The most powerful financial regulators in the world — and they never asked for the job
Just a little more than three years ago, the acronym “PIIGS” was all over the news and the Eurozone crisis was at its very height — the post-EMU high for the Italian government bond spread over Bunds was achieved toward the end of December 2011. This was a pretty chaotic and scary time for everyone involved, and many things went wrong during the month of November, but I’d like to focus on one specific event that has apparently been largely forgotten.
You can see the volatility in November/December 2011, which ended up being brought under control by the ECB’s LTRO program. If you look carefully, though, you can see that the first peak has a sort of double top; after the yield went over 7% for the first time, it shot back down again, but then immediately headed back above 7%. This was the week beginning November 6th 2011, which was one of the most stressful weeks of the whole crisis. It started with the ECB and Italy at impasse over the implementation of the austerity budget. The first spike above 7% happened on the Tuesday. Then on Wednesday, Silvio Berlusconi announced that he would resign, sending yields back down again as it was widely believed that this was a necessary step to rebuild the relationship between Italy and the ECB. And then the day after that, something interesting happened.
What happened was that LCH.Clearnet SA raised the initial margin requirement for collateral to be posted against Italian bond trades which were to be cleared within its framework. Basically, if you were trading Italian government bonds and clearing your trades through LCH.Clearnet SA, you had to come up with more cash. And, of course, coming up with cash was not exactly the easiest thing for anyone to do in November 2011 — it was a fairly serious liquidity crisis.
So, what do you do? You get out of your Italian bond trades, that’s what. You also try to liquidate a load of your other asset positions, either because you worried that something might happen to them too, or simply to raise cash. And of course, forced selling by levered traders had a predictable effect on yields. The Clearnet margin call was hardly the only thing going wrong in Europe at the time, but it certainly helped to make a bad situation worse.
In fact, things were a lot less serious than they could have been. LCH.Clearnet SA is not the main clearing house for repo in Europe — that is the RepoClear service of LCH.Clearnet Ltd, the London operation. Repoclear never raised its margin requirements on Italian debt, although it had a strange fixation throughout the crisis with tweaking the margins on Irish bonds. And Italy, given its status as the Eurozone’s largest and most liquid government bond market, has a significant domestic clearing industry, which handled the lion’s share of clearing and which also never changed its requirements. So it was never more than a small fraction of the overall market in Italian bonds which was subjected to a sudden liquidity squeeze.
But if the whole market had been caught, the squeeze would have been a big problem. There’s a simple matter of arithmetic here; margin requirements are, necessarily, a small percentage of the value of a trade. But because of this, there’s a built in leverage effect — a small increase in the protection given to the clearing house equates to a very big percentage increase in the demand for cash. So, for example, it might seem reasonable to increase the margin from 1% to 5% if you think the volatility of the instrument has gone up a bit. But if you do this, then someone with $1m of margin posted with you has to find another $4m, immediately. And of course, the correlation properties of this liquidity risk are horrible — the demand for more cash is going to arrive, more or less inevitably, at the worst possible time for the people you’re demanding it from.
The deep issue here is that clearing houses are the choke-points of financial trading. This is going to be even more the case going forward, as regulators have insisted that more and more markets should be centrally cleared. Given this, you can see why it’s such a big priority for supervisors and market players alike that a clearing house should never be allowed to fail — they are the single points of vulnerability, so there have been an absolute raft of new regulatory measures for them over the last four years, increasing capital requirements, layering on cross-guarantees and bickering like hell about default funds, all aimed at making sure that something which has more or less never happened in the past — the failure of a major clearing house — should never ever happen in the future.
Hurray for that &c. But I worry, quite a lot, that people are kind of missing the point. The problem with clearing houses is really not the remote, theoretical (although admittedly horrifying) risk that one of them might suffer a counterparty default which forced it into insolvency. The problem about clearing houses is that the ways in which they protect themselves against credit risk tend to have the effect of radiating liquidity problems out into the rest of the system.
The ECB’s own Risk Control Framework — the criteria it uses to determine acceptability and haircuts on collateral for open market operations — is a key tool of policy, and has been altered on several occasions to avoid an iatrogenic disaster, particularly whenever it looked like a credit rating downgrade to Greece might have precipitated a banking collapse. But this is one of a very small number of risk control frameworks and collateral standards which is actively managed by professional policymakers in the interests of the stability of the system as a whole.
Much more normally, collateral, margin and haircutting decisions are the responsibility of risk managers at clearing houses, which are themselves independent and profit-making private sector companies. In other words, a crucial parameter affecting the liquidity of the financial system — almost the antimatter equivalent of the central bank’s Lender of Last Resort function — has been handed over to a group of people who only have utterly counterproductive incentives to protect their own institution.
It doesn’t seem very satisfactory to me. The Federal Reserve seemed to be moving in the direction of understanding this problem with the “fire sale risk”, but this work programme was associated with Jerome Stein, and seems to have gone on the back burner since he left the Fed. Paul Tucker also seems to get it (and indeed raises the question of whether clearing houses should be in the private sector at all), but he isn’t a central banker any more. Meanwhile, the regulatory authorities of the world seem to be congratulating themselves for ever tighter regulation of OTC markets, albeit without ever really explaining to anyone why we should have been so frightened of them in the first place, while continuing to put more and more control over liquidity requirements in more and more securities markets in the hands of people who didn’t ask for the job, don’t want it and can’t reasonably be expected to be any good at it.
