CCPs are an unnecessary addition to systemic risk, says Manmohan Singh
Manmohan Singh of the International Monetary Fund has done more than any other public official to improve understanding of the role played by so-called shadow banking - of which prime broker-intermediated financing of hedge funds is the classic instance - in the global financial system. In particular, he was the first to point to the velocity of collateral as a major indicator of the mounting leverage ahead of the financial crisis of 2007-08 and its declining velocity as a major factor in the replacement of commercial bank money by central bank money in the funding of banks in the aftermath of the crisis.
Collateral velocity is one of those phenomena where cause is hard to distinguish from effect, but what was incontrovertible in the argumentation of Manmohan Singh was the importance of the ability to reuse collateral in any system where demand for collateral is rising. In a fresh paper prepared for the SWIFT Institute, the think tank funded by the Brussels-based payments and securities messaging network, Singh has returned to the theme. In it, he argues that the drastic under-collateralisation of the OTC derivatives markets is about to be seriously exacerbated by the shift of swap transactions to central counterparty clearing houses (CCPs).
The text is dense, and seems at times unable to decide whether the looming disaster is driven by a shortage of good collateral, or an increased demand for it, or both, or something else altogether, but its argument runs something like this. First, shifting OTC derivatives into central clearing fails to address the risk which it ostensibly addresses- namely, the risk that the net swap liabilities of a failed bank will fall on the taxpayer. Secondly, the reason why it fails to address the risk is that it leaves the OTC derivative markets under-collateralised.
Singh estimates, after netting gross exposures and making allowance for re-use of collateral, that a mere $700-900 billion of dedicated assets are currently collateralising gross credit exposure of $3.6 trillion in the global swaps markets. He attributes a large part of this shortfall to the fact that all sorts of swap counterparties that did not have to post adequate collateral in bi-lateral markets intermediated by investment banks - such as sovereigns, supranationals, central banks and of course corporates - are retaining that privilege in the new world of multi-lateral clearing.
Thirdly, clearing makes this under-collateralisation hard to solve because, by forcing swaps into CCPs, it traps collateral in silos. In other words, CCPs will not inter-operate efficiently, or even at all, not least because regulators do not want them to. Singh argues that this means one of the principal benefits claimed for clearing - namely, multilateral netting across markets and asset classes - will not be achieved. Indeed, he thinks CCPs will do a worse job in netting down risk than the existing system of independent banks netting swap assets and liabilities (and the accompanying collateral held and owed) through their own balance sheets.
This is a more contentious notion than it at first appears. In recent years European and American regulators have argued fiercely about the merits of balance sheet netting of swap assets and liabilities, ending in an agreement to disagree. American accounting standards (GAAP) continue to permit netting while international accounting standards (IFRS) do not. The International Swaps and Derivatives Association (ISDA), whose members are horrified by the prospect of the increased capital costs of gross representation of swap portfolios on the balance sheet, has predictably argued throughout that liabilities net of assets and collateral is a truer representation of risk.
Counterparties to banks would be wiser to reflect that even the strongest balance sheet - the allegedly "fortress" balance sheet of a major swaps house such as J.P. Morgan is a case in point here - would look a lot less healthy without netting, and that the arithmetical neatness of netting will bear no relation to the chaos that would ensue in the funding and collateral markets in the event of a default by a major swap counterparty
Oddly enough, Singh touches indirectly on this possibility. He contends that a consequence of the attenuation of the collateral benefits of netting by banks will be to force collateral-hungry banks active in the swap markets to source CCP- eligible collateral in the repo and securities lending markets. Singh says that this process - what the sell-side already calls "collateral transformation," or even "collateral upgrade," even though it is a collateral downgrade for the lender - will actually enlarge systemic risk by increasing the interconnectedness of financial institutions.
Singh thinks there are already worrying signs of a collateral shortage, and that the clearest is negative repo rates in Europe and near-zero repo rates in the United States, as commercial lenders compete to lend on a collateralised basis against the central bank alternative. Indeed, the central banks attract some predictable criticism from Singh for further draining the markets of liquid collateral (or, as he puts it, creating "zero velocity" collateral) through their quantitative easing programmes. He also blames the Swiss National Bank for exacerbating the shortage of high quality liquid collateral by buying the most creditworthy European government bonds during its controversial campaign to contain the rise of the Swiss Franc by buying euros.
In short, Singh reckons the centralised clearing of swaps is going to achieve precisely the opposite of what was intended. He says that it will create new systemically important concentrations of risk at the CCPs and reduce the velocity and volume of good and liquid collateral available, so increasing rather than reducing systemic risk.
This is a message that will play well with investment bankers. His alternative solution - that every counterparty to every swap put up the "right" amount of collateral, and that the policy of interposing CCPs between swap counterparties be dropped altogether - may suit them too. But it will be less popular with the governments and central banks that have exempted themselves from the collateral obligations they are imposing on others. Which means, of course, that it will not happen.
Fund managers should not waste any time worrying about what will never happen. But it is always worth remembering how banking works. Investment bankers - indeed bankers as a whole - have a large (and largely personal) financial interest in leveraging up balance sheets, and both increased flows of collateral and increased opportunity to re-use collateral help them to do that.
This translates into cheaper borrowing of both cash and securities for fund managers, which are cheaper still if the investment bank can offer effective cross-margining or portfolio margining. But if the bank fails, the downside for fund managers is unlimited in a way that - the Lehman case notwithstanding - it is not for bankers.