Creditflux Newsletter

As the shape of the regulatory response to the financial crisis emerges from the smoke and hot air of Washington and Brussels, it seems clear that central counterparties will be big winners. The robust performance of clearing houses, and the way they improved liquidity and transparency after the demise of Lehman Brothers, has helped them find almost universal favour. Provisions in the US financial reform bill will serve to consolidate this advantage. It is one of the few good things to come out of the bill.

But counterparties do create new problems. Buried deep in the June edition of the Bank of England’s increasingly valuable Financial Stability Review is a section on the need to strengthen central counterparties’ risk management regimes. And the bank is right to point out that, as regulators and the market place more confidence in central counterparties it is important that their risk management practices come up to scratch.

Managing credit risk is arguably more complicated and certainly very different from managing interest rate, commodity or equity risk, with which clearers are more familiar. At banks, professionals with decades of experience have demonstrably failed to manage some aspects of the complex inter relationships between credit, liquidity and counterparty risk. What grounds do we have for thinking that the risk managers at the Intercontinental Exchange, the London Clearing House or the Chicago Mercantile Exchange will do any better?

Wolseley has worried here before that central counterparties lack knowledge of credit markets and credit risk. This remains a concern. Why haven’t we seen a Bill Winters, Richard Williams or Eraj Shirvani recruited to the clearing houses? Let us hope it won’t be long.

In the mean time, the Bank of England worries about the impact of competition amongst clearing houses. Where two or more clearers are competing for business in a single product, competition can take the form of lower margins and consequently less conservative risk management. This concern about the undesirable aspects of competition has been heard often of late. We hear about regulatory competition between banking centres, competition described as “a race to the bottom”. Or, when (over) paying for “talent”, managements bemoan the “reckless generosity” of their competitors.

Wolseley is sceptical of all these apparent market failures, but in the spirit of constructive engagement offers a proposal: regulated clearing franchises.

Regulators should award time-limited monopoly franchises to clear particular contracts. Winners will be those central counterparties that offer the best service at the lowest price for a given minimum risk management standard.

Contract terms of, say, five years, should give winning bidders the time to invest in risk management infrastructure and so on. Where winning bidders conspicuously fail, regulators should reserve the right to re-tender. Short of that, competition would be maintained by the periodic franchise renewal.

This scheme implicitly recognises the utility-like structure and importance of central counterparties. Its implementation would be fraught with problems, but many of the challenges will have been met before in waste water management or electricity generation.

Since credit markets are going to be increasingly dependent on central counterparties, it is worth taking time to try to incrementally improve how they work. 

Wolseley is a leading practitioner in the credit market. Feedback is welcome at wolseley@creditflux.com