Tuesday, October 14, 2014

Do Central Counterparty Clearing Houses (CCPs) have enough capital? A closer look at the CME.

Guest post by Jasper Tamespeke

I was bemused to read the other day a news report that ISDA chair Stephen O’Connor has stated that the major CCPs (LCH and CME) ‘probably’ have enough capital. Bemused because as far as I can see CME Group doesn’t have any real capital at all.

To understand this, we have to do a bit of forensic accounting. Not very exciting, but given the central role the CCPs have been given in clearing OTC derivatives in the future, it is important.

According to CME Group’s 10-K for 2013 the group had stockholders equity of $21.6 billion, which appears to be very healthy. However, when regulators and credit analysts look at a Financial Institution they will critically assess the assets on the balance sheet and deduct from capital any assets that cannot be readily realised in a crisis (which is when we need capital). They particularly focus on intangible assets such as goodwill (what someone pays to buy a company above the tangible value its assets, the franchise value). In CME Group’s case, there are a lot of intangibles: goodwill of $7.6 billion, other intangibles of $2.7 billion and a whopping $17.2 billion relating to Trading Products. In total these amount to $27.5 billion and therefore tangible equity is about $6 billion negative.

The most important number here is the trading products. This is the ‘brand value’ of futures contracts acquired in the mergers with other futures exchanges, particularly CBOT and NYMEX. These have been capitalized on the basis that such products have to be licensed by the CFTC and the license has no expiry date. In theory, it is not difficult to create rivals to CME’s valuable contracts, but anyone who remembers Eurex’s attempts to set up a rival to the Eurodollar Future a decade ago knows that CME’s franchise is implicitly protected. However, there is no guarantee against a less monopolistically inclined regulatory framework being developed in future, and it seems to me that this accounting is really just window dressing: the ‘mergers’ (really takeovers) naturally generated a lot of goodwill, but if it is rebranded ‘Trading Products’ this sounds much better and makes the balance sheet look superficially stronger.

To me, this is a sobering thought for Sober Look readers : possibly the largest CCP in the world (certainly the largest clearer of exchange traded derivatives) has no capital.

But how can this be? CCPs are regulated so surely they must be required to have capital? CME Group Inc. is the holding company of the group and not itself the CCP, and therefore (I presume) not directly subject to the CFTC’s capital requirements. The CCP is a division of its most important operating subsidiary, CME Inc. CME Inc. does have about $1 billion of capital. How is this possible, given that CME Inc. is wholly owned by CME Group? As far as I can see, this is achieved through a bit of alchemy called double leverage. CME Group has about $2.85 billion of long and short term debt and part of this is used to provide equity capital for CME Inc. CME is not regulated under the Basel regime, which has been subject to much criticism, at lot of it justified. However it does at least require that capital requirements are met on a consolidated basis, which would stymie this sort of manoeuvre.

So there appears to be some clever creative accounting going on here. But does this really matter? Anyone who has spent more than 5 minutes studying CCPs knows that capital is not really relevant in protecting them against counterparty credit risk, which is what they are about. The main line of defence is Initial Margin, and to a lesser extent the Default Funds, which are there as a top-up if extreme losses run through the margin deposits. And CME has a veritable wall of money here: nearly $120 billion at end 2013. So $1 billion of capital, whether it is real or not, gets lost in the roundings.

I think it does matter for a number of reasons. The money of members and their clients may be the primary mitigants against a CCP’s credit risk, but what happens if there is an operational failure (e.g. if systems errors lead to a CCP having an unbalanced position, creating losses in a volatile market)? Here the primary loss absorber should be capital. Double leverage makes a group more fragile if there are problems. The holding company’s debt has to be serviced by upstreaming dividends from its subsidiaries, but if they are subject to prudential capital requirements this may not be possible, increasing the risk of default (although at the moment CME does generate prodigious cash flow).

Also it is important that CME’s shareholders have skin in the game. Most of the CCPs these days are public, profit seeking companies and it is important that they operate with the right incentives (not that the banks and brokers can complain too much about this, as they opportunistically sold their seats and relinquished control in the course of the last decade in pursuit of a quick buck).

It matters most of all because we are concentrating so much potentially lethal risk in 3 or 4 critical nodes in the financial system. G-20 politicians made a fateful decision in 2009,moving from the (arguably reasonable) declared aim of requiring credit derivatives to be cleared to the much more ambitious mandate that all standardized OTC derivative are centrally cleared (for reasons which as far as I know are largely unexplained). In my opinion this is just one manifestation of the failure of politicians and the regulatory community who serve them to learn the right lessons from the Financial Crisis: they want to centralise the risk so that it is easy to see and control. However surely the moral of Too Big to Fail was that it is an illusion that we can control everything in human affairs, in this case by confidently assuming that margin at 99.5% with a top up based on stress tests will make us bullet-proof against the unknown unknowns. Instead of concentrating risk in the massive CCPs and the equally massive small number of banks with the economies of scale to afford to be clearing members, in my view it would have been better to diversify risk around the system, to minimise the impact of the things we can’t control. However, it is probably too late to reverse these decisions now, but it is certainly emphasises the need for CCPs to be stable, strong institutions with good governance.


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