A Reshuffled Deck Includes All the Same Cards

To paraphrase a classic, keep your opportunities close and your risks closer. US derivatives clearinghouses will be seeing a high volume of domestic trades going forward as a result of Dodd-Frank rules. The major selling points of this Central Counterparty Clearing system (CCP) are transparency for regulators, margin requirements against trades, and the clearinghouse serving as the counterparty rather than the traditional party-to-counterparty dealings in the OTC market.

The clearinghouses benefit from a “clearing member” system. To go through a CCP, members agree to share losses resulting from defaults that arise from fellow members. The funds flow for default coverage does follow a waterfall to protect members’ contributions, but as losses deepen, these members are very much on the hook. While this may seem like a great idea, at its core it represents nothing more than a syndication of counterparty risk.

In many ways, this syndication of credit risk is like the RMBS deals of the mid-2000s — pooling together a bunch of credits so that the good credit risks can offset the bad, mitigating single-name risk, and providing “feel-good” benefits in terms of quantitative measures of risk through diversification a la Modern Portfolio Theory.

But what are we losing? With the transition from single-name risk to pooled risk, we introduce a false sense of security and bring a need to quantify (or otherwise ignore) the specter of correlation risk. If one clearing member’s business is struggling, it’s likely many others are too (as in 2007 – 2009), which puts into question the solvency of the clearinghouse. Ever since Bear Stearns’ collapse in 2008, concerns about macroeconomic solvency have led to blanket concerns about all financial institutions’ liquidity, causing an increase in their funding costs. How will banks manage their counterparty risk in that situation when it inevitably occurs again?

Using single-name CDS costs as a proxy for borrowing costs, remember back in October 2011 when Morgan Stanley CDS jumped nearly 10% in one day to 640 and Goldman Sachs and Bank of America both sold over 400 over Eurozone solvency concerns? (Source) How do those risks look when pooled together? In a sense, instead of having a number of separate “too big to fail” entities, we’re dumping them all into the same boat.

As we learned in 2008, pooling credit risk through syndication doesn’t necessarily constitute sound risk management — in fact, it hinders the ability to nimbly manage your exposure to troubled counterparties. By muddling the ownership of risk, you’re left with no greater tactics for risk management than relying on blind faith in the system and portfolio diversification math. So even with margin requirements, pooled risk, and an armload of good intentions, we still face the possibility of repeating our lingering past mistakes.

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