(Bloomberg Opinion) -- The recent turmoil in commodities markets reveals how important clearinghouses are to the fabric of modern financial markets. Whether it's higher margin requirements, lower liquidity or canceled trades, follow the money and you find yourself standing in front of a clearinghouse.
Clearinghouses fulfill two main functions. The first is to protect buyers and sellers against the risk that the other party doesn't deliver on their side of the trade. They do this by stepping into the middle of transactions, legally becoming the buyer to every seller and the seller to every buyer. The second is to promote efficiency by netting positions of counterparties and providing anonymity of trades. Before the collapse of Lehman Brothers Holdings Inc., clearing houses were little known entities that combined some of the attributes of a bank, a post office and an insurer. “We allow the City to sleep at night,” was how the chairman of London-based LCH Group, one of the world's largest clearinghouses, once described his job.
Lehman Brothers, though, was a defining moment for clearinghouses. While banks were racing to unwind exposure, blind to the tangle of trades elsewhere, LCH did just fine. The clearinghouse unwound Lehman's interest-rate swaps portfolio – all 66,390 trades with a notional value of $9 trillion – without loss. Policy makers noticed and insisted that all trading work along the same lines. Today, close to 75% of interest-rate derivatives and 85% of credit-default swaps are cleared via central clearinghouses.
By making clearing mandatory, policy makers invested clearinghouses with a unique authority. Traders have always had to post margin to deal in derivatives, but unlike in a bilateral arrangement, where traders can agree to terms with each other, in a centrally cleared contract the clearinghouse unilaterally determines margin requirements. Archegos Capital Management LP is a good example of the bilateral model. In 2019, the family office approached Credit Suisse Group AG to ask for a reduction in its margin rates. “Archegos argued that another prime broker offered lower margin rates,” according to an official investigation by the bank into its role in the collapse of Archegos. “Credit Suisse agreed to Archegos's request.” That was an obvious mistake. No such negotiations are possible with a central clearinghouse.
Such power has wide ranging consequences on the way markets behave. By hiking margin requirements in times of stress, clearinghouses can reduce liquidity across the financial system. This became evident in November 2011 during Europe's debt crisis, when clearinghouses raised their requirements against positions in Italian government securities “based partly on discretionary criteria,” according to a report by Italy's central bank. The substantial increase in margins had a big impact on the secondary market of Italian government bonds, provoking a widening of their yield spreads against safer German bonds and causing “liquidity strains for participants in the guarantee system,” the central bank found.
Back then, central banks had to step in to ease those liquidity strains. They did so again in March 2020 when central clearinghouses raised initial margin requirements by roughly $300 billion at the onset of the pandemic, and daily variation margin calls rose from $25 billion a day to a peak of $140 billion.
Such a liquidity drain is currently evident in commodities markets. The European Federation of Energy Traders complained last week that “initial margin (collateral) requirements have increased by circa 6 times within the last 4-6 months. Market volatility has led to the average amount of variation margin required increasing by 10 times from one business day to the other.” Seeing the precedent established during the euro zone sovereign debt crisis and then the Covid-19 pandemic, it is perhaps no surprise that commodity traders should call on central bankers for help. “Liquidity support should be provided by governments or financial public law institutions (e.g. central banks),” the group pleaded.
Central clearinghouses are a useful bulwark against counterparty risk, but the cost may be the transformation of one risk (counterparty risk) into another (liquidity risk). Even in normal market conditions, clearinghouses have a hand in market behavior. That's because margin requirements establish the price of risk. Just as banks influence the amount of credit in the system by how they price credit risk, clearing houses can influence market activity by where they set margin requirements. Set them too low, based on historic correlations, and they provide an incentive to take excess risks.
The difference with banks is that clearinghouses have a lot less skin in the game. When the spread between Nordic and German power prices blew out in 2018, Norwegian trader Einar Aas was caught on the wrong side. He failed to make a margin call and was put into default. After his positions were liquidated, his clearinghouse found itself sitting on a loss of 114 million euros ($126 million) in excess of the margin it had required him to deposit. The clearinghouse took a loss of 7 million euros, but the bulk of the hit was shared between its other customers.
A look at the balance sheet of any clearinghouse tells the same story. LME Clear Ltd., the clearing house at the center of the London Metal Exchange nickel trading saga, has equity equivalent to just 1.05% of its balance sheet. Its contribution to the default fund it administers is just $23.2 million out of $1.36 billion, based on data at the end of 2020. Clearinghouses are the “dumbest money you've ever seen,” says hedge fund manager Russell Clark. “And the reason they're dumb is that they don't have any capital at risk.”
Banks and other market participants are beginning to push back. In 2020, a group of them laid out a series of recommendations to make clearinghouses more resilient to shocks. Recognizing that most central clearinghouses have for-profit ownership structures that may not make them conducive to higher capital requirements, they urge regulatory action.
Prior to the Lehman Brothers crisis, banks grew too powerful. Since then, the pendulum has shifted toward clearinghouses. For some time, commentators have worried that they may have become too big to fail. At the very least, as the commodities crisis shows, they are too big to ignore.
More From Other Writers at Bloomberg Opinion:
- Commodity Traders Go From Bonanza to Bailout Plea: Javier Blas
- Matt Levine's Money Stuff: Nickel Can't Find a Price
- Archegos Is No Big Deal, But Still Sounds a Warning: Editorial
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Marc Rubinstein is a former hedge fund manager. He is the author of the weekly Net Interest newsletter on financial-sector themes.
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