Clearinghouses used for derivatives trades can be vulnerable and potentially spread risks through the financial system, according to a U.S. Treasury report.
The Treasury's Office of Financial Research (OFR) said Wednesday that threats to stability have increased slightly in the past year. Its assessment of risks in the financial system, however, hasn't been affected by the Federal Reserve's decision to raise interest rates in December. The Fed's monetary policy makers decided Wednesday to leave rates unchanged following a two-day meeting in Washington.
Clearing trades at a central location, rather than between dealers or between dealers and clients, helps reduce the likelihood of counterparties defaulting, but clearinghouses can lead to systemic risks if they don't have sufficient resources to cover payments, or margin, according to the research office's fourth annual report.
Regulators including Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp., and firms such as asset manager BlackRock Inc. have raised concerns that there could be too much risk concentrated at clearinghouses.
U.S. officials turned to clearing firms after the 2008 crisis to help make the derivatives market more transparent. One objective was to ensure that losses at one financial company wouldn't spread to others and the broader economy. Swaps trading—when it was largely unregulated—amplified the meltdown and prompted a US$182 billion rescue of American International Group Inc.
After the crisis, authorities in U.S., Europe, and Asia required that most derivatives be guaranteed at clearinghouses instead of allowing risks to mount directly—and unseen—between traders. That move increased the role of platforms owned by CME Group Inc., Intercontinental Exchange Inc., and LCH.Clearnet Group Ltd., where traders clear swaps tied to interest rates, bonds, and other assets.
The report also raised other concerns, such as that U.S. banking activity remains concentrated among eight global banks that have been labeled systemically important—including Citigroup Inc., Bank of America Corp., Goldman Sachs Group Inc., and Morgan Stanley. The OFR conducts research for regulators and works closely with the Financial Stability Oversight Council, a group of U.S. financial regulators led by Treasury Secretary Jacob J. Lew.
Overall, threats to financial stability still remain in the medium, or moderate range, the OFR said. The office reiterated regulators' concerns over the past several years about incentives created by low interest rates.
“Persistently low rates will continue to prompt investors to take higher risks to increase their returns on investment and may encourage excessive borrowing,” according to the report.
The OFR said that reaching for yield along with vulnerabilities from heavy debt loads and eroding credit quality in emerging markets will increase the U.S. financial system's susceptibility to shocks.
Rapid, sharp declines in market liquidity could also pose a threat to financial stability, the research unit said. Regulators are studying ways in which they can prevent that to help the U.S. Treasury market operate more smoothly. They want to avoid the kind of sudden price swings that occurred on Oct. 15, 2014, when Treasury yields fluctuated in a way that had only happened three other times since 1998.
–With assistance from Jesse Hamilton and Silla Brush.
Copyright 2018 Bloomberg. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.
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