Manmohan Singh, the IMF economist, has published a new paper “Limiting Taxpayer “Puts”—An Example from Central Counterparties” (IMF Working Paper WP/14/203), November 2014. We have long admired his work on collateral velocity and were interested to see what he had to say about central counterparties.
The starting point of the paper is that CCPs need to be robust and avoid reliance on taxpayer cash for bailouts.
“…Recognition of the risk that CCPs may be “too important to fail,” or systemically important, has led to efforts at both the international and national levels to design specific statutory frameworks for their recovery and resolution, with the stated objective of minimizing the amount of public funds that could be needed for their rescue (Tucker, 2013)…”
The speed at which a CCP could spiral downward and the damage that can be done is significant.
“…The interests of safeguarding financial stability through preserving the continuity of critical services dictates that the recovery and resolution procedure for those entities must be relatively swift and simple and arithmetically supportable. In order to safeguard financial stability, a mismatch in the balance sheet of a CCP has to be arrested at a much earlier stage than would be possible under a regular corporate insolvency framework (Gibson, 2013)…”
“…the classic tools for managing CCP credit and market risk may not perform as well as they have historically, leaving a residual risk that a CCP may exhaust its waterfall of default resources in managing the failure of a significant clearing member. In this light, it might be argued that CCPs have (or will) become, by regulatory fiat, “too important to fail”…”
“…Should CCPs be given a public-interest utility status, becoming entirely user-owned, not-for profit operations?…”
While CCPs have been around for a while, they weren’t as complex as those serving the OTC derivatives market.
“…This is unchartered territory, and the past history of CCP failures and bailouts has not been associated with CCPs that were primarily derivative entities…”
So what happens if the risk waterfall is not sufficient to cover losses? Assuming that a collapse of a CCP and the systemic risk radiating out is to be avoided, what is there to do? What options lie in the narrow space between default and tapping taxpayers to foot the bill? Singh has an interesting idea. A layer that comes at the bottom of the risk waterfall, but above a taxpayer bailout (or, we suppose, total meltdown): variation margin gain haircuts (VMGH).
“…A further option for loss allocation is haircutting variation margin so that clearing members on the profitable side of market movements (i.e., opposite the loss-making positions held for the defaulting clearing member) do not receive the entirety of the profits expected…The larger the haircut, the smaller the recourse to government will be needed to keep the CCP operational…”
“…If the waterfall is robust (as CCPs claim they are) then the problem will be solved without recourse to any other mechanism. However, if the waterfall is not robust, then a VMGH would provide a sizable cushion that should be sufficient to cover most jump events, or, at least, delay the demand for government/central banks funds. As end-users will have to contribute in a VMGH (unlike the traditional waterfall structures), it is in their best interest to use CCPs with robust waterfall…”
But is Singh’s objective really to advocate VMGH? By showing the worst-case impact (the loss of positive mark-to-market), the alternatives of higher IM and default funds, more capital from the clearing house, etc. doesn’t look so terrible. Investors won’t know with certainty that on any given day they don’t have exposure to VMGH. It is a kind of mutualization on steroids. Alternatively, thicker layers in other parts of the risk waterfall will certainly raise the cost of trading and hurt CCP profitability. But the trade-off vs VMGH might still be appealing to the (risk adverse) investor and their clearing member. CCPs having to pony up more capital may be less thrilled. Will it take much to convince regulators that more protection (of the kind VMGH provides) is better than less (even if this is, as Singh wrote “a tail of tail risk”)?
We have just seen the Bank of England take a slightly different approach, confirming that CCPs have LOLR access in the case of liquidity risk (see our November 10th post “The Bank of England explicitly includes CCPs for LOLR access. It is good policy.”). But in the US, where CCPs aren’t explicitly seen as market utilities that deserve official support, the options in a very high stress scenario aren’t that obvious (beyond the mantra that the existing safeguards will be just fine, thank you). As an alternative to a taxpayer funded bailout or systemic collapse, the idea of VMGH may resonate with regulators. Perhaps a dual approach of backstopping a CCP from a liquidity crunch (à la the BoE) while pushing for a more robust risk waterfall — but just short of VMGH — might be the way to thread this needle?