SIX years after the financial crisis exposed the systemic dangers of derivatives, the industry faces questions as to whether risk management systems will contain the next significant bout of market turmoil.

Last Tuesday, FIA Global, the futures industry trade association, added its voice to a growing debate about the role of clearing houses, the centralised risk managers charged with bolstering stability. It called for greater transparency and disclosure from clearers to help identify credit and operational risks.

Since 2009 regulators have put pressure on the market to push more swap trades into clearing houses, which stand between investors and banks, and are tasked with ensuring that a deal is completed should one side default.

Shift in role of clearing houses has not removed systemic risk as calls for transparency grow

However, uneasiness pervades this fundamental shift. Some market watchers are worried that global regulations have not created a resilient framework that could function if a large financial institution fails. While the risk of derivative trades is being collected in one place via clearing houses, the potential for systemic pressure remains.

The Bank of England has expressed concern that clearing houses are being asked to take on risk management for market liquidity, when they were built for managing counterparty credit risk.

“It’s largely the reshuffling of risk — it has not gone away,” says Craig Pirrong at the University of Houston in the US. “Regulators have not taken a truly systemic approach to analysing risk.”

Market participants say risks cannot be consistently compared because of clearing houses’ differing and opaque risk models. These models are ‘procyclical’, and so require more margin for derivatives portfolios at times of market stress — when it is hardest for traders to find relatively stable liquid assets.

Neither regulators nor market participants want a replay of Lehman Brothers, whose failure in 2008 exposed a huge interlinked world of trades across the market and thus threatened other institutions.

Today most of the world’s derivatives trades will be handled by four clearing houses, owned by CME Group and Intercontinental Exchange of the US, Germany’s Deutsche Börse, and LCH.Clearnet, controlled by the London Stock Exchange Group.

Given the concern for insulation from the next financial meltdown, two issues dominate industry debate: the need for greater financial participation by clearing houses, and for more transparency in their risk management models.

Dennis McLaughlin, chief risk officer at LCH.Clearnet, the world’s largest swaps clearer, says: “What if Lehman happened again tomorrow? Customers want to know two things: how safe is my money in the default fund, and are you going to ask me for any more?”

The ‘members’ of a clearer contribute to a mutual default fund and are prepared to share losses. The house has ‘skin in the game’ and contributes to the fund. But the arrangement is expensive for large users. Calls for more direct contributions, led by JPMorgan and Citigroup, have been strongly resisted by CME, LCH and Eurex.

“Clearing house skin in the game is generally a negligible percentage of the overall default fund,” says Mariam Rafi, US head of over-the-counter clearing at Citi. “However, clearing houses are for-profit entities. They decide the risk model; they determine what new products are going into the clearing houses. It brings up the question of misalignment of incentives.”

Behind the FIA’s warning is a nagging fear of another Hanmag Securities. The South Korean futures broker went bankrupt in late 2013 when an errant algorithm racked up nearly $45m in losses in 143 seconds. The local clearer, KRX, dumped the losses on other users. Regulators are beginning to address concerns.

Next year the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions will require clearing houses to publish their models for calculating users’ risk.

“The bankers should be reassured as to the risk modelling when the quantitative disclosures are introduced,” says Thomas Krantz, senior adviser for capital markets at Thomas Murray, a markets consultant. “They’re going to go from a black box to southern French nudist colony.”

Banks and brokers are calling for standard stress tests, so they can compare risks. CPMI-Iosco has promised a review, but this has started a fresh debate as to which model would be deep and transparent enough without publicising market positions. Others worry that about a homogenised market in which most derivatives trades are among a handful of clearing houses, all using similar risk models and deciding which instruments are introduced into the mutual default fund.

“When you take an interbank market and stick it into capital markets,” says Mr Krantz, “it’s never going to be an easy mix.”

Published in Dawn, Economic & Business, May 4th, 2015

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