In the Global Crisis, counterparty risk caused severe market stress. During 2007, the perception that default risk on asset-backed securities was increasing caused a dramatic increase in haircuts on the repurchase agreements that were collateralised with these securities (Gorton and Metrick 2012, Copeland, Martin and Walker 2014, Krishnamurthy et al. 2014). The re-pricing of risk made it harder for many financial intermediaries to roll over their debt. After the failure of Lehman Brothers in 2008 and the near-failure of AIG, counterparty risk was also a major concern in derivatives markets. Both had been counterparties on several trillion of dollars of trades in CDS and other swaps.
The regulatory agenda worldwide has since attempted to prevent market breakdowns due to counterparty risk. In 2009, at the G20 Pittsburgh summit, public authorities mandated the use of central clearing counterparties (CCPs) for standardised financial derivatives (Duffie et al. 2015). CCPs are designed to insulate investors against the risk that their counterparties default.
What is a central clearing counterparty?
Between 2007 and 2008, most derivatives trades were agreed over the counter, and settled bilaterally. The introduction of a CCP radically changed the structure of markets. Specifically, after a trade was agreed, a CCP interposed itself between the two parties and became a buyer to the seller, and a seller to the buyer. The two parties were therefore no longer exposed to each other, but only to the CCP. Provided that the CCP had a negligible probability of default, counterparty risk should no longer be a concern, and markets could function smoothly.
Figure 1 shows the radical shift in the structure of financial markets as a result of central clearing. The left-hand panel shows a bilateral network of exposures. The right-hand panel shows the same network after a CCP (the red node) has been introduced. CCPs substitute for buyers and sellers, and therefore know all exposures market-wide. Because they are exposed to the risk of failure of each investor, CCPs evaluate their default risk and call margins (collateral) to cover that risk. Information aggregation, together with the collection of margins, should reduce the risk that markets break down.
Figure 1 Bilateral clearing (left panel) versus central clearing (right panel) (the red node represents the CCP)
Thanks to regulatory changes, more than 70% of derivatives are now centrally cleared worldwide. A side effect has been that CCPs are now becoming ‘too important to fail’ financial intermediaries (Tucker 2013, Duffie 2015, Coeuré 2015). For example, a CCP such as LCH in London is clearing several hundreds of trillions of dollars of interest rate swaps at any time. While CCPs increase financial stability, they also create the risk that the CCP itself could fail, with dramatic effects for financial stability. It is therefore critical to design CCPs that cannot fail.
When do CCPs fail?
In a recent paper (Bignon and Vuillemey 2017), we provide the first detailed quantitative analysis of the failure of a CCP. Using archive data, we study the failure of the Caisse de Liquidation des Affaires en Marchandises (CLAM) in Paris in 1974. The CLAM was the only clearing house in the Paris Commodity Exchange, a market most active for sugar futures. Between 1973 and 1974, a six-fold increase in global sugar prices (see Figure 2) spurred trading. Sugar prices collapsed in November 1974. Margins calls mean that the largest clearing member, and ultimately the CCP, failed.
Figure 2 Spot and nearest-term future sugar price in Paris from January 1973 to June 1975, at a daily frequency (in current FRF per tonne)
Source: Bignon and Vuillemey (2017).
We found that three main causes led to the failure of the CLAM in 1974:
- The composition of the pool of investors. The number of unsophisticated and non-diversified retail investors meant that many defaults occurred when sugar prices dropped. In contrast, investors in sugar markets in London and New York were diversified financial institutions. Therefore, the same fluctuations in sugar prices across all three markets induced massive investor defaults only in Paris.
- Initial margins are note a sufficient instrument for risk management. Therefore, the CLAM failed to contain the growth of a large position by one of its member. On the day of its default, the largest member had a position representing 56% of the total open exposure. The rationale for controlling members’ position size is that liquidating large positions is not frictionless: it takes time, and may be done only at fire-sale prices. Therefore, the larger a position, the larger potential losses for a CCP.
