In a blog post titled “Creeping Recognition That Regulation Has Created a Liquidity Death Star,” University of Houston finance professor Craig Pirrong argued that clearing and collateral mandates transform credit risk into liquidity risk, which increases systemic risk. According to Professor Pirrong, (i) variation margining causes spikes in the demand for liquidity, “exacerbating the liquidity squeeze” in stressed market conditions, and (ii) clearing “creates tight coupling because failures – or even delays – in making variation margin payments can put the clearinghouse into default or force it to liquidate collateral in an illiquid market.”
In spite of this, Professor Pirrong said, awareness of the danger of spikes in liquidity demand right when liquidity supply evaporates remains “sadly insufficiently widespread” among regulators.
Professor Pirrong expressed astonishment that regulators persist in thinking they are solving systemic risk problems “by imposing a mechanism that will sharply increase liquidity demand and restrict liquidity supply during periods of market stress . . . even though every major financial crisis in history has been at root a liquidity crisis.”
Lofchie Comment: Numerous pieces posted in the Cabinet have highlighted concern about the liquidity risks caused by central clearing organizations that use their ability to demand more margin, which can precipitate a spiraling sell-off as customers and clearing firms liquidate assets and positions to raise margin, which causes prices to decrease, which requires further sell-offs. See, e.g., FRB Governor Powell Discusses Expanding the Central Clearing of OTC Derivatives (with Lofchie Comment) (Nov. 6, 2014). Though Professor Pirrong’s views on central clearing are pessimistic, his blog post does not deal with another issue that should cause him to be even more pessimistic: not only will the clearinghouses call for more variation margin on positions (which in theory should merely reflect the movement of capital from one party to another); they also will demand more initial margin from both parties, which could suck liquidity out of the financial system. That is because one of the biggest differences between bilateral derivatives contracts and central clearing systems is that in the bilateral world, large institutions generally do not have the ability to demand more initial margin from each other. In a centrally cleared world, the central clearing party has the unlimited ability to keep itself safe by raising initial margin requirements.
Although it is good that regulators finally are paying attention to the risks created by central clearing, the problem is that they are focusing on the wrong risk. The biggest risk is not that a central clearing corporation might fail. It is, as we said in the 2014 story cited above, “the ability of a major [central clearing party] to survive by dragging down everyone else.”