The economics of CCP operations and netting by Prof. Robert Kosowski

Transcription

1 Cross-jurisdictional netting and global solutions LSE conference, 12 May 2011 The economics of CCP operations and netting by Prof. Robert Kosowski (Assistant Professor and Director of Risk Management Lab and Centre for Hedge Fund Research at Imperial College London)

2 Presentation Outline 1. CCP and netting: basic structural elements 2. Economic role of CCPs in the global financial system and regulatory context 3. Economic Costs and benefits of CCP/netting: Risk-adjusted return on capital and capital charges, informational asymmetries, counter-party risk, risk-return trade-off, systemic risk/moral hazard, economies of scale, network effects, 4. Economics of CCP operations/netting, corporate governance Perspective of the operator Perspective of Members and their clients Perspective of governments 5. Conclusions Appendix: References, Definitions 2

3 1. CCP operations and Netting: Basic Elements Clearing/CCP structural elements GCM, clients of clearing members (NCM/TM) Ownership and corporate governance issues (EMIR, CPSS) The default waterfall Business models (vertical silo,...), Pre-trade/post-trade links US paper crisis and DTCC Netting (settlement/payment, novation, open-offer, close-out netting, multilateral netting, gross/net) Eligible parties (banks, funds, non-financials, CBs..) Dealer-Dealer (IRS, CDS) vs Dealer-Client clearing Eligible contracts (primary/cash securities, derivatives (ETD, OTCD), securities lending, CFDs..) Interaction with country s legal regimes Collateral versus contracts; collateral segregation/portability 3

4 2. Economic Role of CCPs in the Global Financial and Regulatory Context Regulation EMIR (asset segregation, ESMA) Country/ Government 1 Central Bank 1 OTC Different Legal & Regulatory Environments (insolvency laws, ownership transfer, supervisors, CB collateral) Exchange 1 MTF Country/ Government 2 CCP 2 Central Bank 2 Exchange 2 BIS(capital charges), CRD4 MIFID (MTF) GCM (e.g. Bank 1) CCP 1 (netting/ clearing) Silo Model Settlement Custody (CSD,..) Collateral Man t CPSS/ IOSCO, D-F T2S, CCBM2, SEPA Bank 2 A L. Loans Dep. Sec. Equity TM/NCM (e.g. Bank 3) Client 1 Settlement Custody (CSD,..) Collateral Management Post Trade NCM GCM Bank 4 Bank 5 Swap Fund 2 Client 3 Fund 1 Client 2 4

5 3. CCP and netting: Potential Economic Costs and Benefits Benefits Fungibility of contracts, capital efficiency and reduced margins (in theory relative to properly collateralised bilateral system!!!) Reduced information asymmetry (about CPs) Through standardisation and trade repositories Choice for clients; lower dealers barriers to entry & information advantage Reduction of settlement risk, fewer contracts and lower back office costs Reduction of liquidity risk (anonymous trading increases liquidity) Reduction of systemic risk (risk mutualisation) Reduction of information asymmetry compared to bi-lateral clearing (CCP reduces information problem; CCP is neutral) Reduction of operational risk by end-to-end STP? Lower credit risk Costs moral hazard for users; (reduced incentives of market participants to monitor each other, Pirrong (2009)); competition on margin Clearing fees Systemic risk from one or few Super-SIFIs Collateral: Extra $2tr collateral (TABB (2011) Pro-cyclicality of collateral Concentration risk for collateral (letters of credit) Fewer options regarding acceptable collateral 5

6 Issues to Address when Moving OTC derivatives from SIFIs to CCPs (Singh (2011, IMF)) 1) Interoperability of CCPs which would allow multilateral netting of positions across SIFIs residual positions; e.g. U.K. s LCH.Clearnet/Swapclear issues in US 2) Sizable additional collateral needs Tabb (2010), Singh and Aitken (2009), Singh (2010); Zawadowski (2011, Entangled Financial Systems ) 3) Unbundling netted positions; 4) Duplicating risk management; 5) Likely regulatory arbitrage Senator Lincoln s push out clause under Dodd-Frank Act 6) Concentration of systemic risk; 7) Decrease in rehypothecation of collateral 8) Backstopping by central banks; (BoE position and (1)) 9) more SIFIs to supervise (old SIFIs to retain exposures + new CCPs) 6

