Volatility in the stock market is not new. But, even if one takes a broad perspective, the recent experience with GameStop is extraordinary. As we write, the story is far from over, with several U.S. stocks—like GameStop, AMC Entertainment and Express—still on something of a wild ride. The Securities and Exchange Commission seems poised to investigate. And, members of Congress are planning to hold hearings. We don’t have any particular insights into how or when this will end. That is, except to say that history teaches us that episodes like this typically end badly.

Since this is an unusual post, we begin with a very clear disclaimer: nothing in this blog should be construed either as investment advice or legal advice.

In our view, we can already draw three big lessons from the equity market events of the past week. The first is about how narratives and the limits to arbitrage can lead to unsustainable asset price booms. Second, short sellers are important for the efficiency of asset pricing and the allocation of capital. Moreover, with the ongoing rise of passive index investing, their potential role in keeping the U.S. equity market efficient will become more, not less, salient. Third, to keep the financial system safe and resilient, it is essential that clearing firms maintain sufficiently stringent margin and collateral requirements even if, on occasion, it limits a broker’s ability to implement trades for its clients….

Stress Testing Financial Networks: The Case of CCPs

Following the crisis of 2007-09, in which AIG’s bilateral derivatives trades played a notable role, the G20 leaders called for central clearing of standardized derivatives. The resulting shift has been dramatic: central counterparties (CCPs) now clear about three-fourths of interest rate contracts, up from less than one-fourth a decade earlier (see Faruqui, Huang and Takáts).

By substituting a CCP as the buyer to every seller and the seller to every buyer, central clearing mutualizes and can—with appropriate margining, trade compression, position liquidation procedures, and reporting—reduce counterparty risk (see Tuckman). CCPs also contribute to financial resilience by promoting uniform margin standards, reducing collateral and liquidity needs, and making risk concentrations (like that of AIG in the run-up to the crisis) more transparent.

At the same time, the shift to central clearing has concentrated risk in the CCPs themselves. Reflecting economies of scale and scope, as well as network externalities, a few CCPs serving global clearing needs have grown enormous. For example, as of the last report at end-September 2018, open interest at LCH Clearnet exceeded $250 trillion. Moreover, the clearing activity of some CCPs lacks any short-run substitute. As a result, to avoid disrupting large swathes of the global financial system, any recovery or resolution plan for these CCPs must ensure continuity of service (see CCP Resolution Working Group presentation to the OFR Financial Research Advisory Committee). Finally, CCPs are the most interconnected intermediaries on the planet, making them channels for transmission and amplification of financial distress within and across jurisdictions. As then-Governor Powell clearly states in the opening quote, the safety of CCPs is central to the resilience of the global financial system.

We and Richard Berner have been studying how regulators use stress tests (see our earlier posts here and here) to assess the resilience of financial networks, including banks and nonbanks. In our joint work, we focus on CCPs due to their centrality, their extreme interconnectedness and their lack of substitutability. This post is based on our research….

What Risk Professionals Want

As memories of the 2007-09 financial crisis fade, we worry that complacency is setting in. Recent news is not good. In the name of reducing the regulatory burden on small and some medium-sized firms, the Congress and the President enacted legislation that eased the requirements on some of the largest firms. Under the current Administration, several Treasury reports travel the same road, proposing ways to ease regulatory scrutiny of large entities without changing the law (see here, here and here). And, recently, the Federal Reserve Board altered its stress test in ways that make it more likely that poorly managed firms will pass. It also voted not to raise capital requirements on systemically risky banks over the next 12 months.

A few weeks ago, one of us (Steve) had the privilege to speak at the 20th Risk Convention of the Global Association of Risk Professionals (GARP). Founded in 1996, GARP engages in the education and certification of risk professionals and has several hundred thousand members worldwide. (Disclosure: Brandeis International Business School and NYU Stern are GARP Academic Partners.) The organizers allowed us to solicit the views of the 100-plus attendees on two issues that are central to financial resilience: Are bank capital requirements high enough? And, do central counterparties (CCPs) have sufficient loss-absorbing buffers? They answered both questions with a resounding “NO” ….

