Clearing as Systemic Risk
Pfäffikon SZ, Switzerland – Ever since the outbreak of the crisis in 2008 there has been more emphasis on the emergence of systemic risks. After all, the bank’s infection shook the financial system at its foundations. Large asset management companies such as Blackrock, Fidelity and Pimco, but also investment vehicles such as Berkshire Hathaway would, according to some regulators, pose a systemic risk. I hold the opinion, however, that the size of a fund or an investment company says nothing about the possible existence of a systemic risk. When it comes to systemic risks, regulators had better take a closer look at clearing houses.
Course
Yours truly started his career in the financial world on 1 April 1989 as the youngest clerk at the back office of Strating Effecten N.V. on the Herengracht in Amsterdam. I have literally been drilled in the correct unwinding of securities transactions. A flawlessly operating back office forms the basis for any business that is active on the global markets. It is sometimes forgotten how many (hidden) risks are lingering inside the back office. Many stock- and option traders have no idea what takes place under the hood of the broker or bank – not to mention their superiors. Next to a course in compliance and cross-border transactions, some lessons on clearing and settlements would not be an outlandish requirement.
Pivot
A pivotal part here is played by the clearing house. A clearinghouse concerns itself with the unwinding of financial transactions between different market actors. You have probably never heard of companies such as Euroclear, Clearstream or SIX x-clear. Billions flow through these companies on a daily basis in order to ensure that investors receive their stocks or bonds in time and to make sure they pay for them. This involves figures you would probably have a hard time imagining. According to Euroclear themselves they unwind EUR 570 trillion in transactions on a yearly basis. It goes without saying that there are risks involved.
Everything comes together
All transactions in for instance a specific government bond come together at the clearing house. I myself got to witness several occasions where the ‘overnight’ unwinding of several extremely large and complex transactions simply failed. With automatic programmes clearing houses try to guide and support the settlement process, but sometimes this goes awry. Remarkably, things would go wrong for us only for the larger more specific transactions, just before the weekend. Many lauded traders do not realise that the profit on “their” transaction, can instantaneously turn into a considerable loss, if the back office doesn’t respond adequately. They have never heard of collateral, counterparty risk, haircuts or interest losses. They believe their position as reported in their expensive Bloomberg to be accurate, not knowing that the reality at T+3 might be a different one.
Risk profile
In a bond market which continues to dry up, in combination with an assertively operating ECB, the odds of the actual risk moving to the clearing house becomes, in my view, big. But also grouped transactions – for instance caused by flash traders – contribute to a higher risk profile for the clearing house. Regulators would be well advised to do more to educate themselves on the inner workings of clearing houses. A decent investigation into the clustering of transactions would have to take priority. On that basis further requirements such as collateral can be tightened and assigned to parties that harbour extra risks.
It remains for me to wish you a good weekend.
Jan Dwarshuis is a senior asset manager at Thirteen Asset Management AG, where he is responsible for the Thirteen Diversified Fund. Dwarshuis writes his columns in a personal capacity and is not paid for them. Nor is he paying for his columns to be placed. Professionally, he holds positions in major European, American and Russian stock funds. The information in his columns is not intended as professional investment advice or a recommendation to make certain investments. At the time of writing, he has no position in the above shares and has no intention of doing so in the next 72 hours.
