All clear…

In the world of finance, the headlines are usually generated by grandstanding politicians, or by the perceived ethical failings of a large bank, while less attention is paid to the “plumbing”, because that is seen as matter-of-fact, and eveb (perish the thought) “boring”.

Well, we have news for you, dear Reader. The “plumbing” is becoming more, not less important; and you ignore its risk of failure at your peril.

In the wake of the Great Financial Crisis, the Dodd-Frank Act, inter alia, required a far greater proportion of hitherto unregulated and opaque derivatives transactions to be cleared through a regulated clearinghouse; and similar outcomes were mandated in Europe. This is all very well as long as the relevant clearinghouse is robustly capitalized, well-managed and has an effective regulator. However, the clearing business has become ever more concentrated, as owners seek economies of scale and pricing power, with LCH.Clearnet now estimated to clear over 90% of interest rate swaps, while the Intercontinental Exchange (ICE) controls most of the credit default swap (CDS) clearing market.

Such concentrations, given that the clearinghouse stands behind each side of a transaction, in itself poses increased risks of a catastrophic failure and significant market disruption. In theory, regulators can designate a US-based clearinghouse as systemically important, and potentially give it access to the Fed’s discount window for emergency funding, but the current Administration’s at best ambiguous attitude to enforcement of much of the Dodd-Frank Act makes reliance on such regulatory action perhaps unwise, especially if the confusion engendered by most financial crises is compounded by political paralysis.

It is also argued that Title II of the Dodd-Frank Act enables regulators to have the Orderly Liquidation Authority (OLA) take over a failing clearinghouse. Unfortunately, this interpretation is uncertain; and, perhaps fortunately, has yet to be tested, while it also now suffers from regulatory ambiguity.

Of course, a US clearinghouse would be subject to federal bankruptcy laws; but, in a quirk of history, as a clearinghouse would probably be designated as a “commodities broker” for such purposes, it would require immediate application under Chapter 7’s liquidation provisions- an outcome that would be likely to exacerbate rather than dampen market disruption.

Given all this uncertainty, clearinghouses have worked assiduously to create a sequential waterfall of backstops through contractual arrangements between themselves and their members and owners (who are often many of the same entities.) While there are variations (including whether or not a clearinghouse’s legal structure is compartmentalized by type of transaction), in general, the waterfalls are intended to minimize the risk that a clearinghouse will have to exhaust its own capital and thus become insolvent, while the risk management models are designed to ensure that a clearinghouse can withstand the failure of its largest or two largest counterparts.

The structures and models are quite elegant, but depend upon the membership standing fast and complying with all the various contractual requirements of the waterfall, rather than “heading for the exits” at the first sign of trouble; and on the assumptions about the scale of member failure being conservative. While, the clearinghouse system withstood, for example, the failure of Lehmans, and the financial system is more heavily capitalized by now, none of this has been tested in a world of increased concentration.

At Awbury, we have studied this issue in depth, and created a number of mechanisms that we believe would help address the uncertainties described above as part of our programme of financial research and development, so that we are able to assist our clients with their seemingly most complex and intractable problems in the credit, financial and economic realms.

We always welcome calls from those in need of solutions.

The Awbury Team


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