Market structures under no illusions on risk elimination

The securities market infrastructures forum sessions at this year’s Sibos started on a sobering note with Global Custodian editor-in-chief Dominic Hobson noting that central counterparties by their nature concentrate and redistribute risk in the financial system rather than reduce it.

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The securities market infrastructures forum sessions at this year’s Sibos banking conference in Osaka started on a sobering note with Global Custodian editor-in-chief Dominic Hobson noting that central counterparties (CCPs) by their nature concentrate and redistribute risk in the financial system rather than reduce it.

These “fragile” entities are tasked with finding additional capital as regulators want them to have “skin in the game”.  While CCPs net transactions against each other, trading large numbers means greater demands for liquidity, Hobson said.

Hobson said clearing brokers would struggle to make their margins completely while CCPs would suck the margin of collateral dry.

“CCPs inject liquidity into the system on the way up and withdraw it precipitately on the way down,” Hobson said, adding that CCPs are a worrying panic transmission mechanism in the financial system. Rather than eliminate risk, CCPs concentrate risk and redistribute it to clearing members, creating a risk hurricane.

Broker-dealers have to find variation margin, but we are not eliminating the risk of default – we are repackaging default as liquidity risk, Hobson insisted.

Eating collateral 

CCPs are going to eat a lot of collateral, adding to trading costs, he warned, observing that in theory brokers are free to pile on as much leverage as they can because they know who will ultimately pay. Multilateral netting at CCPs even helps them to cut the capital cost of over trading as does anonymous trading – ultimately speculative traders are going to be drawn to the market.

“We’ve yet to put together an action plan in the case of a failure of a CCP and a central securities depository (CSD),” said Hobson.

Opening up the discussion, John Gubert, chairman of UniCredit’s Global Securities Services executive committee, asked panelists from the CSD and CCP world to comment on the sustainability of these market infrastructures and whether they felt the situation was catastrophic, given Hobson’s comments about risk. Euroclear CEO Tim Howell said certain aspects of risk could be eliminated. “The more CCP netting, the more efficient things will be,” he said. “The infrastructures allow you to mitigate risk to some degree, but saying CCPs are the answer is simplistic. It’s a balancing act for regulators. It’s a case of helpful competition and risk mitigation.”

Diana Chan, CEO of EuroCCP, agreed that there is a means to reduce risk through netting. “Bilateral is a riskier transaction,” said Chan. “CCPs always work through their collateral and they won’t risk their own capital to take risks. If there is a problem then they take action to manage a default situation. There needs to be a resolution regime for CCPs to protect against financial institution failure.”

Sergei Sinkevich, managing director, primary market and globalisation, Moscow Exchange, said: "The risk-reward ratio is an issue. How much risk appetite these CCPs have is also important. We need to look at risk policies for CCPs. Interoperability among these CCPs could help in mitigating risks."

John Gubert, UniCreditGubert then asked whether the current market infrastructures are safe or whether defaults were inevitable. Howell replied that while defaults are inevitable, they do not derail the system. “There will be a shortage of collateral but regulation would be a good outcome,” he said.

Chan said: “The notion that there is not enough collateral is not justified. Collateral transformation and more dispersing of risk not through one provider but maybe several could be a good solution.”

Collateral arbitrage 

Given the concentration of risk through CCPs, the question of default was explored further. Howell said some infrastructures could be amalgamators of risk.

The panelists then tackled the matter of collateral arbitrage, which could have a significant impact on leverage. Hobson noted that if a party fails to deliver collateral the event becomes systemic.

Tim Howell, EuroclearHowell replied: “There, you would look to the infrastructure as liquidity sources. But if you’ve got the assets, it’s second order. It’s difficult to have rules for collateral arbitrage. There is a cost for mitigating risk, high capital and the people.”

Broaching the subject of client failure, Chan argued that more needs to be done to prepare for that risk in terms of liquidity. “Trust in the system, intervention from central bank, CSD and centralisation – it is not all bad and we do have a place where infrastructure comes together,” she said.

Juggling costs and volumes 

The second securities market infrastructure session addressed the cost of settlement amidst an ever-changing regulatory landscape, characterised by low transaction volumes and CCP netting.

Against this backdrop, Hobson asked panelists from the custodian, broker-dealer and infrastructure community for their thoughts on whether transaction volumes would rise. Robert Scharfe, CEO, Luxembourg Stock Exchange, gave an upbeat view of the landscape from the Grand Duchy. “We have 45,000 stocks listed for trading,” he said. Trading volumes may not come back any time soon, but OTC derivatives on exchange can create more volumes.”

Goran Fors, SEBIn contrast, Goran Förs, head of global transaction services at SEB, described the reduction in volumes as damaging. “They won’t come back in the future,” he commented.

Christopher Flanagan, co-chief administrative officer for Asia ex-Japan, Nomura, commented on the region’s role in sustaining securities business. “For broker-dealers, investment bank margins are going down,” he said. “Our exchange and custodian customers want lower commissions. Asia is the bright spot. It will provide customers for us all.”

Costs of fragmentation 

Panellists addressed the cost implications of a lack of harmonisation among market infrastructures. Providing the Asian perspective, Flanagan remarked that, “Asia has different capital markets in each location. I’m hopeful that stage-by-stage things will improve and liquidity will grow with an opportunity for new exchanges.”

In Europe meanwhile, Scharfe saw the role of exchanges as having changed under MiFID with more competition in terms of organised trading facilities and multilateral trading facilities. Exchanges, however, have a pubic institutional role. Instead of cherry-picking they need to cover the full range of securities.

Reporting by Janet du Chenne, Global Custodian