How Clearing Mandates Have Transformed Credit Risks Into Liquidity Risks

by: Craig Pirrong

All you clearing and market infrastructure aficionados must read Bill Hodgson’s piece on collateral transformation at DerivSource. He points out quite accurately the new sources of fragility and vulnerability to stress that will arise from collateral transformation services that are being offered to finance CCP margins in the aftermath of clearing mandates.

The bitter irony here is that many derivatives end users (real money investment funds, industrial hedgers) did not pose any real systemic risk under bilateral structures. But forcing them to clear drives them to utilize funding mechanisms that are systemically risky. As one big corporate end user told me: Clearing mandates have transformed credit risks into liquidity risks: I can manage the first, but the second scares me.

I continue to gape in amazement that the sorcerer’s apprentices that created these mandates did not think to step two. They did not step back and ask: “Gee, we’re imposing a major change on the structure of financial markets. How will market participants respond?” This is especially unbelievable since a big component of the narrative of the financial crisis is that it was the result of excessive financial engineering. What, did FrankenDodd, Timmy!, GiGi, the G-20, the EC, etc., think that the big changes that they imposed would not lead to a new burst of financial engineering? Are they really that clueless?

I think I know the answer. I think you do too.

Markets do not stand still. Market participants will adjust contracts in response to regulations and laws motivated by beliefs that the existing system of contracts is flawed. A useful first approximation is that these contractual adjustments will try to reproduce the economic substance of the banned or restricted contracts. However, many of the work-arounds necessarily utilize less efficient-- and often more fragile-- ways to achieve that substance. Which means that vulnerabilities have largely been relocated, rather than eliminated, and in many cases the new vulnerabilities are more dangerous than the old.

Read Bill’s piece to get an excellent illustration of this dynamic at work. And then remember that the biggest systemic risk is government, and in particular, ill-considered government policies. And that’s especially true when static-minded legislators and regulators attempt to impose their vision on a dynamic, strategic, reacting, self-ordering system.