Streetwise Professor Claims "Brexit Horror Story" Highlights Dangers of Clearing Mandates

Commentary by Bob Zwirb and Steven Lofchie

In his latest post on the Streetwise Professor blog, University of Houston Finance Professor Craig Pirrong described the "horror story" of systemic clearing mandates, and explained why he remains skeptical that regulators will "take heed of the lessons of Brexit and take measures to ensure that the next time it isn't a head shot."

Professor Pirrong argued that "clearing mandates have supersized the clearing system, and commensurately increased the amount of liquidity needed to meet margin calls." He highlighted Brexit as a "harrowing example" of "how tightly coupled the system is," and listed other risk factors that clearing corporations' response to Brexit have demonstrated. Those risk factors include the following:

  • "[m]uch of the additional margin was to top up initial margin, meaning that the cash was sucked into the [central clearing parties] and kept there, rather than paid out to the net gainers, where it could have been recirculated"; and

  • "each [central clearing party] acted independently and called margin to protect its own interests" – which is "ironic, because one of the alleged justifications for clearing mandates was the externalities present in the [over-the-counter] derivatives markets."

Professor Pirrong observed that Brexit might prove to be as instructive as it is "horrific":

Horror stories are sometimes harmless ways to communicate real risks. Perhaps the Brexit event will be educational.

Nevertheless, he concluded, the "clearing mandate is a reality, and is almost certain to remain one." Given that reality, he maintained, it is doubtful that "whatever is done will make the system able to survive The Big One."

Commentary

Bob Zwirb
Bob Zwirb

Less than four years ago, the CFTC proclaimed that the mandated central clearing of interest rate swaps would "serve to mitigate counterparty credit risk, thereby having a positive effect on reducing systemic risk." Clearing Requirement Determination under Section 2(h) of the CEA, 77 Fed. Reg. 74284, 74312 (Dec. 13, 2012). Today, we know better. As Professor Pirrong points out, the problem with mandated clearing is that it "transform[s] credit risk into liquidity risk, and . . . liquidity risk is more systemically threatening than credit risk." Ironically, this view is confirmed by the CFTC itself. In its preamble to rules requiring enhanced risk management standards for "systemically important" clearinghouses, the CFTC acknowledges that, during times of financial stress, clearing may amplify risk instead of reducing it. At such times, the CFTC notes, a clearinghouse's call for additional capital from its clearing members could start a "downward spiral which, combined with restricted credit, might lead to additional defaults of clearing members . . . and play a significant role in the destabilization of the financial markets." Enhanced Risk Management Standards for Systemically Important Derivatives Clearing Organizations, 78 Fed. Reg. 49672, 49663 (Aug. 15, 2013).

Commentary

With respect to central clearing, the systemic risk on which regulators have focused is that clearinghouses will fail. However, the greatest risk created by central clearing as mandated by Dodd-Frank is this: in an attempt to save themselves from the risk of failure, clearinghouses could use their ability to demand an unlimited amount of initial margin from clearing member participants and so drain needed liquidity from the financial system. In other words, clearinghouses likely would save themselves from going under by sucking all of the liquidity out of the financial system. This, in turn, could trigger the failure of clearing members, or their customers who are required to post additional margin. It also could cause a downward spiral of pricing, forcing market participants to liquidate positions in order to eliminate margin calls.

Premium Content

Available only to Premium subscribers.

 

Tags