In his recent book Thinking, Fast and Slow, Nobel-prize winning economist Daniel Kahneman outlines what he terms theory induced blindness. This is the phenomenon whereby once you accept a theory, it is very difficult to identify its flaws. Are we suffering theory induced blindness over the safety of CCPs?
The logic behind the move to central clearing is well understood: by passing trades through a clearing house, you reduce counterparty risk that banks and other financial institutions are exposed to in the traditional bilateral OTC model.
But in reducing counterparty risk, we should not infer that we are reducing risk as a whole.
Risk is akin to energy and, as the first law of thermodynamics tells us, in a closed system energy cannot be reduced or created, only transformed. After the CDO craze of the last decade, in which the fallacy that risk could be reduced by being spread took hold, we are now embarking on a fallacy that risk can be reduced by being centralised.
As CCPs consolidate, an inevitable trend considering the market benefits of a small number of large, global clearing houses, this fallacy will become ever more prescient. At the same time, there is a clear flaw that central clearing reduces counterparty risk as banks will be forced to repo assets with their peers to meet collateral requirements, in doing so they remain exposed.
Clearinghouses can and do fail. In the definite book on CCPs, The Risk Controllers, Peter Norman outlines three incidents in which a clearing house has failed. The first was the insolvency of the Caisse de Liquidation des Affaires en Marchandises, the Paris-based sugar market clearing house, which collapsed following the demise of Bankhaus Herstatt in 1974.
Then nine years later, the Kuala Lumpur Commodity Clearing House failed after the default of six brokers on palm oil contracts traded on the Kuala Lumpur Commodity Exchange. Most dramatically, the Hong Kong Futures Exchange clearing house failed in the wake of the global stock market crash in 1987 resulting in the temporary closure of both the futures and the main capital market in Hong Kong.
The clearing house had to be rescued by the Hong Kong Government for trading to recommence. In June, Paul Tucker of the Bank of England said of the latter example: “Had it been London, Chicago or New York, it would have entered the folklore of policy memory”.
Advocates of the invincibility of the clearing model point to its success in mitigating market meltdown in the wake of the collapse of Lehman Brothers. Even in that unprecedented time of market stress, leading clearinghouses were able to close positions without tapping the default fund.
This is true but clearinghouses were not then left holding positions on the illiquid contracts that they may be forced to clear under new regulations. Also, could the CCPs have withstood the flood of client failures that would have ensued had government’s not “bailed-out the banks”?
In addition, in the event of a wide-scale downgrade of credit ratings of European debt, how can we prevent clearing houses from becoming creators of systemic risk, black holes sucking up vast amounts of additional collateral from the financial system?
In its recent Financial Stability Report, the Bank of England warns: that “the likely impact of a CCP failure is greater now than in the past. This reflects the expansion of central clearing to new products and markets — a trend that is likely to continue as central clearing of certain products is mandated — thus further increasing the systemic importance of these infrastructures”.
New regulation and CCP consolidation will create giant risk centres. Stuffing them full of illiquid assets will inevitably lead to a new crisis further down the road. We must ensure that we have a plan of how to react to that crisis now.
The Bank of England maintains that clearinghouses should not have an implicit government guarantee and that any bailout in the event of a failure should not come from the government. But if the governments insist on sowing the seeds of the next crisis, they must bear the responsibility for containing it.