7 TABB estimates OTC Derivatives collateral may need to be raised by up to $2tr TABB group uses margins on ETDs in 2009 as benchmark for OTCD collateral requirements Applying the $3.8tr benchmark to existing collateral implies that additional collateral requirement could be as high as $ tr (assuming total estimated OTCD collateral for 2009 was $ 1.6tr) Factors that reduce collateral: 1) Not all OTCD exposures will move to CCPs, 2) high likelihood of end-user exemption, 3) extremely short term exposures, like a majority of FX, will require little or no collateral, and 4) innovations in cross-margining. Factors that increase collateral: (1) increasing volatility, (2) decreasing liquidity, (3) increasing duration, (4) increasing complexity, (5) and lack of netting efficiencies 7

8 4. Economics of CCP operations/netting: different perspectives A. Operator/ CCP Competition on price, risk management (moral hazard), quality, coverage Inter-operability, corporate governance, Ownership: profit centre vs utility; B. GCMs/NCM choice of CCP issue, Gross/Net netting C. Clients of GCMs/NCMs Under certain conditions, incentives for moving certain positions to CCP (but not necessarily tail risk), see Singh (2011, IMF) regulatory and business model uncertainty, sunk costs of choosing one CCP as well as cost of breaking portfolio BRC, BIS 190 capital charges and membership D. Government Backstop and moral hazard Competition vs natural monopoly National champion vs footing the bill in crisis 8

9 Price Compression and Cost Savings Example from Cash Securities: Competition on (Explicit) Price This slide shows data from Euroccp Results dependent on assumptions Careful to distinguish explicit (clearing fees,..) and implicit costs (risk management) Source: 9

10 How many CCPs will there be/should there be in the future?...consolidation into fewer, better capitalised CCPs. A globally competitive system with less systemic risk? DTCC response to paper crisis Via MiFID I &II Competitive trading Via EMIR: Access & Interoperability for equities Via: TARGET2 Securities Distinguish investor vs issuer (that influences where liquidity is) source: 10

11 IMF Report (Singh, 2011): Which risk will SIFIs offload to CCPs? Source: Singh (2011) 11

12 Potential Inconsistencies in Regulation: BIS CPSS demand for Enforceability of netting arrangements may clash with BIS CPPS asset segregation/portability (Principle 14) ((see BIS CPSS Principles for financial market infrastructures (March 2011)) Zero-hour rules BIS 190 ( Capitalisation of bank exposures to central counterparties ): incentives for BRC structures which will have no capital charge compared to proposed 2 percent capital charge when moving derivatives to CCPs (without any BRC structures). The demand for BRC structures suggests that there is concern about the failure of CCPs to warrant such schemes. Many end-users of OTC derivatives (Pimco, Blackrock, etc.) are reluctant to post collateral with certain CCPs that do not have CB backstopping (e.g. LCH/Clearnet). A non-member bank is only eligible to claim the reduced capital charges associated with a CCP exposure under certain conditions! Should Clients become clearing members? How costly? E.g. Each Fidelity fund as opposed to Fidelity the firm... 12

13 Default Waterfall - How a CCP protects itself 1. Liquidate defaulters position to see what remains 2. Liquidate defaulter s initial and variation margin 3. Liquidate defaulter s contribution to the CCP s loss-sharing pool 4. Loss sharing among surviving GCM/participants 5. CCP s equity, retained earnings 6. Other possible financial resources: 1. Insurance 2. Financial guarantees, e.g. from bank, parent of CCP, etc 7. Government bailout and moral hazard 1. Monetary Authorities (BoE no, ECB/Fed/SNB maybe ), 2. Fiscal Authorities Considerations: Should governments levy an insurance/bailout premium on CCPs? Which countries should host CCPs? 13

14 Has a clearinghouse ever failed? I still believe that clearing houses could and should make the derivatives world safer. In practice, though, they could also end up creating new dangers if they are not put on a sound footing, particularly if the fact that no clearing house has ever failed before creates a false sense of complacency. source: Insight: The clearing house rules, by Gillian Tett, Financial Times, November 5, 2009 It is true that no clearinghouse in the US has failed, but there were near misses in the US and clearing houses outside the US have failed Considerations: Are banks (CCPs) international in good and national in bad times? EMIR: Where a CCP risks insolvency, the fiscal responsibility may lie predominantly with the Member State in which it is established How volatile an economy / a financial system do we want? 14

