Tuesday, October 29, 2019
“Big banks do not usually gang up to demand more financial regulation, least of all with asset managers in tow.” That’s the first sentence of Gillian Tett’s recent piece, Banks are right to say that clearing houses are ripe for reform, in the Financial Times (here – subscription required). Her title and lead sentence are spot on. That should be worrisome to all. Tett’s piece centers on a white paper, A Path Forward for CCP Resilience, Recovery, and Resolution (here), released on October 24, 2019, by nine financial institutions (Allianz Global Investors, BlackRock, Citi, Goldman Sachs, Societe Generale, JPMorgan Chase & Co., State Street, T.RowePrice, and Vanguard). Tett states: “the current status quo around clearing houses is worrying.” As BLPB readers know, I agree.
The white paper calls for “enhanced risk management standards and aligning incentives through requirements for meaningful CCP [clearinghouse] own capital for covering both default and non-default losses and recapitalization resources.” (p.1) It highlights the incentive misalignment present in many clearinghouses given their publicly-traded, shareholder ownership status: “Although CCP shareholders take 100% of the returns a CCP earns from clearing revenues, they bear only a small portion of the losses the CCP incurs as a result of a default.” (p.10) Many of its recommendations are not new, but some are. These include: a clearing member voting mechanism in recovery; ex-ante provision of financial resources for resolution; and, the possibility of “long-term debt that could be bailed in for recapitalization.” (p.1)
While I generally agree with the white paper’s recommendations, I don’t think they go far enough. As I’ve posted before on clearinghouses (here, here, here, here) and will do so in the future, I’ll just highlight a few things. First, while increasing clearinghouse capital is a step in the right direction towards better incentive alignment, it’s only a start. The ownership structure itself of these institutions needs to be addressed. If clearinghouses were owned by their members – as they were historically – the incentive misalignment between members and owners would largely diminish. However, as I’ve noted in Incomplete Clearinghouse Mandates (here), even if clearinghouses are all member-owned, this doesn’t solve the problem of who ultimately holds the extreme tail risk of these institutions. In a previous post (here), I pointed out parallels between clearinghouses and the residential mortgage giants, Fannie Mae and Freddie Mac, whose exit from government ownership is still pending more than a decade after the financial crisis. Let’s not go down the same route in the clearinghouse space.
Second, the white paper argues that clearinghouses should generally be responsible for non-default losses. I agree. However, as I’ve noted before, both types of losses could occur in close proximity. Hence, it could be very difficult in practice to separate them out to allocate any losses in the case of investor-owned clearinghouses. Finally, as I write about in forthcoming research, clearinghouses are self-regulatory organizations (SROs). Presumably, they would be acting in a regulatory capacity in a recovery scenario as it is arguably the analog to government action in a resolution scenario. Exchanges, as SROs, are generally entitled to regulatory immunity for actions taken in a regulatory capacity (for more on exchange immunity, see here). At the same time, the recovery of an investor-owned, distressed clearinghouse is also inherently a commercial endeavor. It is fundamentally about the survival of the clearinghouse, and potentially the exchange group structure itself. So, it could be very difficult in practice to separate regulatory from commercial action for purposes of regulatory immunity. Given this consideration, investor-owned clearinghouses could have less incentive to be circumspect about recovery decisions that might adversely impact members.
Tett refers to a “trenchant letter” from the Systemic Risk Council to the Financial Stability Board “demanding action” on clearinghouses. Paul Tucker, who chairs the Council, is the former Deputy Governor of the Bank of England. In closing, I recommend that readers interested in understanding more about the centrality of clearinghouses in financial markets read a 2014 speech by Tucker: Are Clearing Houses the New Central Banks? If the answer to Tucker's question is yes, that says it all!