IOSCO Launches Securities Markets Risk Outlook (with Lofchie Comment)

IOSCO published its Securities Markets Risk Outlook 2014-2015, a report intended to identify future potential risks in securities markets.

The Outlook is divided into two parts: Part I describes selected global trends and potential vulnerabilities in securities markets, and Part II identifies potential systemic risks in or related to securities markets. Some of the potential systemic risks identified include:

• the search for yield and the return of leverage in the financial system;
• the search for yield and volatility affecting emerging markets;
• risks in central clearing;
• the increased use of collateral and risk transfer; and
• the governance and culture of financial firms.

Lofchie Comment: The report discusses a range of risks - from an overheated global housing market to the growth of credit default swaps on municipal debt. The risks associated with central clearing are a major focus. The report states that central clearing has been strongly supported by all of the various government regulators. The conclusion of the report, however, suggests that the benefits of central clearing are less certain and subject to far more contingencies than commonly accepted.The report states: "The design of the default waterfall and the placement of the [Central Clearingparties' ("CCPs'")] contributions therein are likely to influence incentives. . . . [It is also important for central clearing corporations to] . . . do proper due diligence on credit risk of (potential) clearing members. Determining the amount of capital that is placed, however, is a fine balancing act. The default waterfall acts like insurance. The more CCP capital that is placed senior in the default fund, the more likely the clearing members are going to be indifferent to the counterparty, with the knowledge that any default will be internalised within the CCP and its resources. In other words, it undermines the incentives to do proper due diligence and source proper counterparties, so that in the end, overall default rates may increase. So from that point of view, a model where default fund resources are placed before that of the CCP aligns the practices of clearing members and their own risk management due diligence with that of their counterparties. Looking forward as the nature of CCP business becomes more complex, through expansion into new markets, and more centralised through consolidation, the systemic importance of CCPs may grow, and it will be important for CCP risk management capabilities to evolve to reflect these developments. Regulators, additionally, will need to be cognisant of the changing business environment that CCPs operate under, and remain vigilant to any moves in operational standards due to competitive pressures" [emphasis supplied].This reads as less than a ringing endorsement for central clearing; it portrays a system that massively centralizes credit risk in one place, yet "must conduct a fine balancing act" in order to be safe and is required to be subject to "vigilant" ongoing regulation in light of "competitive pressures." Judging by the above excerpt and other sections of the report, it is not entirely obvious that central clearing is superior to an economic model in which credit decisions are decentralized.

See: Securities Markets Risk Outlook 2014-2015; IOSCO Press Release.