Financial Stability: Central Counterparties

Lord Sharkey Excerpts

Thursday 10th December 2015 Lords Chamber

[Lord Sharkey (LD)]

My Lords, I am indebted to the Bank of England for its publication Central Counterparties: What Are They, Why Do They Matter and How Does the Bank Supervise Them?. I am glad to see that the Minister is similarly indebted. This report sets out the merits of CCPs and it also sets out, very clearly, the risks associated with them.

There are three main risk areas. The first is the systemic impact of a CCP failing. The failure of a large CCP could act as a channel of contagion, resulting in significant failures elsewhere in the financial system. The second risk is that CCPs may act as amplifiers of other systemic shocks. In some cases, CCPs may produce procyclical effects by exacerbating other stresses. For example, increasing initial margin requirements in response to high price volatility may force members to liquidate positions. In an illiquid market, this would only increase price volatility. The third risk concerns inadequate solvency, the ability to meet short-term margin calls and the operational reliability of CCP members. All these risks are well known and appear to be well defined.

What is perhaps less clear from this rather bloodless and technocratic language is the potential scale of these risks, and the extent to which these risks are fully understood. In January this year, the IMF published a workshop paper entitled Central Counterparties: Addressing Their Too Important to Fail Nature. This paper estimated the market size of open, over-the-counter derivative trades at $293 trillion. Some 95% of these open trades were concentrated in the top five CCPs.

These are truly gigantic numbers and truly gigantic interdependencies. It is easy to see how failure could bring down the financial system. It is easy to see why the IMF workshop paper describes these CCPs as “too important to fail”. In fact, it singles out LCH.Clearnet Group and CME in particular because they also operate CCPs in the exchange-traded or equity markets.

In fact, 59% of turnover in exchange-traded derivatives and 78% of equity trades go through the top five CCPs. This is concentration on a very grand scale. I acknowledge, of course, that the G20 brought about this concentration deliberately as a response to the post-Lehman events and that it did so for a very good reason. Nevertheless, the scale of the concentration certainly focuses the mind on the need to prevent failure or at least to properly mitigate risk.

In the view of the IMF workshop paper, four risks are not yet mitigated. The first is the composition of the risk waterfall, referred to by my noble friend Lady Kramer, and the fear that loss-sharing arrangements may be a source of contagion for surviving clearing members. Secondly, the dependency of CCPs on only a few commercial banks for liquidity, custody, settlement and other services can put the CCP and surviving members under severe pressure. The report notes:

“If the defaulting clearing member is one of the contracted service providers of the CCP, the surviving banks may have to step in, placing them under significant pressure. At the same time, the ability of the CCP to manage the default can be significantly weakened by its dependence on those banks”.

Thirdly, collateral sales by multiple CCPs may increase market volatility. Fourthly, the diverging interests of authorities in a globally cleared market may present a problem. If the authority in charge of supervising a CCP is not from the same country as the authorities in charge of the banks, international co-ordination would be very difficult to achieve during distress. Does the Minister agree that these risks are not yet mitigated? If he does, can he tell us how we are progressing towards mitigation? In particular, what progress are we making in reducing risks relating to the interconnectedness and interdependencies of CCPs?

As my noble friend Lady Kramer mentioned, the latest quarterly review from the Bank for International Settlements also turns its attention to the issue of risk and CCPs. It notes, almost in passing, that:

“The competitive dynamics in the CCP industry may work against a strengthening of capital buffers”.

It says that CCPs are for-profit companies and,

“are strongly motivated to generate revenues by expanding their product offering and capturing market share. However, new products could bring incremental risk, which clearing members may end up bearing if the CCP does not increase its capital commensurately”.

This worry is not raised explicitly by the Bank of England or the IMF workshop. Does the Minister think that this is a real concern? If so, what are we doing to mitigate it?

The BIS report concludes by restating some of the benefits of the very rapid shift to central clearing, but says clearly that this shift may give rise to other systemic risk, in particular that,

“the concentration of the risk management of credit and liquidity risk in the CCP may affect system-wide market price and liquidity dynamics in ways that are not yet understood”.

It says:

“It is possible that CCPs can buffer the system against relatively small shocks, at the risk of potentially amplifying larger ones”.

This is obviously an absolutely critical issue. Does the Minister agree with these two points? If he does, can he say how we are working on these issues?

The concentration of risk into CCPs—its benefits and potential downsides—is clearly the focus of a great deal of thought and discussion. I have the distinct impression that there is a reasonably settled consensus about the questions that need to be asked, but no settled consensus as to what the answers may be. Clearly, the debate is still vigorously proceeding and has the air of a work in progress. For example, in September, a group of 24 US banks, rather confusingly calling themselves The Clearing House, wrote to regulators criticising inconsistencies in the risk governance of central counterparties and called for tougher minimum standards. Their letter set out demands in three areas. The first was that CCPs should maintain risk committees with consistent minimum standards. The second was that CCPs should be obliged to consider feedback from clearing members about material risks. The third was that the records of communication between CCPs and clearing members that are the subject of material risks should be properly maintained.

I find all this quite alarming, as the obvious implication is that none of that is in fact happening at the moment. I am conscious that I have asked the Minister quite a lot of questions already but I would like to ask one more. Does he agree with the banks’ three demands, or do we already apply these standards to CCPs in our jurisdiction?

There is, of course, always a tension between regulation and growth—too much of one; not enough of the other. Are we getting the balance right? There is a very old Woody Allen joke about this quoted, rather surprisingly, in the Financial Times. The joke is about a man who cannot have his brother—who thinks he is a chicken—treated by a psychiatrist, because the family needs the eggs. Is the regulation of CCPs somewhat in the same position?