OFR Publishes Working Paper on Process Systems as a Modeling Paradigm for Analyzing Systemic Risk

The Office of Financial Research (“OFR”) published a working paper titled “Process Systems Engineering as a Modeling Paradigm for Analyzing Systemic Risk in Financial Networks.” The paper proposes a methodology to quantify systemic risk. More specifically, it proposes that signed directed graphs (“SDGs”), modeling methodologies that are used extensively in process systems engineering, can be used to create frameworks that (i) address the cause and effect of financial instability feedback loops and (ii) can automate the identification and monitoring of potential vulnerabilities. More generally, the paper asserts that a process systems engineering framework is a “useful model” with which to analyze potential hazards and instabilities in the financial system that may not be apparent from a “network-based perspective” on large financial systems.

Lofchie Comment: It has never seemed apparent that the central clearing of swaps makes the financial system safer. Much of what clearinghouses do to improve safety comes at the expense of clearing members and their customers. Because the pricing “signals” that clearing members send have more power than those of individual market participants, any change in valuation declared by a clearinghouse may affect the market and market participant behavior generally and quickly in ways that could be negative. As a result, the actions taken by individual market participants in order to protect themselves may in fact do damage to the safety of the larger financial system.

To put this into more concrete terms, under the logic set out in the paper, if a clearinghouse determines that the value of a commodity has declined, and that the volatility of the commodity has increased, then market participants will come under immediate pressure to sell the commodity in order to pay for losses on the decline and because the cost of financing the required margin has risen. Additionally, clearing members and their customers cannot protect themselves by contract against the margin demands of the clearinghouse (as they could against other private parties).

The paper confirms the concern that clearinghouses are at least a potential source of systemic risk. Query: under what circumstances/assumptions does the model show that clearinghouses increase or decrease systemic risk?

See: OFR Working Paper: Process Systems Engineering as a Modeling Paradigm for Analyzing Systemic Risk in Financial Networks.