15 Source: Push to underpin clearing house foundations, by Jeremy Grant, Financial Times, June 7,

16 Conclusions and Key Takeaways Increased use of CCPs can be socially beneficial in presence of appropriate risk management, inter-operability and international coordination (competition, capital requirements, legal, contingencies) Inter-operability must be carefully thought through before being implemented Benefits and costs of CCP depend on outcome of many regulatory initiatives ( EMIR, BIS CPSS, CRD4, MIFID, CPSS/ IOSCO T2S, CCBM2, SEPA) Trade-off between competition and natural monopoly (capital efficiency and systemic risk) Theoretical discussion of benefits and costs of CCP must take into account current realworld under-collateralization of OTCD Clash between BIS CPSS demand for asset portability/segregation/brc and enforceability of netting arrangements BIS CPSS 190 capital charge proposals for using CCP members change incentives of membership and raises issues Competition on price may lead to less robust CCPs, in particular in countries with higher moral hazard (i.e. with central bank back-stop) Considerations: Which countries should host CCPs?, Are CCPs international in good times but national in bad times? 16

17 Appendix: The following slides contain Definitions and common abbreviations Relevant regulatory initiatives Select references and sources 17

18 Common Abbreviations CCPs central counterparties CSDs - central securities depositories SSSs - securities settlement systems OTC - over-the-counter TRs - trade repositories (TRs). FMI Financial Market Infrastructure GCM General Clearing Member NCM Non-Clearing Member TM Trading Member BRC Bankruptcy Remote Collateral SIFIs - systemically important financial institutions ECB (European Central Bank), CESR (Committee of European Securities Regulators),CEBS (Committee of European Banking Supervisors) CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors) ESMA (European Securities and Markets Authority) TARGET2 - real-time gross settlement system (RTGS) for the euro/eurosystem. T2S(Target 2 Securities): CCBM2 (Collateral Central Bank Management) SEPA (Single Euro Payments Area ) Project 18

19 Regulatory Initiatives Relevant for CCP EMIR (European Market Infrastructure Regulation) Framework vs rulemaking (level 1 vs level 2) Clearing exemption (participant): In EU for non-financial counterparties, exemption only to the extent institution s positions in qualifying derivatives fall below certain thresholds, whilst the US approach does not have thresholds but instead has exclusions for particular behaviors. Clearing exemption (asset class): In US, FX exempted. EU not decided but parliament and commission not in favour Governance: US contemplating numerical limits on clearing firm ownership of CCPs to avoid conflict of interest. EU focusing on governance. Repository recognition: The US requirements do not specifically provide for the recognition of non-us repositories. Repository indemnity: Required in the US, not in the EU Ultimate goals: Avoid arbitrage, Avoid commercial disadvantage, Avoid tit for tat MiFID (Markets in Financial Instruments Directive regulates trading and exchanges/mtfs) CRD IV: capital requirements (transposition of Basel III) CSDs: central securities depositories January 2001, CPSS published the Core principles for systemically important payment systems (CPSIPS) T2S, CCBM2, SEPA 19

20 References Acharya, Viral and Alberto Bisin, Centralized versus Over-The-Counter Markets," New YorkUniversity, Working Paper, Allen, Franklin and Douglas Gale, \Financial Contagion," Journal of Political Economy, 2000,108 (1), Bliss, R. and C. Papathanassiou, 2006, Derivatives clearing, central counterparties and novation: The economic implications, Brunnermeier, Markus, Deciphering the Liquidity and Credit Crunch ," Journal of Eco- nomic Perspectives, 2009, 23 (1), Diamond, Douglas W. and Philip H. Dybvig, Bank Runs, Deposit Insurance and Liquidity, Journal of Political Economy, 1983, 91 (3), Duffie, D. And Zhu, H., 2011, Does a Central Clearing Counterparty Reduce Counterparty Risk?, Forthcoming, Review of Asset Pricing Studies ECB Payments & Markets: FSA website on CRD 4: Pirrong, Craig, The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks Through a Central Counterparty," University of Houston, Working Paper, Singh, M., 2011, Making OTC Derivatives Safe A Fresh Look, Stulz, Rene M., \Credit Default Swaps and the Credit Crisis," NBER Working Paper, No , TABB Group, 2010, The Global Risk Transfer Market: Developments in OTC and Exchange-Traded Derivatives, A TABB Group Study by E. Paul Rowady, Jr. Zawadowski, A., 2011, Entangled Financial Systems, Working Paper, Boston University, people.bu.edu/zawa 20