- The CLAM engaged in risk-shifting (Jensen and Meckling 1976). In principle, a CCP should immediately liquidate the position of any defaulting member. However, such liquidation may come at a loss for the CCP. In this context, the CLAM chose to ‘gamble for resurrection’. It delayed the declaration of the largest member’s default, possibly betting on a price reversal. It also attempted to manipulate the price at which margin calls were made by calling for the temporarily closure of the sugar market. Due to a specific rule of the exchange, the settlement price would then have been significantly higher than market prices. Subsequently, it also refused value-increasing renegotiation plans. Overall, we find that the interests of the CLAM and of the defaulted member became closely aligned near distress, at the expense of solvent members.
First, our findings highlight the need for a CCP to monitor the pool of ultimate investors in cleared contracts. While this may prove difficult in the case of client clearing (investors trading and clearing through a broker), margins can play a useful screening role, because by asking for higher margins, a CCP can exclude traders that are financially more constrained. An important lesson from this is that uniform margins are not a sufficient instrument for risk management. A CCP also needs to control the growth and the concentration of exposures (Cruz-Lopez et al. 2016, Menkveld 2017). Potential instruments include member-specific margin adjustments and position limits.
Most importantly, our results suggest that risk-shifting problems can be important in CCPs. The distortions we found are likely to arise in other contexts, since CCPs are often thinly capitalised compared to their largest potential clearing liabilities (Duffie 2015).
Risk-shifting incentives can be limited in several ways:
- CCPs could operate with higher equity ratios. Given the size of centrally cleared markets, however, it seems unlikely that CCPs can reach capitalisation levels that completely prevent risk-shifting. W
- Well-designed default management schemes (‘default waterfalls’) can also reduce risk-shifting incentives. By combining tranches of equity with additional resources called from surviving members, the sensitivity of the CCP’s equity value to settlement prices near distress can be reduced.
- Risk-shifting incentives can be limited through better CCP governance. We highlighted the importance of two types of members. The first is hedgers, who value the continuation of clearing services. The second is liquidity providers, who derive little value from future clearing services. A governance structure that gives more weight to hedgers is less likely to have interests aligned with those of a defaulting member. Therefore, it is less likely to delay the liquidation of a defaulting member’s position – a decision which proved fatal to the CLAM.
Finally, our findings have implications for the current debate on the trade-off between rules and discretion in CCP management (see, for example, ISDA 2015). While discretion over risk-management can enable the CCP to use more information about the conditions of members, our research shows that managerial discretion can also be used to lower total CCP value. Thus, if risk-shifting incentives are large enough, a management of CCPs based on strict rules, near distress, can reduce expected default costs.
This also supports the idea that, if private attempts to negotiate a recovery are inefficiently distorted by risk-shifting incentives, it is desirable that resolution authorities intervene early. If the regulatory environment evolves this direction, that would be a good thing.
Bignon, V and Vuillemey, G (2017), “The failure of a clearinghouse: Empirical evidence”, Working paper.
Coeuré, B (2015), “Ensuring an Adequate Loss-absorbing Capacity of Central Counterparties”, BIS Central Bankers Speeches, Bank of International Settlements: Basel, Switzerland.
Copeland, A, A Martin and M Walker (2014), “Repo Runs: Evidence from the Tri-Party Repo Market”, Journal of Finance 69(6):2343-2380.
Cruz Lopez, J, C Hurlin, J H Harris, and C Pérignon (2016), “CoMargin”, Journal of Financial and Quantitative Analysis (forthcoming).
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Duffie, D, M Scheicher, and G Vuillemey (2015), “Central clearing and collateral demand”, Journal of Financial Economics 116(2): 237-256.
Gorton, G, and A Metrick (2012), “Securitized banking and the run on repo”, Journal of Financial Economics 104(3): 425-451.
Krishnamurthy, A, N Stefan and D Orlov (2014), “Sizing Up Repo”, Journal of Finance 69(6): 2381-2417.
ISDA (2015), CCP default management, recovery and continuity: A proposed recovery framework.
Jensen, M C and W H Meckling (1976), “Theory of the firm: Managerial behavior, agency cost, and capital structure”, Journal of Financial Economics 3: 305–360.
Menkveld, A J (2017), “Crowded trades: An overlooked systemic risk for central clearing counterparties,” Review of Asset Pricing Studies (forthcoming).
Tucker, P (2013), “Solving too big to fail: where do things stand on resolution?” speech at Institute of International Finance Annual Membership Meeting, Washington, DC, 12 October 12.