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StreetwiseProfessor<>Financial Regulators Are Finally Grasping the Titanic’s Captain’s Mistake. That’s Something, Anyways
— The Professor @ 7:11 pm
October 17, 2017

A couple of big clearing stories this week.

First, Gary Cohn, Director of the National Economic Council (and ex-Goldmanite–if there is such a thing as “ex”, sorta like the Cheka), proclaimed that CCPs pose a systemic risk, and the move to clearing post-crisis has been overdone: “Like every great modern invention, it has its limits, and I think we have expanded the limits of clearing probably farther beyond their useful existence.” Now, Cohn’s remarks are somewhat Trump-like in their clarity (or lack thereof), but they seem to focus on one type of liquidity issue: “we get less transparency, we get less liquid assets in the clearinghouse, it does start to resonate to me to be a new systemic problem in the system,” and “It’s the things we can’t liquidate that scare me.”

So one interpretation of Cohn’s statement is that he is worried that as CCPs expand, perforce they end up expanding what they accept as collateral. During a crisis in particular, these dodgier assets become very difficult to sell to cover the obligations of a defaulter, putting the CCP at risk of failure.

Another interpretation of “less liquid assets” and “things we can’t liquidate” is that these expressions refer to the instruments being cleared. A default that leaves a CCP with an unmatched book of illiquid derivatives in a stressed market will have a difficult task in restoring that book, and is at greater risk of failure.

These are both serious issues, and I’m glad to see them being aired (finally!) at the upper echelons of policymakers. Of course, these do not exhaust the sources of systemic risk in CCPs. We are nearing the 30th anniversary of the 1987 Crash, which revealed to me in a very vivid, experiential way the havoc that frequent variation margining can wreak when prices move a lot. This is the most important liquidity risk inherent in central clearing–and in the mandatory variation margining of uncleared derivatives.

So although Cohn did not address all the systemic risk issues raised by mandatory clearing, it’s past time that somebody important raised the subject in a very public and dramatic way.

Commenter Highgamma asked me whether this was from my lips to Cohn’s ear. Well, since I’ve been sounding the alarm for over nine years (with my first post-crisis post on the subject appearing 3 days after Lehman), all I can say is that sound travels very slowly in DC–or common sense does, anyways.

The other big clearing story is that the CFTC gave all three major clearinghouses passing grades on their just-completed liquidity stress tests: “All of the clearing houses demonstrated the ability to generate sufficient liquidity to fulfill settlement obligations on time.” This relates to the first interpretation of Cohn’s remarks, namely, that in the event that a CCP had to liquidate defaulters’ (plural) collateral in order to pay out daily settlements to this with gains, it would be able to do so.

I admit to being something of a stress test skeptic, especially when it comes to liquidity. Liquidity is a non-linear thing. There are a lot of dependencies that are hard to model. In a stress test, you look at some extreme scenarios, but those scenarios represent a small number of draws from a radically uncertain set of possibilities (some of which you probably can’t even imagine). The things that actually happen are usually way different than what you game out. And given the non-linearities and dependencies, I am skeptical that you can be confident in how liquidity will play out in the scenarios you choose.

Further, as I noted above, this problem is only one of the liquidity concerns raised by clearing, and not necessarily the the biggest one. But the fact that the CFTC is taking at least some liquidity issues seriously is a good thing.

The Gensler-era CFTC, and most of the US and European post-crisis financial regulators, imagined that the good ship CCP was unsinkable, and accordingly steered a reckless course heedless to any warning. You know, sort of like the captain of the Titanic did–and that is a recipe for disaster. Fortunately, now there is a growing recognition in policy-making circles that there are indeed financial icebergs out there that could sink clearinghouses–and take much of the financial system down with them. That is definitely an advance. There is still a long way to go, and methinks that policymakers are still to sanguine about CCPs, and still too blasé about the risks that lurk beneath the surface. But it’s something.

http://streetwiseprofessor.com/?p=10715