Sunday, March 3, 2019

Clearinghouse Ownership Redux

Wenqian Huang at the Bank for International Settlements recently posted a new version of her working paper: Central counterparty capitalization and misaligned incentives.  Here’s its abstract:

Financial stability depends on the effective regulation of central counterparties (CCPs), which must take account of the incentives that drive CCP behavior. This paper studies the incentives of a for-profit CCP with limited liability. It faces a trade-off between fee income and counterparty credit risk. A better-capitalized CCP sets a higher collateral requirement to reduce potential default losses, even though it forgoes fee income by deterring potential traders. I show empirically that a 1% increase in CCP capital is associated with a 0.6% increase in required collateral. Limited liability, however, creates a wedge between its capital and collateral policy and the socially optimal solution to this trade-off. The optimal capital requirements should account for clearing fees.

For those who understand the different incentive structures associated with member versus investor owned clearinghouses, some of the model’s finding will be unsurprising: in the absence of capital requirements (such as in the U.S.), member-owned clearinghouses hold more capital than investor-owned institutions.  This has important public policy implications.  Nevertheless, as I noted in an earlier post, there has been a surprising lack of attention to clearinghouse ownership structure in the global conversations that have been taking place for several years now about what to do with a distressed clearinghouse (the problem of clearinghouse recovery and resolution). 

A welcome recent development was the attention to ownership structure in the Financial Stability Board’s November 2018 consultation paper on “Financial resources to support CCP resolution and the treatment of CCP equity in resolution.”  And I did a jig as I read the following language in the joint response letter to this consultation by The International Swaps and Derivatives Association, The Futures Industry Association, and The Institute of International Finance (who collectively “represent the largest number of participants in national and global clearing, banking and financial markets”):

Current legislative proposals on resolution and CCP [clearinghouse] rulebook provisions disproportionately allocate the burden of recovery and resolution on clearing participants in general and clearing members in particular.  On the other hand, in recovery from large defaults, the CCP will solely lose its SITG [skin in the game - any capital the clearinghouse has put in the default waterfall].  While profits in business are privatized by the CCP equity holders, losses in recovery and resolution will be socialized to clearing participants and in extremis the tax payer.  It is inappropriate and in contrast to basic corporate finance principles that clearing participants are asked to “bail out” a CCP yet future profits that the CCP would not have had without the support from participants go to the shareholders of the CCP.

AGREED!  Let’s just be sure to apply such sound thinking to all areas of global financial markets!

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