Resolution Regimes for Central Clearing Parties

Clean water and electric power are essential for modern life. In the same way, the financial infrastructure is the foundation for our economic system. Most of us take all three of these, water, electricity and finance, for granted, assuming they will operate through thick and thin.

As engineers know well, a system’s resilience depends critically on the design of its infrastructure. Recently, we discussed the chaos created by the October 1987 stock market crash, noting the problems associated with the mechanisms for trading and clearing of derivatives. Here, we take off where that discussion left off and elaborate on the challenge of designing a safe derivatives trading system―safe, that is, in the sense that it does not contribute to systemic risk.

Today’s infrastructure is significantly different from that of 1987. In the aftermath of the 2007-09 financial crisis, authorities in the advanced economies committed to overhaul over-the-counter (OTC) derivatives markets. The goal is to replace bilateral OTC trading with a central clearing party (CCP) that is the buyer to every seller and the seller to every buyer....

Dodd-Frank: Five Years After

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (hereafter, DF), the most sweeping financial regulatory reform in the United States since the 1930s. DF explicitly aims to limit systemic risk, allow for the safe resolution of the largest intermediaries, submit risky nonbanks to greater scrutiny, and reform derivatives trading.

How to celebrate its fifth birthday? Well, if you are like us, it will be a sober affair, reflecting serious worries about the continued vulnerability of the financial system.

Let’s have a look at the most noteworthy accomplishments and the biggest failings so far. Starting with the successes, here are our top five:

Trade repositories: Still far from the "risk map" we need

Among the many reforms in the aftermath of the financial crisis is the agreement among international regulators that all over-the-counter (OTC) derivatives contracts should be reported to trade repositories. The goal is to help market participants and regulators gain a better understanding of the extent and distribution of risk taking in financial markets. G-20 leaders committed to this and other improvements to financial market infrastructure (we described the move to central clearing parties (CCPs) in earlier posts). But, unlike the shift to CCPs, trade repositories seem very unlikely to meet officials’ lofty aspirations in the next few years...

Steve Cecchetti and Kim SchoenholtzMay 29, 2014Derivatives, OTC, Trade repository, CCP, CDS, Collateral, Margin

Central Clearing Parties: What they are and why we need them - Part 3

The CCP Advantage: Incentive and Means to Control Counterparty Risks

The case of the insurance giant, AIG, highlights the information and incentives problems that CCPs can address. In the run-up to the financial crisis, AIG’s London-based Financial Products Group managed to sell enormous amounts of credit risk insurance without the liquid resources necessary to cover potential cash calls. By end-June 2008, AIG had taken on $446 billion in notional credit risk exposure as a seller of credit risk protection via credit default swaps (CDS).

Kim SchoenholtzFebruary 21, 2014AIG, CDS, Credit default swaps, Counterparty risk, Collateral, Margin requirements, Clearinghouse, Incentives, CCP, OTC

Central Clearing Parties: What they are and why we need them - Part 2

Experience Shows CCPs Safer than OTC Trading

Experience both before and after the crisis revealed that the system of bilateral OTC derivatives transactions was far more fragile than experience with CCPs. As a result, many people began to advocate a shift to central clearing. And, the G20 leaders agreed.

Kim SchoenholtzFebruary 21, 2014CCP, OTC, Counterparty risk, Clearinghouse, Collateral

Central Clearing Parties: What they are and why we need them - Part 1

G-20 Leaders Vote for CCPs: What are they?

In September 2009, as the financial crisis was starting to slowly recede, the leaders of the twenty largest economies of the world (the G-20) met in Pittsburgh. At the end of their summit, they issued a communiqué of nearly 9000 words. Somewhere in the middle of the statement, the following sentence appeared:

All standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.