CCP bailouts, liquidity risk and machine learning

The week on Risk.net, July 21-27 2017

BAILOUT obsession holds back US CCP resolution regime

UK proposes gold plating of liquidity risk rules

BLACKROCK  to use machine learning to gauge liquidity risk

 

COMMENTARY: Hard line on liquidity

The demand for collateral and liquidity services has never been greater – and the potential cost of a misunderstanding of liquidity risk is now so high that funds are investing significant resources, including machine-learning technology, into modelling it more accurately. But the regulatory environment around liquidity risk continues to be damagingly uncertain, in particular for non-bank institutions. Proprietary traders are worried they could come under the European Union’s Mifid II Capital Requirements Regulation (CRR) from January next year if alternative rules aren’t ready in time – the traders themselves are worried that the rules, intended for banks, could throw them out of business, and exchanges such as LSE fear the loss of prop traders could damage market liquidity.

In December next year, meanwhile, US mutual funds will come under new rules that require them to have a formal liquidity risk management programme – another deadline the industry complains it will have trouble meeting.

Banks aren’t escaping either. In the UK, the Prudential Regulation Authority, part of the Bank of England, is proposing liquidity risk precautions well beyond what the EU has required under CRR – a move the BoE’s deputy governor justified as a response to banks gaming the rules by putting funding in place that barely meets the CRR’s requirements and no more.

It’s not an easy problem to address – far more than credit risk, liquidity risk could be the largest threat to central counterparties, researchers believe. And especially at a systemic level it is notoriously difficult to model, with much research in financial network theory aimed at explaining or predicting the flow of liquidity – and the reasons it dries up. But ever since the financial crisis it has been recognised as a major threat not only to institutions. This explains regulators’ interest – and also, perhaps, their haste.

 

STAT OF THE WEEK

Private credit funds raised more money in the first half of this year than in the whole of 2016. By the end of 2016, funds specialising in direct lending, worth next to nothing a decade ago, managed assets of $42 billion – a seven-fold increase since 2012.

 

QUOTE OF THE WEEK

“If we are talking about a market-wide disruption that is affecting all CCPs, you couldn’t just look at taking one struggling CCP and dealing with it by turning to the guarantee fund and then moving its positions to other clearing houses, assuming it would wind up well… In theory, we would turn to Title II in the event of a CCP failure, but at the same time, in this scenario, some of the clearing members themselves may be subject to procedures under Dodd-Frank, not just the CCP. And then CCPs become too big to fail and you assume some kind of public bailout” – Joel Telpner, Sullivan & Worcester

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