Unfinished Business - John McPartland

By: John McPartland, Director of Research, Hidden Road May 2022

One potential challenge that central counterparties (CCPs) face continues to be the increasing concentration present in the clearing space. This concentration of business among a few large clearing members is not only noted in derivatives, but also in equities and fixed income securities. To revisit clearing basics, if a clearing member fails to perform either as a buyer or seller of financial instruments or contracts, the CCP steps in to guarantee performance and contract continuity.

The CCP instantly assumes the responsibility and authority to perform as the defaulted clearing member should have. This also requires that CCP functionally assumes the positions, or open interest of the defaulter until the CCP can encourage other parties to assume those positions. Under normal circumstances, the CCP auctions off the open positions of the defaulter. In this manner, the open positions that were momentarily assumed by the CCP are shifted to other parties, most typically solvent clearing members. While this sounds quite logical and straightforward, concentration of business in the clearing space can make achieving these lofty goals quite difficult. This issue has not really been adequately addressed and the passage of time has only exacerbated the magnitude of the challenges.

CCPs, clearing members and exchanges all share a similar cost structure. Expenses are largely fixed (pretty much known at the start of the year) and revenues are variable (largely driven by market volatility and product adoption). Once fixed costs are covered by year-to-date revenues (the break-even point), the organisation becomes profitable. Profitability can be maximised by accelerating the organisation’s break-even date earlier and earlier in the year. In sum, the best way to ensure a profitable enterprise is to maximise scale. This is important (and irrefutable) as we see exchanges, CCPs and (in the instant case) clearing members all striving to increase market share and to grow organically. There is no way to change this; clearing members have both the means and the motivation to grow bigger and bigger.

Enter the CPMI/IOSCO cover 2 principle. While clearing members have every financial incentive to get bigger and bigger, CCPs on the other hand are required to “maintain additional financial resources sufficient to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the two participants and their affiliates that would potentially cause the largest aggregate credit exposure to the CCP in extreme but plausible market conditions.” In doing so, and unless remedied by other mitigating CCP specific policies, there are potential and significant inequities to the clearing membership as a whole. That is, the guarantee fund is not based upon the overall growth of the industry or the overall growth of the clearing membership at large, but solely upon the growth of the two largest clearing members.

To give a truly unfair but poignant example, imagine that you are part of a mutualised car insurance pool. Most drivers are middle aged and have good driving records. Also, in this pool are two 18-year-old males driving Maseratis. The safe drivers would cry foul that their insurance premiums would be raised unduly and unfairly (the cover 2 standard). While the example is admittedly exaggerated, it is done so to make the point. When the cover 2 guarantee fund requirement increases mostly due to the success of the largest two clearing members (which could have been achieved partially at the expense of the other clearing members) the financial responsibility for the majority of the increase should equitably fall upon the largest clearing members that were driving the cover 2 requirement. Save that thought.

Just as irrefutable financial forces incent clearing members to get larger and larger, in doing so, the proportion of the open interest attributable to them also gets larger and larger. This is also true when clearing equity securities and fixed income securities. That phenomenon raises another issue: under “extreme but plausible market conditions” how realistic is it to believe that a CCP could liquidate the open positions of both the largest and second-largest clearing members? I know of two CCPs in different countries where the open interest held by the largest two clearing members approaches or slightly exceeds 50% of the open interest of the CCP. We have always come to believe that other, solvent clearing members would assume those positions given a reasonable if not generous profit motive for doing so. Do we truly think it is feasible to liquidate half of the open interest and under the very stressed market conditions that would undoubtedly accompany the loss of two firms of that size? It is also truly naïve to think that the dire circumstances that caused #1 and#2 to fail would not also cause other clearing members to either fail, or be seriously wounded.

Enter the Leverage Ratio. Assume that only one of the top 10 clearing members of all major CCPs is not a bank. So veritably all of the logical clearing members that would bid on the positions of the defaulter would be banks. Also assume, at least for financial contracts, that 18-32% of a bank’s open positions are proprietary positions (call it 27%), and that banks’ positions are all one way (personal experience). So, it is logical to assume that if a major clearing member were to default, it would be a bank. Let us assume that all banks are long product A (the largest product in the defaulter’s portfolio). That means that all of the other bank clearing members are also already long product A (in the normal and prudent course of managing their business). In order for the CCP to auction off the defaulter’s positions, the solvent clearing members (largely other banks, also long product A) would have to assume new, arguably speculative long positions in product A. Depending on the national venue, some combination of actual banking policy, political pressure and/or the Leverage Ratio provide powerful incentives for those same banks not to assume the defaulter’s positions. Recall that the rules of some CCPs require that solvent clearing members bid on the defaulter’s positions.

Lastly, if banks’ proprietary positions account for 27% of the long positions in product A, it must then be that customer positions at all clearing members (including the defaulter) must be net short 27% of the open interest in product A. So, if commercial customers of solvent clearing members were invited to participate in the auction of the defaulter’s long positions in product A, a plurality of them would be liquidating their own short position in doing so (assuming some new long positions) and could potentially lose hedge accounting benefits in doing so.

All of which (hopefully) begs the question who is going to assume upwards of 40% of the open interest if the two largest two clearing members were to default. If you assume that the above assumptions are grounded in fact, who is going to assume 20-30% of the open interest if just the largest clearing member were to default?

My point: 10 years ago (April 2012), the CPMI/IOSCO group that gave us the 24 principles for financial market infrastructures should have given us 25. The CPMI/IOSCO group should have proposed an outcome-based principle similar to a GSIB score for clearing intermediaries that strives to achieve the same public policy objective as the GSIB score does for banks. The Cliff Notes version: there would be real public costs associated with the failure of a major bank. In order to protect the public good, (and to make such a potential insolvency as improbable as possible) banks are required to increase their respective ratio of capital to assets as the bank gets larger and larger. This accomplishes three things: (1) It makes it increasingly improbable that the bank would fail at all (2) If the bank did fail, the larger capital base would decrease the public costs of its failure (3) Most importantly, it creates a significant financial incentive not to grow (at least through balance sheet assets) beyond a level that serves the public good.

The self-appointed guardians of financial market infrastructure seem to have done an excellent job of addressing most of the critical aspects, except for the concentration of clearing. It is probably too late to inaugurate a GSIB framework for financial market infrastructure, given the concentration of business currently resident in most major CCPs.

A last and comforting thought. Imagine what circumstances it would take to cause the demise of the largest two clearing members at all major CCPs. Also assume that in most of those cases, the largest two clearing members are banks. It is truly difficult to imagine an insufficient public sector response that would allow some (don’t assume that #1 and #2 would become insolvent in isolation) of the largest deposit-taking financial institutions on the planet to fall away. Although I have serious reservations about the laissez-faire approach that has allowed clearing concentration to reach its current level, it is nonetheless very difficult to envision a scenario where public sector support would be insufficient to preclude Armageddon.