Morgan Stanley: CCPs next "too big to fail"
28 September 2011
Central counterparties are intended to reduce risk in the financial system but according to Morgan Stanley they could be the next entity to be too important to let fail. Annabelle Palmer reports
Read more: IMN
Despite being introduced with a view to driving down risk in the financial system, central counterparties (CCPs) could pose a systemic risk, and instead result in the creation of another group of institutions that could be "too big to fail", according to Andrew Ross, the European head of OTC clearing at Morgan Stanley.
Currently there is no explicit programme for CCPs in securities lending as there is for over-the-counter (OTC) derivatives but discussion at IMN's securities lending conference in London yesterday focussed on the potential impact of any such development.
CCPs are considered to mitigate counterparty risk in securities lending transactions by collecting margin from the lender and the borrower, thereby protecting the CCP if the borrower fails to return the securities or the lender fails to return the collateral.
But a lot of collateral would need to be held should there be another liquidity crisis like there was in 2008. Therefore, the concern is that risk is being concentrated within the CCP and so could actually increase risk.
Ross said: "I once made a joke at a Bank of England meeting that I didn't want LCH.Clearnet to be the biggest derivatives clearing house in the world because as a UK taxpayer I wasn't sure I wanted to underwrite that."
Mick Chadwick, head of trading, securities finance, Aviva Investors, said that increased margin requirements in CCPs and other demands could be prohibitive. If this were to outweigh the perceived benefits for lenders, they could exit the market and this would actually increase risk.
"If you make it harder for [clients] to engage [in securities lending] to be blunt – if only in terms of investment effort – to get up to speed to engage in CCPs takes time and effort, the risk is that they will simply cease discretionary activity. If we are a proxy for the buy-side as a whole there is a risk of withdrawal of supply to the market which I would argue increases systemic risk," he said.
Chadwick also doubts whether securities lending is even risky enough to warrant CCPs in the first place. "To what problem is a CCP a solution?" he said.
The latest Bank of England quarterly bulletin discusses securities lending and the use of CCPs under the assumption that securities lending is systemically risk because: "by increasing the interconnections between institutions [securities lending] can pose potential risks to financial stability."
Chadwick said that CCPs have a role to play in certain products and markets but that he is not convinced by "the arguments advocated by the CCP initiatives for our product."
"They are passionately argued but don't convince," he said.
Chadwick said that if transparency is the issue then there are other solutions, such as using a data/trade repository or enhanced disclosure requirements.
Acting as a central data centre, trade repositories increase transparency by collecting details of transactions, such as notional value, currency, maturity and counterparties. They are already used in credit, interest rate and equity derivatives transactions.
Dirk Bruckmann, head of securities lending, Europe, DWS investment, was equally sceptical about the use of CCPs in securities lending. He doubts that a CCP could get "enough [collateral] on hand" to cover the risks and that it would upset the markets to make these volumes of collateral available.
He also doesn't believe that asset managers would be convinced enough by the CCP counterparty risk guarantee to lower their collateral standards.
"I don't think that a lot of professional asset managers will accept rubbish as collateral just because the CCP is behind it," he said.
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