Davidson: Six lessons drawn from the financial crisis relevant for CCPs
27 April 2018 Chicago
Image: Shutterstock
There are six lessons to be learned from the financial crisis that are relevant for central counterparties (CCPs), according to the OCC鈥檚 John Davidson.
Davidson made the comments at the World Federation of Exchanges IOMA Conference in Chicago in the run-up to the 10-year anniversary of the financial crisis which he also referred to as the 鈥楲ehman Weekend鈥� in September 2008.
In a recent blog, he reiterated the six lessons he鈥檇 drawn from the financial crisis that he claimed should be considered by all CCPs.
He said, for one, that 鈥淔at tails can't be underestimated鈥攖he returns on the many over-the-counter products that caused issues during the financial crisis are characterised as having 鈥榝at tails鈥�. That is to say, extreme negative outcomes occur with significantly greater frequency than would be the case in the widely assumed 鈥榥ormal distribution鈥�.鈥�
鈥淭hose unprepared for such outcomes [...] experienced significant and sometimes material losses during the crisis. This characteristic was manifested with respect to credit risk exposures, as well as liquidity risk exposures, particularly where liquidity step-in components had been built into certain complex products.鈥�
Davidson also claimed that for CCPs, 鈥渁ggregation is a must, in managing or supervising large complex financial institutions, aggregation is extremely demanding, but critical.鈥�
He stated: 鈥淟iquidity reigns鈥攗ltimately, it was not market or credit risk that brought many large financial institutions to the brink, it was the failure to understand the importance of liquidity.鈥�
鈥淭he market-funded broker/dealer investment bank model that was the predominant form of organisation on Wall Street for most of the second half of the 20th century failed completely with the financial crisis. At the end of the day, the only dependable source of liquidity comes from bank deposits.鈥�
Another lesson Davidson said should be considered is that 鈥渓egal entities matter鈥�.
He said: 鈥淚t's critical to understand the exact regulatory form of your CCPs. While the long-standing instinct of a trader is to 鈥榖ook it fast and worry about the details later鈥� that ends up producing exposures that are virtually unfathomable. What protected clients, customers and US CCPs, and what enabled the coordinated handling of the consequences of the holding company's insolvency in the Lehman case, was the fact that its clearing member component was a fully capitalised and regulated broker/dealer and futures commission merchant.鈥�
He further stated that 鈥渢he right of set-off will be invoked鈥�. He commented: 鈥淎 fundamental component of the banking ecosystem is a bank's nearly unilateral right of set-off, which exists under common law and in specific regulations that are in place in nearly every major jurisdiction in the world.鈥�
He concluded: 鈥淩ules matter, and flexibility does, too. A great deal of progress has been made with respect to completely appropriate regulatory oversight of CCPs and other elements of the financial infrastructure. However, one area where we've moved in the opposite direction is in regulators' unwillingness to grant flexibility to the managers of CCPs to use their professional judgment when they need to handle unanticipated events.鈥�
鈥淲hile rules, policies, procedures and associated internal documentation and governance have been greatly enhanced since the crisis, it's absolutely the case that the next systemic financial crisis will be much different from the last one. When it comes, CCPs will need the flexibility to respond to unexpected developments as the crisis plays out.鈥�
Davidson closed by stating that when the next crisis comes along, and when unique circumstances may present themselves, the industry鈥檚 new regulatory regime will 鈥減resent substantial challenges to the system鈥�.
Davidson made the comments at the World Federation of Exchanges IOMA Conference in Chicago in the run-up to the 10-year anniversary of the financial crisis which he also referred to as the 鈥楲ehman Weekend鈥� in September 2008.
In a recent blog, he reiterated the six lessons he鈥檇 drawn from the financial crisis that he claimed should be considered by all CCPs.
He said, for one, that 鈥淔at tails can't be underestimated鈥攖he returns on the many over-the-counter products that caused issues during the financial crisis are characterised as having 鈥榝at tails鈥�. That is to say, extreme negative outcomes occur with significantly greater frequency than would be the case in the widely assumed 鈥榥ormal distribution鈥�.鈥�
鈥淭hose unprepared for such outcomes [...] experienced significant and sometimes material losses during the crisis. This characteristic was manifested with respect to credit risk exposures, as well as liquidity risk exposures, particularly where liquidity step-in components had been built into certain complex products.鈥�
Davidson also claimed that for CCPs, 鈥渁ggregation is a must, in managing or supervising large complex financial institutions, aggregation is extremely demanding, but critical.鈥�
He stated: 鈥淟iquidity reigns鈥攗ltimately, it was not market or credit risk that brought many large financial institutions to the brink, it was the failure to understand the importance of liquidity.鈥�
鈥淭he market-funded broker/dealer investment bank model that was the predominant form of organisation on Wall Street for most of the second half of the 20th century failed completely with the financial crisis. At the end of the day, the only dependable source of liquidity comes from bank deposits.鈥�
Another lesson Davidson said should be considered is that 鈥渓egal entities matter鈥�.
He said: 鈥淚t's critical to understand the exact regulatory form of your CCPs. While the long-standing instinct of a trader is to 鈥榖ook it fast and worry about the details later鈥� that ends up producing exposures that are virtually unfathomable. What protected clients, customers and US CCPs, and what enabled the coordinated handling of the consequences of the holding company's insolvency in the Lehman case, was the fact that its clearing member component was a fully capitalised and regulated broker/dealer and futures commission merchant.鈥�
He further stated that 鈥渢he right of set-off will be invoked鈥�. He commented: 鈥淎 fundamental component of the banking ecosystem is a bank's nearly unilateral right of set-off, which exists under common law and in specific regulations that are in place in nearly every major jurisdiction in the world.鈥�
He concluded: 鈥淩ules matter, and flexibility does, too. A great deal of progress has been made with respect to completely appropriate regulatory oversight of CCPs and other elements of the financial infrastructure. However, one area where we've moved in the opposite direction is in regulators' unwillingness to grant flexibility to the managers of CCPs to use their professional judgment when they need to handle unanticipated events.鈥�
鈥淲hile rules, policies, procedures and associated internal documentation and governance have been greatly enhanced since the crisis, it's absolutely the case that the next systemic financial crisis will be much different from the last one. When it comes, CCPs will need the flexibility to respond to unexpected developments as the crisis plays out.鈥�
Davidson closed by stating that when the next crisis comes along, and when unique circumstances may present themselves, the industry鈥檚 new regulatory regime will 鈥減resent substantial challenges to the system鈥�.
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