Derivatives and Market Stability
A Work in Progress
by claude lopez
claude lopez is director of international finance and macroeconomics research at the Milken Institute. This article draws on research done with Elham Saeidinezhad, a research economist at the Institute.
Illustrations by Gary Taxali
Published April 27, 2018
Of all the new terminology Americans were forced to absorb in order to remain financially literate during the Great Recession, few were as baffling as “derivatives” and the whole family of synthetic financial products hovering around them. The global economy was awash in derivatives — trillions and trillions and trillions worth, we were told. And for good reason: over the decades, they had become indispensable tools for managing risk and leveraging stakes in fast-moving, complex markets.
The clock could thus not be rolled back to simpler times as part of reforms to prevent the next crisis. Derivatives had to be tamed by integrating them into a transparent structure that could withstand great stress. Here, I offer a progress report on efforts to shield derivatives from instability by requiring third parties to stand between buyers and sellers as umpire and backstop.
First, a refresher on what wasn’t supposed to happen in 2008, but did. Financial derivatives — contracts requiring payments from one party to another in the event, say, interest rates go up, have been all over the place for a long time. Some, like futures contracts on commodities, have routinely traded on exchanges, making it possible for grain farmers and millers to lock in the price of wheat they’ll face a year from now. But much of the spectacular growth in derivatives was in the over-the-counter (OTC) market, where contracts were customized to the specifications of the contracting parties and no third-party watchdog was automatically bound to save the day if one party defaulted.
Bulletproofing the Clearinghouses
The 2008 financial collapse showed that large losses in unregulated OTC derivatives could destabilize global finance, as the rupture of critical strands in the web of obligations linking practically every financial intermediary with every other sent shocks through the entire system. To prevent a repeat performance, the leaders of the G20 countries agreed in 2009 to reform the OTC derivatives market by requiring a central counterparty clearinghouse (CCP) for standardized contracts. By stepping into the middle of trades, a clearinghouse becomes “the buyer to every seller and seller to every buyer.” In their function as a sole principal for derivatives trades, CCPs provide transparency and collective loss mitigation — along with such arcana as multilateral netting and collateralization — that enhance the ability of the system to withstand shocks.
Since the reform, CCPs have become an indispensable part of the infrastructure for derivatives trading. Approximately 75 percent of the garden-variety derivative agreements known as swaps (which usually involve the “swap” of distinct cash flows) are now cleared through clearinghouses, compared with just 15 percent before the financial crisis. This rapid increase in the concentration of trading exposure has since led regulators and market participants to shift their focus to the resilience of the CCPs to systemic shocks.
Accordingly, regulators have required the largest CCPs to follow a three-step assessment process. First, a CCP is identified and designated as a systemically important market utility. Second, each CCP is required to implement stress testing (along the lines required of the banks), whose results are evaluated by the regulator. And third, each CCP must present a plan for recovery and orderly resolution in the event of a great shock.
The stress tests are intended to detect vulnerabilities and improve the risk management of the CCPs, including tuning levels of capital and collateral (margins). Margins are in the form of cash or other acceptable collateral such as U.S. Treasuries or government agency securities that are highly liquid. The amount of initial margin required is based mainly on the risk characteristics of the clearing member’s portfolio.
This resolution planning helps to ensure the continuity of the trading system by designating a well-defined “waterfall” — a cascade of financial backstops triggered in the case of default of a CCP member.
While strengthening CCPs is a necessary condition for bulletproofing the broader financial system, it’s worth remembering that it isn’t sufficient. The stress tests evaluate the individual CCP’s resilience in isolation, without considering potential spillovers or feedback new derivatives trading rules may have on the rest of the financial system. Indeed, many of the channels of risk transmission between CCPs and the financial system — direct and indirect — remain to be identified.
Meanwhile, market participants’ trading behavior and changes in their risk profiles associated with mandatory central clearing tend to be overlooked. Ignoring such links may lead to unwarranted optimism when it comes to CCPs’ ability to alleviate pressure on the financial system, particularly in a time of financial distress.
For example, an increase in the amount required to backstop CCPs may reduce leverage in derivatives markets, thus making them more stable. But this may amount to robbing Peter to pay Paul, worsening liquidity conditions in other financial markets as margin requirements kick in just when collateral is most scarce. And more frequent trades, particularly intra-day adjustments, cleared through a small number of CCPs using similar margining methods may make matters worse.
Other feedback loops in markets add complexity to the analysis. The ability to meet margin requirements depends strongly on the extension of credit by clearing members, since they usually fund margin calls for their clients. In periods of extreme financial market stress, CCP members’ need to extend credit to their clients competes with their obligation to provide collateral in the event of counterparty defaults. And these competing obligations place extra pressure on clearing members at the worst time because defaults often occur during — or can even be induced by — widespread illiquid conditions.
Consider, too, that CCP members are mostly banks, which are also the main liquidity providers for the rest of the financial system. Consequently, CCP member margining responsibilities could hinder banks’ ability to lend to other parts of the financial system at moments when the system most needs liquidity.
Finally, as emphasized earlier, the increasing systemic importance of CCPs raises questions about the balance between increasing capital to bolster CCPs’ resilience to large shocks and ensuring that CCPs have adequate resolution plans. When the backstop provided by a CCP is no longer credible, current procedures call for the CCP to raise funds from third parties In essence, this view regards end-user balance sheets of derivatives users to be a public good that could bolster a failing CCP in times of financial market stress. This is because the CCP assures trade finality to all market players when conditions are normal. However, recovery and resolution is still very much a work in progress for CCPs that are important financial market utilities. Among other issues, the process requires coordination across different regulatory bodies (e.g., the Commodity Futures Trading Commission and FDIC).
The absence of swift recovery and resolution procedures increases uncertainty and may induce market behavior among non-CCP members that worsens financial stability. Unlike clearing members, an investor in derivatives does not have a contractual relationship with the CCP beyond the completion of the trade to which the CCP is a counterparty. Without assurances under a resolution process, third parties may want to sell their derivative holdings as soon as possible if the CCP’s viability is questioned or if the backstop waterfall is likely to be triggered. In other words, even less-connected CCPs, clearing members or parties to the derivatives contracts may transmit or amplify shocks to the network.
The Neverending Story
These realities leave CCP regulators, who are seeking maximum stability with minimal intervention, in a bind. It is extremely difficult to evaluate the impact of a stronger mandate for, or expanded use of, CCPs on overall financial stability. Studies focusing on financial stability usually attempt to assess macroprudential policy changes holistically, often with a succession of “what if” scenarios, since the financial system is too complex to model completely.
By contrast, most derivatives-centric analyses overlook the potential for spillovers from CCP operations and member obligations to affect other segments of the financial ecosystem. However, as CCPs become more connected among themselves and within the financial system, policies that assign to them added responsibilities may tax their ability to raise capital or improve liquidity during stress. That’s why there is no true substitute for regulatory vigilance. CCP regulation has surely toughened the system. But the relevant agencies still need to monitor market liquidity conditions, ensure effective price discovery and stand ready to support illiquid financial institutions if CCPs and markets threaten to seize.