A referendum on clearing

Brexit margin calls show swaps CCPs are relying on funding strength of a handful of banks


If you owe the bank $100, that's your problem; if you owe the bank $100 million, that's the bank's problem.

Or so the saying goes. Now substitute the word ‘bank' for ‘clearing house' and read it again.

On the morning of June 24, clearing houses in Europe and the US found themselves with exactly this problem, repeated across a handful of big member firms. Violent moves in currencies, rates and stocks meant each of those members was asked – at various points during the day – to pay margin calls that are estimated to run into multiple billions of dollars in some cases. At the point of each call, they had an hour or so to make the payment.

This caused some tension at the banks. A senior executive at one large clearer says, in deadpan fashion, that "suddenly being asked to make 10-digit payments makes people uncomfortable".

But the discomfort was felt more widely. During the day, each bank was contacted by the clearing houses – and by regulators – looking for assurances that the margin would be forthcoming. If a bank failed to pay, its positions would be closed out, pouring fuel onto the fire of the Brexit vote. Even the perception of payment difficulties could have triggered panic.

On the day, it all went well. But that's not the point.

The point, which has been made numerous times over the past few years, is that imposing mandatory clearing for over-the-counter derivatives was essentially a decision to trade counterparty risk for liquidity risk: having a third party calculate and enforce margining requirements should reduce the risk of a domino effect when a big market participant collapses, but the need to stump up that margin introduces a new source of fragility.

The aftermath of the 1987 stock market collapse is instructive. Writing a couple of years after the fact, Ben Bernanke, then a Princeton University professor, was one of those to document multiple flaws in the clearing and settlement system. Chicago's clearing houses issued more than $4 billion in variation margin calls during a two-day period – calls with which "the banks were initially reluctant to comply", Bernanke wrote. Fears grew that payments would not be made, and that clearing houses would be unable to act in their role as insurers in the event of a default. This may in turn have made the markets more chaotic.

Brexit margin calls owed less to stock market volatility and more to yield curve moves acting on the interest rate swap market – now in its third year of mandatory clearing in the US – and this is why it is worth a closer look. Unlike the futures market, the bulk of cleared over-the-counter derivatives risk is handled by a small, and shrinking, number of banks. The last time Risk.net did the sums, in March 2015, 73% of cleared OTC risk in the US was passing through just five futures commission merchants.

This is a concentration risk that banks themselves would not tolerate. As one clearing house executive says: "No bank would ever offer a standby letter of credit for $10 billion to one counterparty. You don't ever let yourself be exposed that way."

The old saying would lead to the conclusion that this is the clearing house's problem – not the bank's. But this is where the saying breaks down: it could be everyone's problem.

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