for the region, counterparties, or eligible derivative types that they support. That means I can’t offset exposure between CDS positions vs. their IRS positions. The reality is that bilateral netting of exposure with an individual counterparty across multiple OTC derivatives types outside the CCP may yield a more efficient use of collateral. And if you think there will be any “interoperability” among CCPs for the purposes of netting exposure, you clearly need to reduce your daily dosage of meds, or perhaps increase them. Interoperability is a fairy tale.
We should also keep in mind that derivatives will always be innovative and bespoke and there will be a large number of positions that will never be eligible for clearing. Those positions must also be reconciled and the credit risk must be accounted for through appropriate collateral management processes without a CCP.
So what is my point?? I do not intend to cast aspersions on CCPs themselves. They absolutely add value and will help mutualize and isolate risk related to any individual participant. They will undoubtedly grow in popularity and accelerate the maturity and transparency of the market which will hopefully result in a vibrate OTC market for years to come. After all, fragmentation is not their fault. They have the absolute right to compete for derivatives clearing business and are too smart to let a good crisis go to waste.
My point is that CCPs are just one aspect of a sound collateral management infrastructure. Counterparty risk will not be eliminated that easily and bilateral risk will still need to be accounted for positions that are outside the CCP. Many buy side firms continue to sit on the sidelines and haven’t invested in the systems to manage the risk associated with their derivatives book. Most haven’t automated the reconciliation of positions and don’t compare their valuations with their counterparties. Very few proactively ensure the appropriate collateral is where it should be.
Perhaps many firms are still suffering “bailout syndrome” which is the irrational expectation that the government or some central authority will somehow protect firms that are careless in risk management or that are apathetic about managing exposure to market counterparties. Unfortunately, no government or utility is going to cure systemic risk. Each firm is accountable for themselves. The number one rule in risk management is the same as in boxing: protect yourself at all times.
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