The Three Tenets Of Capital Markets Reform
By Fred Ponzo, CEO, GreySpark Partners
Capital markets reforms crystalised in the US Dodd-Frank Act and in its EU counterparts that are also being similarly implemented by a growing number of other countries like Australia and Canada, for example, have a single aim: to reduce systemic risk in the global financial system.
As such, three tenets underpin the new architecture devised by legislators. First is the management of market and counterparty risk, both of which historically were commingled and buried within bank balance sheets. These risks must now be segregated and dealt with independently from each other.
The second principle of the financial markets reform is the steep disincentive now applied to banks regarding risk-taking activities. It takes the form of punitive capital charges on uncleared or uncollateralised trades (Basel III), as well as through outright bans on proprietary trading (e.g. the Dodd-Frank Act’s Volcker Rule). The intent of these rules is clearly to nudge investment banks to fall back into their place within the global financial system as intermediaries, instead of behaving like supercharged hedge funds. Lawmakers in the EU and US favour a world wherein the provision of market liquidity is assumed by shadow banking outfits instead of deposit-taking banks. In short, this change will push market risk onto firms that do not need bailing out by taxpayers if their bets backfire.
The third tenet is to move most of the counterparty risk onto clearinghouses. The reality is that mandating the central clearing of OTC contracts does not necessarily reduce systemic risk. Instead, by concentrating counterparty risk within a handful of fit-for-purpose institutions, such risk can be accurately accounted for and, therefore, adequately managed. This is a significant improvement from the previous belief that risk would naturally spread out across the universe of investors, making the market as a whole more resilient. This assumption was proved wrong when, in 2008, the London-based trading arm of US insurance giant AIG was found to be at the end of the majority of CDS contracts in the market, leading to an eventual $85bn US government bailout of the company using taxpayer cash.
In this spirit, central counterparties (CCPs) should be, in essence, public utilities, operating as insurance schemes in a manner akin to mandatory, universal healthcare coverage. All clearing members to a CCP should be treated equally and should contribute premiums that are pooled to cover the risk of a default by market participants. In practice, clearinghouses are an oligopoly of competing commercial organisations in which clearing members take an equity stake. This equity cushion is meant to absorb potential losses incurred by a default.
In my view, the capital structure of CCPs represents the Achilles heel of the new market architecture. A single large default event could wipe out the capital of the CCP, triggering its nationalisation to safeguard the whole system. Maybe this is what is required to return clearinghouses to their original form of mutualised, non-profit infrastructure. I cannot help thinking we could have spared ourselves the thrill of having to look into the abyss once again in the not-so-distant future.