CCP ‘Armageddon’ could lead to sovereign default, warns HSBC exec

Mandatory clearing of over-the-counter derivatives could jeopardise policy-makers’ hopes of a no-bailout financial system, according to Gary Dunn, senior manager for regulatory and risk analytics at HSBC.

Speaking at the annual general meeting of the International Swaps and Derivatives Association in Singapore, Dunn sketched out an “Armageddon scenario” resulting from the fact that the same group of international banks are all members of the majority of central counterparties (CCPs) – so, a big bank default would simultaneously hit all CCPs of which it is a member.

“What happens when one bank defaults across six CCPs? The remaining members will have to pick up the bill. Given that they are almost certainly members of the other CCPs, this will result in a default contribution bill so large it could potentially lead to their failure also,” he said.

Given the key role CCPs will play in the future financial system, Dunn argued this would ultimately result in a taxpayer bailout amounting to trillions of dollars. In his Armageddon scenario, that bailout would be preceded by the complete liquidation of CCP initial margin stocks – much of which would likely be held in the form of government debt.

“The wrong-way risk in the current CCP system is so large it could potentially lead to a sovereign default,” he said.

These fears are animating attempts to draw up a resolution framework for CCPs that would ensure they have the ability to stand on their own two feet. Speaking before Dunn, Edwin Budding, director for risk and capital at Isda, said that when discussing CCP resolution with authorities it was wise not to suggest a taxpayer-funded solution, “unless you want to have an unpleasant meeting”.

And whatever approach is chosen for both bank and CCP resolution, HSBC’s Dunn argued the taxpayer will end up footing the bill.

“In the end, the bank is not a wealth holder – it’s simply an intermediary. If regulation increases the cost of banking there are only two routes where it can recover this cash: via its shareholders or by increasing the costs to customers. So that means the pension funds will pay higher costs – as will other financial institutions. And it will also be reflected in lower long-term growth,” he said.

Dunn said the global economy is deliberately being moved to a lower-volatility, lower-growth regime – an approach he said could well be correct. But although authorities may be successful in avoiding further newspaper headlines about bank bailouts, it was “only because no newspaper will ever write, ‘economic growth reduced because of an increase in the cost of financial intermediation'”.


This article was first published on Risk

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