A recent white paper by the CME entitled Clearing – Balancing CCP and Member Contributions with Exposures brings into sharper focus a debate that has been raging under the surface of the markets, about whether the introduction of mandatory clearing for swaps has concentrated risk in the CCPs and made them too big to fail. As with any document published by a participant in a debate, we have to remember who wrote it, but this paper should help to clarify our thinking on this important topic.

The crux of the debate is about how much capital (in whatever form) is necessary to ensure the safety of the cleared swaps market, and who should put up the bulk of it. Since everyone is now aware of the extent to which increased capital requirements raise the costs of trading, everyone should expect all the market participants to argue that any additional capital should come from any other class but theirs. And that just about sums up this debate.

There are, of course, compelling arguments on both sides. For the CME’s part, after saying that “CCPs are fundamentally risk managers responsible for ensuring the overall safety and soundness of their markets,” they go on to say, “Ensuring that market participants and clearing firms have the proper skin in the game is one of the most critical roles of a CCP.” This sets the stage for most of the CME’s argument – that recent financial failures were due to the perpetrators’ not having the same exposure as their customers or the government; i.e. not having skin in the game.

The CME argues that the waterfall approach, where increasing losses tap into ever more general pools of money – from the customer’s IM to the clearing member’s IM, to the clearing member’s part of the default fund, to the default fund in general, to assessments on members – serves not only to spread the risk appropriately but also to discourage risky behavior. They conclude that, “The discussion of skin in the game should focus largely on the amount of skin in the game that each clearing member must contribute to the waterfall, including IM, concentration margin, default fund, and assessments. A clearing member’s skin in the game should scale with the exposures they bring to the CCP.”

So it is appropriate now to take a closer look at how swaps clearing actually works, and see if we can determine how risk is created and then managed. The first thing to understand is that in the omnibus model the clearing member truly stands between the CCP and the customer who is actually creating the risk. Unless the CCP maintains separate accounts for each customer, it performs no KYC, does no credit checking, and assigns no limits to each customer. It knows which positions and margin are proprietary to the clearing member and which are customer positions, but nothing about which customer has which positions. In other words, the CCP is relying totally on the clearing member’s risk management. No wonder they want the members to have lots of skin in the game.

However, there are several other considerations, at least in the minds of market participants. One is that providing clearing services is very much a volume business, in the same way that custody or payment clearing is. Volume businesses always tend toward concentration, since higher volume leads to lower costs. But since clearing is also about risk, this phenomenon automatically tends toward risk concentration.

The second consideration is the typical pattern of financial disasters. The risk always starts out as manageable, and the forecast is rosy. Then a few things start to go wrong, and the victim makes a few “temporary” adjustments to rectify the situation. Then those start to go wrong, and even more questionable measures are taken. All the while, everyone in the know makes sure nobody else knows, because making it public will only make it worse. Then, under further deterioration some blatantly illegal things are done, just before the wave breaks and everyone finds out how bad things are. Except that the public panic makes it significantly worse.

One implication of this scenario is that, as vigilant as a counterparty may be, they might not see the cracks in the façade until the edifice is already falling down. In the bilateral world firms deal with this risk by limiting their exposure to any party to only what they would be comfortable losing. Obviously, customers can open accounts with multiple counterparties and thus build up gargantuan positions, but at least the risk is spread out, based on each firm’s risk appetite.

Clearing adds a few wrinkles to this scenario, but some aspects remain the same. Assuming the customer opens accounts at several clearing firms, and each of them independently does its own due diligence, the same opportunity for a market meltdown exists. And it is likely that the distant rumblings of trouble would be as muted as in the bilateral world, until it all comes out. So far, no difference.

The big question is, what happens when it does come out. Assuming that this one customer represents, say, 70% of the positions on the losing side, everyone would immediately ask, “Where were those positions cleared?” Now, instead of having them spread out amongst many firms, they all appear in one place, the CCP. And the resolution plans of many CCPs indicate that they could use the VM expected to be paid on the winning positions to cover the losses.

Knowing that, customers would rush to withdraw their seg balances from the clearing members, and the members from the CCP, and we start to have lines around the block. It all looks worse, though, if the culprit is a clearing firm itself. In that case, one could be sure that they would have already accessed all their IM, default contributions, and any other cash, and possibly their customers’ cash as well.

As grim as this scenario is, it has already happened on a minor scale. The point is that the swaps markets are huge. The fixed-float outstanding notional is still around $400 trillion, as far as I can tell, so a 100 bp move in short rates represents a full fledged earthquake in terms of VM. Who actually holds all those positions? Nobody knows; not the regulators, not the CCPs, not the clearing firms, nobody.

So in the end, skin in the game may give some folks comfort, but not me. The only way to guard against the dreaded creeping, mushrooming default is transparency and good business practices on the part of the clearing firms. In some ways, the CCPs may only be very interested bystanders, and everyone’s skin is in the game. So risky probably is as risky does.

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