Exchange: Moral Hazard

[Kavita.bhangdia]

Hi,
Gregory says that
1. Exchanges do not fully eliminate counterparty risk.. Why is it so? is it because the exchange may default itself?

2. Clearing houses create Moral Hazard: Please explain how?

3. It is difficult to get rid of counterparty risk entire, may create more toxic assets? How..

Please help me understand this..

Thanks,
Kavita

 

[David Harper CFA FRM]

Hi @Kavita.bhangdia

1. Exchanges do not fully eliminate counterparty risk.. Why is it so? is it because the exchange may default itself?
Yes, Gregory says (emphasis mine) "a CCP does not make counterparty risk disappear. What it does is centralise it and convert it into different forms of financial risk such as operational and liquidity" (specifically, "in accordance with a sort of conservation of risk principal, CCPs will not so much reduce counterparty risk but rather distribute it and convert it into different forms such as liquidity, operational and legal risks. CCPs also concentrate these risks in a single place and therefore magnify the systemic risk linked to their own potential failure") ... but with respect to the counterparty risk that is not eliminated, it becomes concentrated in the CCP:

"A first obvious and almost paradoxical problem with mandatory clearing is that CCPs clearing OTC products will likely become ‘systemically important’, creating a potential moral hazard if it is clear that government financial support will be forthcoming in the event of a CCP risk management failure. [see your question #2] After all, bailing out a CCP is ultimately no better than bailing out any other financial institution. CCPs do not magically make counterparty risk vanish, and forcing derivatives through CCPs could create sizable financial risks via concentrating counterparty risk within a single systemic point in the system. As CCPs clear more complex, less liquid and longer-term instruments, their potential risks will likely increase."

2. Clearing houses create Moral Hazard: Please explain how?
Two moral hazards. First is micro, moral hazard created when members only need to satisfy the clearing requirements rather than qualify each of their own counterparties. Second is macro/systemic moral hazard: created by CCP being "too big too fail." Essentially same as moral hazard of TBTF big banks:

"Moral hazard: This is a well-known problem in the insurance industry. Moral hazard has the effect of disincentivising good counterparty risk management practice by CCP members (since all the risk is passed to the CCP). Institutions have little incentive to monitor each other’s credit quality and act appropriately because a third party is taking most of the risk.
The designation of a CCP as a ‘systemically important’ FMU may exacerbate moral hazard problems. This can occur either by market participants considering their complex CCP activities as safe, thanks to seemingly explicit support for CCPs, or CCPs themselves believing that they can rely on the same level of support that the US banking sector benefited from in 2008 and 2009.

3. It is difficult to get rid of counterparty risk entire, may create more toxic assets? How..
Personally, I am less clear/persuaded on the logic of this. CCP won't be able to trade exotic assets, for example. Not sure I see how CCP itself enables toxic assets. Here is something Gregory writes in his CVA text:

"In a bilateral market, the pricing of counterparty risk will naturally cause institutions with a worsening credit quality to have higher costs and therefore provide an incentive for them to improve this aspect. However, when trading through a CCP, as long as a member is posting the relevant margin, the issue of their declining credit quality may be ignored (up to a point). This may allow poor-quality institutions to build up bigger positions more cheaply than they would normally be able to do in bilateral markets. CCPs may be more popular with counterparties with below-average risk management abilities and firms with weaker credit quality who can only achieve a limited amount of bilateral trading. The products that members may be most keen to clear through a CCP may be the more toxic ones, for example due to wrong-way risk, that cannot be readily managed in a bilateral market. " -- Gregory, Jon (2012-09-07). Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets (The Wiley Finance Series) (Kindle Locations 3430-3436). John Wiley and Sons. Kindle Edition.

 

[QuantMan2318]

Dear @Kavita.bhangdia

This might not be what Gregory stated but this article covers some of the drawbacks of CCPS https://forum.bionicturtle.com/threads/central-counterparties.9308/

There was a current issues section when we wrote, unfortunately removed for the current cohort, that summed up the intellectual arguments against Clearing Houses (We can apply the same to CCPs)

I have the file but I am unable to upload the same, it was Clearing House Over confidence by Mark Roe, it can be found here https://drive.google.com/file/d/0B2oljOhdGf-WaUNQNkFjcFUwVlU/view?usp=sharing

 

[Kavita.bhangdia]

Thanks everyone...
Kavita

 

[David Harper CFA FRM]

Yes thank you @QuantMan2318 Here is the same paper in our DB library (in case this is convenient) http://trtl.bz/1SFRGm9