Pensions: when the tail wags the dog

There’s nothing that’s more fun in a crisis than playing “Hunt the Culprit” and the mayhem which has been visited upon the gilts market in the past couple of weeks is a fully paid-up case in point. The government was blaming the Bank of England. The Bank was blaming the pension funds. The pension funds were blaming Liability Driven Investing or LDI. The gilts market was blaming limited liquidity and when given the chance every one of them ended up blaming all of the others at once. Talk of a saloon punch-up worthy of the best Hollywood Western.

But all the while, another name is coming up again and again and it is that of the London Clearing House or LCH.  

LCH was set up in the aftermath of the Global Financial Crisis. The demise of Lehman Brothers had left tens of thousands of derivative contracts without one counter-party to the agreement. The risk on derivatives, as opposed to the underlying asset, is marginal in that it deals with the differential between the market price of the underlying and the price fixed for the derivative. The idea of setting up a clearing house was to remove the some of the counter-party risk while also enabling trades to be offset against one another. This offsetting, or executing what in formally called a compression trade, was under rules capital efficient but it did not in the end reduce the aggregate amount of risk in the market.

And that is where the problem lies. A significant part of the toxicity during the Global Financial Crash was to be found in the Credit Default Swap or CDS market where default probabilities were being punted around like ten pound notes on the 3.35 at Kempton Park. Banks and hedge funds which had never lent a single cent to any number of both corporate or sovereign borrowers were placing bets on their creditworthiness and whether it would be improving or declining into the future. By the time the balloon went up in 2008, the business had got out of hand and the aggregate sum of bets on whether company X or country Y was going to default on its obligations ended up exceeding manyfold the sum that the borrower actually owed. As a result, the regulators clamped down on willy-nilly trading of default swaps and insisted that they should be tied to actual debt instruments held in portfolio.

The same does not apply to interest rate swaps which can in effect be written by any eligible counterparty with a clearing account at the LCH. The fact the volume of outstanding contracts need bear no relationship to the underlying markets has no influence. Or at least not until it all begins to go wrong and one finds that the market for the underlying – in this case for long dated UK gilts – is far to small relative to the corresponding derivatives market and that the tail is not only wagging the dog but that it is at the same time smashing it against the wall.

The simple fact is that apart from being used for hedging purposes, the swaps market has become a great place to speculate with marginal market risk but no proper default risk. To back that marginal risk, players are asked to post collateral or margin and a margin call occurs when the amount of collateral posted no longer covers the potential losses, were the contract to expire at the current market price. In a volatile market, that price can leap outside of the range for which collateral has been posted. It can be for an hour, a day, a week or is some cases in perpetuity. But the call by the clearing house for more margin to be posted is the same, irrespective.

But the more contracts are outstanding, the more margin will be required from more market participants. If, as in the events which have befallen the gilts market, the aggregate of all outstanding derivatives exceeds by multiples the amount of the underlying market, the greater the distortion becomes if, as and when price stresses do occur. In effect, the gilts market is too small and too illiquid to have so many swap contracts based on its performance.

The introduction of the London Clearing House into the process of booking and settling derivative trades is certainly part of the problem but the real issue is that there is no one who controls how many bets are placed through the swaps market and keep an eye on how the underlying market might be able to cope with stress. Regulators could be found who reined in the rampancy if credit default swaps. Maybe it is time for one to step up and take control of interest rate swaps too. The clearing house solution certainly covers part of the problem but not all of it.  

The author is a retired City trader specialising in fixed income who now works as a freelance strategy consultant. 

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