You have to hand it to the WSJ – they really know how to make the safety of Trillions of Dollars in derivatives trading across dozens of exchanges look pretty pedestrian. Their hero image of the firm, which cleared 4.3 Billion contracts last year and holds about $130 Billion in margin deposits for clients, is this:
Not much in the way of impressive “machinery beneath trading” there, and the gist of the article sort of follows that theme – implying that recent volatility has stressed the plumbing behind the world’s derivatives markets. Here’s the WSJ, quoting a report by JMP Morgan:
Wild trading is straining the plumbing that powers global markets.
At least 49 times this year, major derivatives contracts globally—including on U.S. Treasurys and the S&P 500—have seen price moves that exceeded margin limits, according to figures compiled by JPMorgan Chase & Co.
Now, the knee jerk reaction from those in the biz to an article like this is… please, we’ve been there, done that before. The system is resilient. The system is flexible. The system survived 2008, and 9/11, and 1987, and so on and so forth. As the CEO of CBOE is quoted as saying in the article:
“Central clearing works…I don’t want to lose sight of that.”
But the argument between the lines here is a little more complex, going something like – markets have become way more automated, with way more derivatives traded, and have been purposefully calmed by central bank intervention these past 10 years. Are the current margin breaches signs of cracks in the damn, and/or is the current central clearing system sufficiently modernized to keep pace with the automated computerized algorithmically driven trading world of today?
In speaking with our risk team internally, they noted that there’s really two main issues there: centralization of risk at the clearinghouses, and the inability of the same clearinghouses to foresee the future. The issue of systematic risk is a real consideration, especially when you consider things like the lack of cross-exchange margin hindering a real view on portfolio levels risk (e.g. holding offsetting positions in related products at ICE and CME such as CL-Brent, or CL-WTI (ICE version). SPAN is a reasonably good model, but without interexchange views on these things you end up with one side having to be unwound from a margin perspective, which as a result causes the other side to be unwound to keep the market risk at a balance/neutral level. Of course, one thing they didn’t mention in the article is the use of FCM margin multipliers, and the use of FCM’s in general – which are one more level of capital between the margin breach, client, and the reserve funds of the clearing companies. The FCMs act as another lever to protect the system and are implemented by those who deal most directly with the clients. Further, the clearinghouses do have loss plans in place. It isn’t like they’ve never thought of this before. Here is CME Group’s:
Regarding the second issue here that more volatility means more margin level “breaches”, the recent elevated volatility can be seen as a good thing. It provides new data to feed into margin calculation and likely pushes margins higher going forward. These things are cyclical and reactionary. As markets get more volatile, margins increase. As they increase, trading can fall back and some of the volatility disappears, leading to cuts in the margin, and so on in the circle of (margin) life. To think that any new model will be able to predict when or if these breaches will occur sure seems like a fool’s errand to us. There’s always going to be a risk of underestimating risk when you don’t know the future. The WSJ would seem to paint the margin increases as a source of alarm, but to us, it is more of a normal course of operation.
It’s an example of how flexible the process is.