Quis custodiet ipsos custodes?

Quis custodiet ipsos custodes?

It is unlikely first century Roman satirist Juvenal was thinking about the G20 pledge to reform the swaps markets when he said it but his question is relevant: Who will guard the guards?

The decision by the group of 20 nations in 2009 to force standardised swaps through many of the funnels used in the exchange-traded world was at the time grudgingly accepted as a fairly practical step.

Some five years on, the reality suggests otherwise.

Trade reporting (arguably the least controversial of the three principles backed by G20) has been far from straight-forward, not least in Europe where one bank recently estimated less than 1% of the trades that should be reported are actually being reported almost six months after the law took effect.

The execution mandate to force standardised swaps on to exchange-type platforms has fared little better. Volumes on swap execution facilities in the US are increasing slowly but are still well short of the levels expected.

This is because some firms have stopped trading in the US while others are trading lookalike products that are exempt from Dodd-Frank but are very close to those bound by the controversial rule.

Yet mandatory swap clearing arguably represents the greatest threat to the stability of the financial system.

Forcing the swaps market to clear effectively concentrates the risk into a handful of clearing houses to which all the world’s trading firms are exposed.

Clearing houses are (they claim) experts at managing risk and to be fair to them most of them stood up well in the aftermath of the Lehman collapse in 2008.

But the inclusion of hundreds of trillions of standardised swaps ups the ante massively and the industry has been for the last couple of years trying to work out what happens if a clearing house were to collapse?

The clearers themselves have run scenario tests based on the premise that their two largest clients were to collapse on the same day and they have found (surprise, surprise) that they would be fine.

The procedure in the event of a default suggests there could be an impact on clients however.

Clearers typically use a default “waterfall” that lists sequentially the various sources the clearing house can call on to make good on any losses incurred by members as a result of another member going into default.

At the top of the waterfall are the defaulting member’s margin contributions and at the back of the queue are the clearing house’s cash and finally that of members.

This then acknowledges that a clearing house could be on the hook in the event of major client going down and that, ultimately, the banks themselves might have to step in if the clearing house can’t handle it.

This dilemma has prompted (academic) discussions between the world’s top investment and central banks.

The commercial banks argue that a default waterfall reaching them in the event of clearing house failure will have catastrophic effect because they would be hamstrung and the markets would seize up.

Investment banks think central banks should step in and bail-out a failing central counterparty as this would ensure the markets can at least carry on and the impact of the default can be minimised by trading out the positions.

This line was backed this week by Professor Scott Lubben of Seton Hall University, School of Law who has concluded a study with the finding that the US government should be prepared to step in and support a clearing house on the brink.

But central banks are not having it. They insist they are not going to stand as the lender of last resort in the event of a clearing house collapse and it is up to the clearing house’s clients to make any struggling clearer good.

Governments and investment banks have not agreed on much since the financial crisis but they would surely agree that no-one wants to find out what would really happen if a clearing house went under.

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