The Economist - UK (2019-06-01)

64 Finance & economics The EconomistJune 1st 2019

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only if no one believes they can fail. Their

purpose is to sit between market partici-

pants. If a hedge fund buys $100m-worth of

Apple shares from an investment bank,

say, and the transaction is centrally

cleared, it is the clearing house that guar-

antees the bank gets its $100m and the fund

get its shares. For simple transactions this

is a small role. Cash-equity trades are set-

tled within two days. The risk that a party

goes bust before settlement is minimal.

Now suppose the fund wants to buy an

option—say, the right to buy $100m-worth

of Apple shares at today’s price in a year’s

time. The price it pays—the premium—will

settle quickly, but the parties’ ongoing ex-

posure will vary during the year. If Apple’s

share price rises sharply before its end, the

right to buy those shares at the old price be-

comes more valuable. If the bank holding

the shares goes bust before the year is out,

the clearing house will be on the hook. The

longer the time between execution and set-

tlement, the bigger this credit risk. It is

magnified when products are highly lever-

aged, as options generally are.

That is still better than the alterna-

tive—a bilateral trade, in the industry ar-

got—in which the bank and fund face each

other for the life of the option. This re-

quires each to keep tabs on the other’s

creditworthiness, which is hard when they

do not know each other’s positions. If the

fund wanted to close its position early, for

example, it might sell an offsetting posi-

tion to another bank. It would then appear

to each bank that the fund was exposed to

movements in Apple’s share price, though

in reality its risks would cancel out. If its

trades had been centrally cleared, that

would be obvious to everyone. This lack of

transparency played a big part in the finan-

cial crisis—hence regulators’ desire to shift

from bilateral to central clearing.

The trouble is that central clearing

creates new risks. Incentives are skewed

when the risk of default is spread across a

group, making a weak counterparty every-

body’s problem. Market participants may

become less choosy about their counter-

parties. And most clearing houses are for-

profit entities. Their profits rise with trans-

action volume, but losses for bad trades are

largely borne by their members. That is a

standing temptation to lower standards.

Skimpy margin requirements or shal-

low default funds increase the chance that

the default of a big member would leave a

clearing house with large unmatched posi-

tions. It would then have just four possible

sources of capital: its owner, usually an ex-

change; its members, usually investment

banks; its customers, mostly investment

funds—or, in extremis, the taxpayer.

Each has problems. It is unclear that

owners could be obliged (or could afford) to

cover much. If a big burden were to fall on

members, they too might be forced to de-

fault, or decide to cut their losses and walk

away. If a clearing house looked likely to

call on its customers’ margin, they might

pre-emptively step back, closing positions

to reduce their margin requirements and

perhaps starting a market panic. And fi-

nancial regulators are rightly determined

that taxpayers should not be landed with

the bill for another financial crisis.

Clearing houses have collapsed before.

In 1974 a Parisian house was felled by mem-

bers defaulting on margin calls when sugar

prices plummeted. In 1983 one in Kuala

Lumpur came to grief when palm-oil fu-

tures crashed. But only one has been

deemed too big to fail. After global stock-

markets crashed in 1987, the Hong Kong Fu-

tures Exchange clearing house collapsed

and regulators shuttered the stock ex-

change while the government and city-

state’s largest banks arranged a bail-out.

A clearing-house collapse now would

have far bigger repercussions. In his March

letter Mr Tucker said that a clearing house

that could not withstand a member’s de-

fault could be a “devastating mechanism

for transmitting distress across the finan-

cial system”. Central counterparties, he

said, were “super-systemic”.

The shift to central clearing has been

most pronounced in interest-rate deriva-

tives, but is visible in other categories, such

as credit derivatives, too. And it will con-

tinue. According to research by Citibank,

an American investment bank, from Sep-

tember 2020, when margin requirements

for uncleared trades come fully into force,

investors may have to post three or four

times as much margin when trading bilat-

erally as when using a clearing house.

Regulators have reduced the risk that

derivatives will cause as much disruption

as they did a decade ago. But they have

created a new group of institutions that are

too big to fail. Without certainty about

where a clearing house in distress can seek

capital, its members and customers will be

more likely to behave in ways that mean it

needs that capital. Rules intended to pro-

tect taxpayers may have the paradoxical ef-

fect of putting them back on the hook. 7

In the clear?

Source:BankforInternational Settlements

Global over-the-counter derivatives, notional

amount outstanding , % centrally cleared

December 31st 2018

0 20406080

Interest-rate

derivatives

Credit

derivatives

Foreign-exchange

derivatives

To t a l

$trn

436.8

8.4

90.7

544.4

A

merican investorswanting a piece

of Chinese firms, whether state-owned

oil majors or tech stars, need not stray be-

yond Wall Street. Over the past two decades

some 200 Chinese firms have gone public

in America, more than from any other for-

eign country. (Most have their main listing

there; a few have a “secondary” one, with a

main listing in China.) These firms’ total

market value is more than $1trn. For Ameri-

ca’s stock exchanges, that is a great tri-

umph. But trade hawks are starting to de-

scribe it as a great liability.

In a letter in April a bipartisan group of

politicians led by Marco Rubio, a Republi-

can senator, said American investors faced

risks because of exposure to Chinese com-

panies “that pose national-security dan-

gers or are complicit in human-rights

abuses”. Steve Bannon, President Donald

Trump’s former chief strategist, expanded

the focus to all Chinese stocks in America

in an interview published on May 22nd in

the South China Morning Post. “The next

move we make is to cut off all the ipos [ini-

tial public offerings], unwind all the pen-

sion funds and insurance companies in the

us that provide capital to the Chinese Com-

munist Party,” he said.

Those threats might be dismissed as

idle, but for the actions of a couple of their

targets. On May 24th Semiconductor

Manufacturing International Corp (smic),

China’s largest maker of semiconductors,

SHANGHAI

Economic tensions spill into capital

markets

Chinese stocks in America

Far from home