In my view, this is only a replication of what the old rule is about – in a bilateral world where risk is a bilateral counterparty risk. Sure, a good way to protect margins but an uncertain way to reduce systemic risk.
We actualy need something smarter than that to build a safer environment for swaps. The bad news for dealers is that the emphasis they may have placed on capital is now wreaking collateral damage as bank capitalization is being discussed by the Basel committee and a surcharge seems to be on the agenda for the Systematically Important Financial Institutions (SIFIs) – a surcharge of as much as three percentage points of common equity. The Swiss regulator has suggested an even stricter surcharge.
Maybe dealers and FCMs will end up with converging views on the fact that capital is not the miracle solution to systemic risk reduction and a capital surcharge for CCP participation is not better than mutualization.
The assumption that stronger capital for CCP member banks would be enough to prevent a repeat of the financial crisis is simply wrong. Looking back at 2008 tells a different story. What caused the financial crisis to worsen was the lack of transparency on positions held by the banks and the lack of trust between banks, which led to a paralysis of the financial system.
Banks that went down were well capitalized and capital was not the issue. Transparency and risk concentration inside bilateral relations and contracts was. So why would it be different this time when looking at best solutions on bank capitalization for CCP exposure – the EU Commission consultation, or discussions that are taking place in the U.S. on Dodd-Frank clearing members requirements?
The listed futures clearing and transaction model can probably bring light to most liquid OTC transactions and clearing in the U.S. and in the EU but the issue is a bit mixed up at the moment and one can get lost easily and lose sight of what matters to make the whole thing actually work.
CCPs under the futures model can be an efficient tool for liquid swaps if risk mutualization among members’ diversity is preserved. There is no certainty that higher capital charges for member banks will reduce central clearing risk. But there is certainty that too high capital charges on member banks would limit CCP participation to large dealers.
That’s the reason why client clearing may need separate risk treatment from self-clearing if a surcharge is imposed, and why member capital charges may need to be capped because CCPs need to be open to most clearing members to remain efficient and safe.
Based on the futures model, more clearing members is better than fewer. The futures model did not fail in 2008.
It is also extremely important that CCPs active in OTC derivatives clearing and listed derivatives clearing enforce strong governance rules that prevent default funds’ contagion between listed and OTC asset classes that bear different risk profiles and systemic risk track records. This way default fund levels could be tailored to each specific asset class risk.
To strengthen the financial system, regulators should require CCPs to cover overall risk via an adequate level of initial margin. Capital thresholds may also be part of the equation but cannot be the sole focus if we want to learn from past disasters. One should look at a mix of reasonable capital charges and margins.
Oh, and if you don’t attend conference panels, make sure you take the shuttle to the beach club next year.