We are increasingly concerned about where liquidity will come from to support the myriad of central counterparties that need it for backstop or regulatory purposes. Two recent suggestions we heard were in the case of repo and CCPs seeking to raise a liquidity backstop, but there is only so much clearing member cash, and liquidity in the markets, to go around. The buck will have to stop somewhere, and it looks like it is here.
In repo, NYU Professor Viral Acharya wrote up an idea that sounds great on paper but has some tough holes in practice. He has proposed a repo resolution facility that does the following:
1) In the event of a counterparty default, repo collateral holders of liquid securities get those securities right away but holders of risk assets are subject to a stay.
2) “Immediately upon default, repo counterparties of risky collateral are paid by a “repo resolution fund”… a recovery amount that is based on a conservative value assessment of the collateral.”
3) Wait a minute, go back to #2. This is a good idea and would lead to an orderly liquidation of risk assets, thereby saving the world from a very problematic fire sale of assets, but who will foot the bill? We thought it would be governments but while some are willing, others clearly don’t want to be in that game. At all. Ever again.
In another example, the DTCC’s National Securities Clearing Corp division (NSCC) has been designated a systematically important financial market utility by the US Financial Stability Oversight Council (FSOC), and must show that it holds enough liquidity to meet various member default scenarios. To that end, NSCC has asked the SEC for permission to create a supplemental liquidity funding obligation. This would be targeted at unaffiliated Members and Affiliated Families. The details are here.
NSCC’s proposal has not gone down well at all with its members, who among other things claim that the new liquidity rules will create a very unequal playing field amongst competitive brokers. Here are some quotes from comment letters:
Deutsche Bank: “Unfortunately, while the NSCC had previewed the Proposal with the Commission, it did not adequately consult with its affected Members.”
Schwab: “Schwab has been forced to conclude that NSCC has pursued this course of action with respect to the rule proposal in order to maintain leverage over its members as a negotiating tactic with banks as it begins to work on next year’s renewal of its committed credit facility (the “Credit Facility”).”
SIFMA: “the proposal is fundamentally flawed because it lacks an adequate risk-based justification and would result in the supplemental liquidity deposit obligations of NSCC’s member firms being dependent from year to year on the NSCC’s success in obtaining commitments under its revolving credit facility.”
And this is just one proposal. The FSOC has named eight financial market utilities, each of which need to shore up their own liquidity profiles. Imagine this process with the NSCC playing out seven other times in the US alone.
The fact is, there doesn’t seem to be enough money to go around to keep all of these CCPs and financial market utilities in business, let alone provide the cash for additional resolution authorities to pay out at a moment’s notice (and that would likely be in the midst of a crisis when other CCPs and resolution authorities need additional liquidity too). Something has to give here for banks and brokers to continue their operations. We’re thinking that as much as governments want out of the lender of last resort business, they may not have a choice without further concentration risk of market participants, CCP mergers, and other mechanisms for risk sharing that are literally affordable to individual firms. It’s not a great situation right now.