Centralised risk raises systemic worries over derivatives

Six years after the financial crisis exposed the systemic dangers of derivatives, the industry faces questions as to whether risk management systems will contain the next major bout of market turmoil.

On Tuesday FIA Global, the futures industry trade association, will add its voice to a growing debate about the role of clearing houses, the centralised risk managers charged with bolstering market stability. FIA will call for greater transparency and disclosure from clearers for banks and broker-dealers to help identify credit and operational risks.

This comes after regulators put pressure on the global market since 2009 to push more swap trades into clearing houses, entities that stand between investors and banks, tasked with ensuring a deal is completed should one side default.

However, uneasiness pervades this fundamental market shift, with some worried that global regulations have not created a resilient framework that could function in the event of a major financial institution failing. While the risk associated with derivative trades is being collected in one place, via clearing houses, the potential for systemic pressure, however remains in place.

The Bank of England, for one, has expressed concerns that clearing houses are being asked to take on risk management for market liquidity, when they were built for managing counterparty credit risk.

"It's largely the reshuffling of risk - it's not gone away," says Craig Pirrong, an academic at the University of Houston in the US. "Regulators have not taken a truly systemic approach to analysing risk."

Market participants say that clearing houses' differing and opaque risk models mean risks cannot be consistently compared. Chief among them is that clearing houses' risk models are "procyclical" - meaning they require more margin for derivatives portfolios during times of market stress, which is also the most difficult time for traders to find more stable liquid assets.

Neither regulators nor market participants want a replay of Lehman Brothers, whose failure in 2008 exposed a huge interlinked world of trades across the market and thus threatened other institutions.

But now the majority of the world's derivatives trades will be handled by just four clearing houses, owned by CME Group and Intercontinental Exchange of the US, Germany's Deutsche Borse and LCH.Clearnet, controlled by the London Stock Exchange Group.

To insulate themselves against the next financial meltdown, two issues persistently dominate industry debate - greater financial participation by clearing houses and more transparency in their risk management models.

Dennis McLaughlin, chief risk officer at LCH.Clearnet, the world's largest swaps clearer, says customers worry: "What if Lehman happened again tomorrow?"

He adds: "Customers want to know two things: how safe is my money in the default fund, and are you going to ask me for any more?"

Users of clearing houses are "members" who contribute to a mutual default fund and are prepared to share losses. The clearing house also contributes to the fund - so-called "skin in the game" - but it grows increasingly expensive for large users. JPMorgan and Citigroup are leading the calls for more direct contributions, although it has been strongly resisted by CME, LCH and Eurex.

"Clearing house skin in the game is generally a negligible percentage of the overall default fund," says Mariam Rafi, US head of OTC clearing at Citi. "However clearing houses are for-profit entities. They decide the risk model, they determine what new products are going into the clearing houses. It brings up the question of misalignment of incentives."

Behind the FIA's warning is a nagging fear of another Hanmag Securities. The South Korean futures broker went bankrupt in late 2013 when an errant algorithm racked up nearly $45m in losses in just 143 seconds. The local clearing house, KRX, dumped the losses on other users.

Regulators are beginning to address concerns. Next year the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions will require clearing houses to publish their models for calculating their users' risk, in the hope it will assuage customers' worries.

"The bankers should be reassur?ed as to the risk modelling when the quantitative disclosures are introduced. They're going to go from a black box to southern French nudist colony," says Thomas Krantz, senior adviser, capital markets at Thomas Murray, a markets consultancy.

He, like the FIA and others, warns of the need for more vigilance. Banks and brokers are also calling for standardised stress tests, so they can compare the risks. CPMI-Iosco has promised a review, but it has only started a new debate as to which model would be deep and transparent enough to give users reassurance, without publicising sensitive market positions.

Still, others worry that about a homogenised market in which the majority of derivatives trades are among a handful of clearing houses all using similar risk models, and deciding which instruments are introduced into the mutual default fund.

"It's never going to be an easy mix when you take an interbank market and stick it into capital markets," says Mr Krantz.

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