SWP Acid Flashback, CCP Edition

Sometimes reading current news about clearing specifically and post-crisis regulation generally triggers acid flashbacks to old blog posts. Like this one (from 2010!):

[Gensler’s] latest gurgling appears on the oped page of today’s WSJ.  It starts with a non-sequitur, and careens downhill from there.  Gensler tells a story about his role in the LTCM situation, and then claims that to prevent a recurrence, or a repeat of AIG, it is necessary to reduce the “cancerous interconnections” (Jeremiah Recycled Bad Metaphor Alert!) in the financial system by, you guessed it, mandatory clearing.

Look.  This is very basic.  Do I have to repeat it?  CLEARING DOES NOT ELIMINATE INTERCONNECTIONS AMONG FINANCIAL INSTITUTIONS.  At most, it reconfigures the topology of the network of interconnections.  Anyone who argues otherwise is not competent to weigh in on the subject, let alone to have regulatory responsibility over a vastly expanded clearing system.  At most you can argue that the interconnections in a cleared system are better in some ways than the interconnections in the current OTC structure.  But Gensler doesn’t do that.   He just makes unsupported assertion after unsupported assertion.

Jeremiah’s latest gurgling appears on the oped page of today’s WSJ.  It starts with a non-sequitur, and careens downhill from there.  Gensler tells a story about his role in the LTCM situation, and then claims that to prevent a recurrence, or a repeat of AIG, it is necessary to reduce the “cancerous interconnections” (Jeremiah Recycled Bad Metaphor Alert!) in the financial system by, you guessed it, mandatory clearing. Look.  This is very basic.  Do I have to repeat it?  CLEARING DOES NOT ELIMINATE INTERCONNECTIONS AMONG FINANCIAL INSTITUTIONS.  At most, it reconfigures the topology of the network of interconnections.  Anyone who argues otherwise is not competent to weigh in on the subject, let alone to have regulatory responsibility over a vastly expanded clearing system.  At most you can argue that the interconnections in a cleared system are better in some ways than the interconnections in the current OTC structure.  But Gensler doesn’t do that.   He just makes unsupported assertion after unsupported assertion.

So what triggered this flashback? This recent FSB (no! not Putin!)/BIS/IOSCO report on . . . wait for it . . . interdependencies in clearing. As summarized by Reuters:

The Financial Stability Board, the Committee on Payments and Market Infrastructures, the International Organization of Securities Commissioners and the Basel Committee on Banking Supervision, also raised new concerns around the interdependency of CCPs, which have become crucial financial infrastructures as a result of post-crisis reforms that forced much of the US$483trn over-the-counter derivatives market into central clearing.

In a study of 26 CCPs across 15 jurisdictions, the committees found that many clearinghouses maintain relationships with the same financial entities.

Concentration is high with 88% of financial resources, including initial margin and default funds, sitting in just 10 CCPs. Of the 307 clearing members included in the analysis, the largest 20 accounted for 75% of financial resources provided to CCPs.

More than 80% of the CCPs surveyed were exposed to at least 10 global systemically important financial institutions, the study showed.

In an analysis of the contagion effect of clearing member defaults, the study found that more than half of surveyed CCPs would suffer a default of at least two clearing members as a result of two clearing member defaults at another CCP.

“This suggests a high degree of interconnectedness among the central clearing system’s largest and most significant clearing members,” the committees said in their analysis.

To reiterate: as I said in 2010 (and the blog post echoed remarks that I made at ISDA’s General Meeting in San Fransisco shortly before I wrote the post), clearing just reconfigures the topology of the network. It does not eliminate “cancerous interconnections”. It merely re-jiggers the connections.

Look at some of the network charts in the FSB/BIS/IOSCO report. They are pretty much indistinguishable from the sccaaarrry charts of interdependencies in OTC derivatives that were bruited about to scare the chillin into supporting clearing and collateral mandates.

The concentration of clearing members is particularly concerning. The report does not mention it, but this concentration creates other major headaches, such as the difficulties of porting positions if a big clearing member (or two) defaults. And the difficulties this concentration would produce in trying to auction off or hedge the positions of the big clearing firms.

Further, the report understates the degree of interconnections, and in fact ignores some of the most dangerous ones. It looks only at direct connections, but the indirect connections are probably more . . . what’s the word I’m looking for? . . . cancerous–yeah, that’s it. CCPs are deeply embedded in the liquidity supply and credit network, which connects all major (and most minor) players in the market. Market shocks that cause big price changes in turn cause big variation margin calls that reverberate throughout the entire financial system. Given the tight coupling of the liquidity system generally, and the particularly tight coupling of the margining mechanism specifically, this form of interconnection–not considered in the report–is most laden with systemic ramifications. As I’ve said ad nauseum: the connections that are intended to prevent CCPs from failing are exactly the ones that pose the greatest threat to the entire system.

To flash back to another of my past writings: this recent report, when compared to what Gensler said in 2010 (and others, notably Timmy!, were singing from the same hymnal), shows that clearing and collateral mandates were a bill of goods. These mandates were sold on the basis of lies large and small. And the biggest lie–and I said so at the time–was that clearing would reduce the interconnectivity of the financial system. So the FSB/BIS/IOSCO have called bullshit on Gary Gensler. Unfortunately, seven years too late.