Rules push on clearing houses poses risk to banks

The global regulatory push to force banks to use centralised clearing houses to process their derivatives trades may result in a rapid rise in short-term calls on traders to post sufficient margin to back their trades, a new study has found.

The research paper from the London School of Economics found the daily changes in the valuation of margin, which traders are required to post, may rise tenfold by using central clearing houses. That compared to banks being allowed to clear the same deals between themselves.

The paper’s conclusion that banks may face greater operational risks and more demands on their liquidity underlines regulators’ and market participants’ concerns that a post-crisis global political accord designed to strengthen the financial system may only succeed in shifting risk.

Policy makers have pressed for fewer complex links directly between banks in the wake of the financial crisis. Among the biggest changes is a G20 mandate to push more standardised OTC derivative contracts through central clearing houses, which require trades to post margin to back their trades. Clearing houses, which guarantee trades in the event of a default, are typically owned by exchanges, although some are controlled by a consortium of banks.

Each day traders must have enough margin posted with a counterparty to keep their derivatives contracts open. Rapid, changing valuations of the margin will potentially require more collateral, often for short periods of time.

 However the study also found that banks could find available collateral “immobilised” in a different part of the financial system at critical moments.

“This can be interpreted as tipping the balance of benefits and costs in favour of retaining bilateral OTC markets for a wider range of products and participants,” said authors Ronald Anderson and Karin Joeveer of the LSE’s Systemic Research Centre (SRC).

Assuming a full commitment to centralised clearing, it points out the importance of achieving consolidation and effective integration across infrastructures for a wider range of products

Trades not going through clearing houses will also need to be backed by more collateral. However, the LSE study argued that investors being allowed to net their portfolios in a single place dramatically reduced the changes in margin valuation. That single place could be either a single fully integrated clearing house, or a series of fully interoperable ones.

The move towards centralised clearing, often grouped around a product or geography would greatly increase the number of times the value of the margin value moved, the study concluded.

“Assuming a full commitment to centralised clearing, it points out the importance of achieving consolidation and effective integration across infrastructures for a wider range of products,” the authors said. “The search for new methods to alleviate bottlenecks and seamlessly allocate collateral is the next challenge.”

The Depository Trust and Clearing Corporation, a US clearing house, helped to fund the LSE study, as co-sponsors along with Australia’s Financial Markets Co-operative Research Centre and the SRC.

Some market participants and observers have worried about a global “collateral crunch”, in which demand for high-quality liquid collateral to meet new requirements will exceed supply. Others have downplayed the issue.

The weaknesses in infrastructure included restrictions on investors’ ability to reuse or re-hypothecate collateral and the different risk management techniques used by clearing houses, the study found.