CLEARING HOUSE BUBBLE: Who is watching it?

4 Jun

LCH.Clearnet is one of the leading global clearing houses worldwide.

A brief description from their website explains the role of LCH.Clearnet and the function of a clearing house more specifically:

‘LCH.Clearnet is the leading independent clearing house group, serving major international exchanges and platforms, as well as a range of OTC markets. It clears a broad range of asset classes including: securities, exchange traded derivatives, commodities, energy, freight, interest rate swaps, credit default swaps and euro and sterling denominated bonds and repos; and works closely with market participants and exchanges to identify and develop clearing services for new asset classes.

A clearing house sits in the middle of a trade, assuming the counterparty risk involved when two parties (or members) trade. When the trade is registered with a clearing house, it becomes the legal counterparty to the trade, ensuring the financial performance; if one of the parties fails, the clearing house steps in. By assuming the counterparty risk, the clearing house underpins many important financial markets, facilitating trading and increasing confidence within the market.

Initial and variation margin (or collateral) is collected from clearing members; should they fail, this margin is used to fulfill their obligations. The amount of margin is decided by the clearing house’s highly experienced risk management teams, who assess a member’s positions and market risk on a daily basis. Both the soundness of the risk management approach and the resilience of its systems have been proven in recent times.’

LCH.Clearnet is 83% owned essentially by the investment banks and 17% by the exchanges. The company’s website states that their ‘market leading interest rate swap clearing service, SwapClear, has cleared over 1.5 million OTC IRS trades since launch in 1999. It currently has 49 clearing members and its portfolio contains 850,000 trades with a notional value in excess of $266 trillion.’ The $266 trillion is the net notional and it is important to highlight that this is not the exchanged principals.

While the intentions of a clearing house to centralise risks within the financial participants themselves are healthy and attractable, in practice, this is likely to be superficial. In the event of a credit crisis multiple financial participants are unlikely to withstand the pressure causing widespread defaults. Consolidating the risks centrally and the supervision of it will be a nightmare. Regulators seem to be targeting one of the symptoms of financial instability, rather than the actual root systemic causes of financial volatility and chaos. It is better placed to assess the creation of money and monetary policy, the movement of money and capital and the economic function of investment banks. Housing all risk centrally will ensure that these institutions themselves become, and for the most part, are, already too big to fail. Aggregating risks is dangerous.

Dodd and Frank have got almost all the big decisions wrong. They are a great contrarian indicator. That gives me a lot of confidence. The Dodd-Frank Bill elevates the status of clearing houses with the remit to force financial products onto visibly transparent exchanges. This part of the Bill is healthy as a price-searching mechanism.

However, regulators lack effective controls and insight; the vast majority of interest rate derivatives, credit default swaps, fixed income and equity options are not to hedge farmers output or to hedge fuel costs for airlines; they are purely an instrument for speculators. Enforcing margins of 30 or 70 basis points on deal structures are insufficient; sales coverage at investment banks are wrongly incentivised to push deal volumes. Current NPV’s are extrapolated into the stratosphere to determine future NPV’s; it’s mostly imagination.

For those working within the investment banking community you will be well aware that the majority of the deal volume in derivative and esoteric financial products are heavily weighted towards the hedge fund community. Hedging fuel costs or agricultural produce is not the main function of derivatives; derivatives like Warren Buffet has stated are: “financial weapons of mass destruction” that could harm the whole financial and wider system. There is not enough published information on clearing houses to really delve deeper into how they are able to function in a time of crisis.

Also, there is not enough margin posted between investment banks, financial institutions and clearing houses. New clearing house entrants are likely to enter competing by liberalising margin standards and diluting fees to gain market share. LCH.Clearnet have already accused competitor International Derivatives Clearinghouse (IDCH) of charging flimsy margins on interest rate swaps that are “bordering on reckless”, says Roger Liddell, Chief executive of  LCH.Clearnet. Monopoly concerns within the industry should also be noted.

The silver lining that LCH.Clearnet will vehemently cling to in supporting their franchise and current structure is the successful resolution of Lehman’s  $9 trillion OTC interest rate swap portfolio. LCH stated using Lehman as a case study:

In September 2008, LCH.Clearnet successfully managed Lehman Brothers’ US$9 trillion interest rate swap default, involving 66,000 trades, using SwapClear®’s unique default management process. Less than a week after the default, market risk had been reduced by 90% due to comprehensive hedging. Within three weeks the default was completely resolved – well within the margin held and at no loss to other market participants.

A UK Parliamentary Select Committee report highlights a few problems with the clearing house process in a bankruptcy event succinctly (emphasis in bold):

Lehman Brothers’ involvement in OTC derivatives and financial crisis

Lehman Brothers was a counterparty to many OTC derivative transactions. The clearing of these transactions can be considered a success since the margins provided by different counterparties were sufficient to close out the positions after the default of Lehman Brothers. However, an unexpected adverse consequence arose because of the lack of segregation of collateral payments provided by Lehman clients from those of Lehman’s other assets. Some financial institutions such as hedge funds used Lehman Brothers as a prime broker and provided it with margin and collateral payments. To reduce funding costs, these clients did not insist on the segregation of these payments from other Lehman assets. From the investment bank’s perspective, not segregating these payments gave it the ability to use the collateral to fund further business activity, a process called rehypothecation.

After the Lehman bankruptcy, some funds were unable to reclaim assets they had posted against derivatives and other trades because the collateral had been reused in the bank’s other businesses, including in the UK, and was blocked in bankruptcy proceedings. Several hedge funds suffered a liquidity crisis due to their inability to close positions entered with or through Lehman. This liquidity crisis coincided with redemptions by hedge fund investors.

As a result hedge funds were forced to pull capital from other still healthy investment banks to meet investor redemptions. Since many of these still healthy investment banks were heavily reliant on wholesale funding, [37] these in turn suffered a liquidity crisis.

The actual resolution of Lehman’s interest rate swaps portfolio is highly confidential and there is not enough public information available to truly assess whether ‘no loss to other market participants’ is a wholly accurate reflection of reality. Lehman was resolved in a low interest environment with a very accommodative and loose monetary policy. Fiscal conditions will be signficantly tighter in future credit events.

The pragmatic solution would be a return to basics. Banking needs to be a utility, it should be essentially boring. Investment banks need to return to their core functions of capital raising, market making (not becoming the market), research and advisory, mergers and acquisitions and restructuring. And as Carl Icahn has said recently, Glass-Steagall wasn’t a bad thing. Financial products like CDS protection, for example, should be withheld to those ACTUALLY holding the bonds. Holdings periods on financial instruments should be increased to avoid speculation and manipulation. Leverage ratios should be significantly decreased with a corresponding rise in margin requirements, caps on trading relative to balance sheet fundamentals should also be enforced.

I am not convinced that non-defaulting members will be protected by a clearing house in a significant systemic credit event. The ownership structure of LCH.Clearnet also needs to be independent of those who they serve. Insider trading, fraud and corruption needs to be punished severely as a deterrence to others. As many have said already, Dodd-Frank is not addressing the causes of the financial crisis. The recent news of Goldman Sachs also being the most frequent visitor to CFTC to discuss Dodd-Frank (at least 49 times between July 26 last year and May 26) shows that leaders within the investment banking industry are seeking to maintain their leveraged induced bonuses for a little longer.

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