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Ambrose Evans-Pritchard: BIS warns of seizure at heart of financial clearing system
By Ambrose Evans-Pritchard
The Telegraph, London
Sunday, December 16, 2018
The pillars of the global financial system are fundamentally unstable and could lead to a frightening chain-reaction in the next crisis, the world's top watchdog has warned.
Giant "central counterparties" (CCPs) that clear much of the $540 trillion (L428 trillion) nexus of derivatives are themselves vulnerable to failure in times of extreme stress.
This is a worry looming ever larger as rising US interest rates expose the weak links in global debt markets.
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The Bank for International Settlements said in its quarterly report that the CCPs could cause "a destabilising feedback loop, amplifying stress."
The implicit message is that well-meaning regulators may have made the financial architecture more dangerous by mistake.
The near meltdown of the Scandinavian counterparty Nasdaq Clearing AB in September came as a rude shock to the global authorities, and a foretaste of what might happen on a much bigger scale should anything serious go wrong.
In that case a E114 million default by Norwegian trader Einar Aas -- caught on the wrong side of a "convergence play" on electricity prices -- burned through his collateral and then through two thirds of a reserve fund from non-defaulting members. The crisis was contained but it exposed the fragility of the system.
The notional value of the derivatives cleared worldwide is 4.4 times world GDP, up from 2.8 times in 2008. JP Morgan alone has a $30 trillion book.
The BIS warned that regulators have inadvertently created a "CCP-bank nexus" -- somewhat akin to the sovereign/bank doom loop in the eurozone -- in which the two feed on such other.
The rotten apple contaminates the healthy banks. A fire sale of assets spreads contagion. Banks may be forced to hoard liquidity to protect themselves. The BIS said "balance sheet interlinkages" and what it calls the "CCP default waterfall" could unravel with "potentially system-wide effects."
It is just one of many late-cycle pathologies highlighted by the Swiss-based watchdog, the bank of the central banking fraternity and the high priest of orthodoxy.
Another brutal week on Wall Street has brought these risks into sharper focus. The three key equity indexes in the United States are all in a full correction after falling over 10 percent from their peak.
Germany's DAX index has dropped 19 percent since January, and the Shanghai Composite is down 27 percent. "The market tensions we saw during this quarter were not an isolated event," said Claudio Borio, BIS chief economist.
Central banks are walking a tightrope as they try to extract themselves from a decade of emergency stimulus. Quantitative easing and ultra-low rates have lifted debt ratios to levels that are 40 basis points higher than the pre-Lehman peak, this time led by emerging markets. Nobody knows where the pain threshold lies for monetary tightening in such circumstances.
The BIS says the nature of the world’s business cycle has entirely changed over the last three decades. For most of the 20th century booms turned to bust when rising inflation forced authorities to jam on the brakes.
This is no longer the case. Globalization and the inclusion of China and emerging Asia in the trading system have suppressed inflation. What now brings the party to an end is excess credit and rising debt service ratios. As conditions tighten, the financial system eventually buckles under its own weight.
he thrust of BIS research is that we may be close to this inflexion point. Standard & Poor's says the number of junk bonds rated B minus or below has jumped from 17 to 25 percent over the last year. This is now the highest since global financial crisis.
The average yield on U.S. junk bonds has risen 165 basis points to 7.2 percent over the last year. A cascade of downgrades has begun. The spike has been even more dramatic in the eurozone where stress is nearing danger levels, leaving credit analysts baffled by the European Central Bank’s decision to halt quantitative easing this month.
The BIS fears a waterfall effect. "The bulge of BBB corporate debt, just above junk status, hovers like a dark cloud over investors. Should this debt be downgraded, if and when the economy weakened, it is bound to put substantial pressure on a market that is already quite illiquid," said Mr. Borio.
The volumes are sobering. The ratio of U.S. corporate debt to gross domestic product is 73.5 percent of GDP, higher than in 2008, although this is a children's playground compared to China. The share of leveraged loans in the U.S. with risky "covenant-lite" contracts has reached 80 percent this year.
The $1.3 trillion market for leveraged loans has become an increasing worry. Prices of this debt on the secondary market are breaking down. To clear the transaction in early December, JPMorgan slashed the price for an XOJET takeover loan to 93 cents on the dollar.
The Achilles' heel for the global economy is the surging U.S. dollar. The BIS says offshore lending in dollars by European, Japanese, and increasingly Chinese and emerging market banks has risen to $12.8 trillion. The figure is probably far higher if opaque "off-balance-sheet" liabilities are included.
This web of dollar liabilities is coming under intense strain as the U.S. Federal Reserve drains liquidity, pushing up global lending rates. A worldwide dollar shortage is emerging. This is acting as tourniquet, tightening an international system built on dollar funding.
An estimated $9 trillion of global contracts are priced off 3-month LIBOR rates, which have doubled to 2.77 percent over the last year. The "LIBOR-OIS spread" has also jumped to 40 basis points and is flashing early-warning signs of stress in the overnight funding markets for dollars in Europe and Asia. The 30 percent crash in European banks stocks this year is hinting at a incipient credit crunch.
The BIS warned that some of these offshore dollar lenders may face a "funding squeeze" of their own, forcing them to withdraw credit in a chain-reaction. "Cross-border funding, regardless of the source, may be fickle in a crisis," it said.
The possibility that a major central counterparty might "fall over" in the next crisis is sobering. The G20 mandated a shift in global finance towards CCPs after the 2008 crisis, deeming them the "unlikely heroes" of the Lehman shock. The counterparties managed to auction, liquidate, or transfer almost all of Lehman's derivative portfolios in an orderly fashion, including $9 trillion of interest rate swaps made up of 66,390 trades.
But the G20 may have over-interpreted the Lehman lesson. There have been plenty of CCP failures in the past. France's Caisse de Liquidation des Affaires came awry in 1974 when the sugar market blew up. The Hong Kong Futures Guarantee Corp. failed in 1987. The Chicago Mercantile Exchange had a close shave the same year after the October crash.
There was a whiff of trouble immediately after the Brexit referendum when margin calls hit $27 billion. It is a foretaste of what could happen to Europe's financial system if the European Union persists in its refusal to reciprocate the UK pledge to recognize the legal continuity of E45 trillion of derivative contracts after March 2019.
Nobody knows what would happen if Britain's LCH or Germany's Eurex Clearing came under stress. They have thin layers of capital compared to banks.
Before the 2008 crisis most derivatives were cleared by trading parties in direct dealings. The G20 shift has lifted the share of CCPs for interest rate derivatives from 20 to 60 percent. The effect is to concentrate risk. The BIS warns that the system may encourage a rush for the exit in events of extreme stress.
The International Monetary Fund has also flagged the dangers. It warned this year that CCPs "increase the risk of a failure of the infrastructure itself" and could lead to a "catastrophe" if the all layers of defense were overrun by a big default. It would be like the failure of the Maginot Line.
The G20 may have made the world financial system more hazardous.
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