By Angus Canvin
There is a reason why regulation allows professional investors to use derivatives – and not just to hedge other exposures. They are a highly effective way of taking targeted investment risks. But they do come with ‘counterparty risk’ – the danger that the firm on the other side of the contract turns out to be another Lehman Brothers. Hence the backing by regulators since 2008 for ‘ clearing houses’ (or CCPs), which insulate market participants from each other’s potential default – a key post crisis G20 initiative to enhance financial stability.
Policy makers are also rightly concerned that in concentrating systemic levels of risk in CCPs, new rules are needed to address the situation that a CCP gets into difficulty: the EU plans to legislate in this area in 2016. This has led to suggestions that investors’ own assets might be seized in an effort to rescue a CCP in difficulty. Investors and their asset managers are concerned that confiscation of their property (“haircutting” in the jargon) in a bid to save a failed CCP could amount to throwing good money after bad – and would itself undermine financial stability.
Once a CCP has exhausted its own levels of resource in a crisis, it will have failed its most important test: modelling risk to a standard that gives the market sufficient confidence to go on using it. The market would doubt that the CCP could accurately measure and manage risk arising from the affected asset class post-crisis. This is why the Investment Association supports clear resolution measures, but not open-ended attempts to rescue (or “recover”) the CCP in difficulty.
It is not possible to predict the size of any shortfall at a CCP threatened by crisis, nor, therefore, the amount of investor money at risk of haircutting, because you would be dealing with a systemically unstable situation. Imposing an uncapped liability on end-investors (via open-ended haircutting of margin) at such a time would exacerbate that systemic uncertainty. That prospect would incentivise investors not only to run from a CCP that was perceived to have any weakness relative to others, but also to re-evaluate their exposures in other capital markets – and this at a time of profound financial crisis – potentially propagating the crisis throughout the financial system. EU policy-makers need to take care that well-intentioned measures to save important infrastructure (like a CCP) in a crisis does not precipitate even worse consequences.
Of course, we share with other stakeholders and the public authorities the goal that a CCP should have sufficient ex ante resources in place ahead of any crisis: the CCP must be resilient to crisis. CCP “skin in the game” (or capital) should be substantial, therefore, even if this gives rise to opportunity costs, which should, of course, be measured against the monopolistic revenue-making ability of a CCP. But above all, there needs to be a plan to close any CCP that was discredited, with losses shared fairly and definitively. Maintaining a CCP at all costs will not always be in the best interests of the financial system, hence EU legislative proposal needs to set out an appropriate resolution regime.
Angus Canvin is senior adviser, regulatory affairs, at the Investment Association
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