17 Jun 2014
Procyclicality may not be a word that’s often used in polite conversation – but it is a bad thing. It is a term used by the Bank of England in its review of clearing houses, published in May, and it refers to the tendency of players in a stressed market to behave in ways that make the stress worse.
However, the Bank’s proposal to reduce procyclicality within the safety measures employed by clearing houses has caused concern. It would mean them divulging information about how they manage risk – and potentially exacerbate the problems at times of market stress. As a result of clearing houses’ growing importance in mitigating systemic risk, there have been calls for them to be subject to stress tests.
Clearing houses guarantee trades in the event that one of the parties is unable to deliver on its side of a deal. It is a goal of the G20 to ensure that many of the trades previously done between banks are to be done via clearing houses, where they are easier to monitor. Among the big clearers in Europe are LCH.Clearnet, owned by the London Stock Exchange, Ice Clear Europe, owned by IntercontinentalExchange, and Deutsche Börse’s Eurex clearing.
The clearing house takes assets from market participants – typically high-grade bonds or cash – and keeps those assets as collateral; if one of the trading parties goes bust, the clearing house takes over its open positions and trades its contracts with the rest of the market until its book is clear. There is a good chance the clearer will make a loss from the deal, but it will have the collateral to meet this shortfall.
As market conditions change, if market volatility rises for example, the clearing house may ask for more collateral from traders. But the exact risk-management system used by the clearing houses is proprietary to them and so the formulae for setting margin levels are not publicly available.
Publish calculations
The Bank of England’s paper looks at two quantitative measures of procyclicality and recommends that clearing houses should publish their rules for calculating collateral requirements.
By having greater insight into clearing houses’ margin requirements, traders could more easily predict the demands, thereby reducing the strain.
The Bank’s study, entitled Financial Stability Paper No. 29: An Investigation into the Procyclicality of Risk-Based Initial Margin Models, recommends that clearing houses “disclose the procyclicality properties of their margin models, perhaps by reporting the proposed procyclicality measures”. It said this would help firms using derivatives to anticipate any potential margin calls, and also to ensure they had sufficient access to the required liquid assets.
When mandatory clearing for derivatives was first mooted by the G20 countries in 2009, the initial concern raised was that clearing houses would have an incentive to make their margin requirements as low as possible, to attract business.
Diana Chan, chief executive of EuroCCP, an equities-only clearing house, said: “If you ask clearing houses whether they compete on risk management, they will tell you they do not. But if you ask a market participant if they try to economise on the level of collateral that they need to post, they are likely to say that there is a financing cost associated with collateral and therefore they need to consider the level of margin required from different clearing houses if they had a choice of where to clear. The level of collateral therefore assumes a commercial dimension.”
Lee McCormack, client clearing business development manager at broker Nomura, said: “When mandatory clearing was first proposed, there was concern that there would be a race to the bottom on clearing house risk management.”
However in 2012, the Committee on Payment and Settlement Systems and the technical committee of the International Organization of Securities Commissions agreed a governance framework designed to ensure competitive forces would not damage systemic security. McCormack said those guidelines should prevent a race to the bottom.
Convergence risk
But there is a different risk – the potential of risk models between clearing houses converging. At present, clearing houses use different models for calculating margin and have different collateral regimes. Where some will accept only major currencies and government bonds, others will accept a wider range of currencies and securities issued by other entities, such as local governments, institutions and corporations.
The risk perceived is that once the clearing houses see each other’s models, they will start to converge. Damon Batten, a risk specialist and principal at post-trade consultancy Catalyst, believes that a race to the bottom is unlikely but that convergence of models could be an issue. He said that the tendency of clearing houses is to adopt different risk models, removing the pressure from regulators and adding diversity to the financial system.
He said: “It is difficult for regulators to mandate or control clearing house model divergence, but it seems that clearing houses, in their desire to differentiate themselves from one another, are naturally starting to adopt different risk models and approaches.”
“A potential race to the bottom on risk is a particular concern, but clearing houses have strong governance around risk matters and it is not an issue that we have seen arise thus far.”
However, if there was a disclosure of risk models, he said: “a group-think scenario amongst clearing houses is a relevant risk and one that is more difficult to mitigate for regulators, as it would be difficult for regulators to demand a plurality of models from clearing houses”.
McCormack of Nomura believes convergence is a possibility. He said: “I struggle to see a commercial benefit in being vastly diversified. If clients voted with their feet based on initial margin differences, then other clearing houses could respond quite easily: there are no intellectual property barriers to prevent that from happening.”
Stress testing
Without this plurality, the risk is that when market conditions worsen, a large number of market participants will get asked for the same collateral at the same time, causing a squeeze on supply. Chan of EuroCCP said: “If all clearing houses were to use the same model, and there is a severely stressed market that causes historically correlated relationships to break, then that model may not work anymore. There is then the risk of under-collateralisation and therefore increased risk.”
In an emailed statement, a spokesperson for Eurex noted that regulators are already ensuring clearers have good margin, and talk with their members to reduce procyclical effects. The spokesperson added: “We would not expect that disclosures of margin models lead to any further procyclical tendencies.”
One solution is to conduct a stress test for clearing houses; Iosco currently requires them to stress-test their own risk frameworks and for competent authorities to provide information on changes to their stress framework.
Several respondents to a recent Bank of England paper on Europe-wide bank stress testing believe that centralised stress testing across clearing houses would be advisable, although the complexity of their models was thought to require a tailored test programme, not the one size-fits-all methods used for bank stress tests.
The European Securities and Markets Authority is in the process of authorising clearing houses to clear OTC derivatives trades, and Chan said she expected it will engage in stress tests at the end of this exercise, expected in 2015. A number of clearing houses, including EuroCCP, are already authorised.
Batten said: “Although clearing houses are acting as a mitigant of risk to a large extent, they are also a concentrator of risk; and as more trades flow to them they will become increasingly important to the financial system – so involving them in industry-wide stress testing is a good conclusion.”
