In this exclusive interview MoneyScience talks with Dr Jon Gregory, author of Central Counterparties: Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives.
In this exclusive interview MoneyScience talks with Dr Jon Gregory, author of Central Counterparties: Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives. Jon is a partner at Solum Financial Partners LLP and specialises in counterparty risk and CVA related consulting and advisory projects. He has worked on many aspects of credit risk in his career, being previously with Barclays Capital, BNP Paribas and Citigroup. He is also author of the book Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets now in its second edition. Jon holds a PhD from Cambridge University.
You can hear a segment from the interview in the first edition of the MoneyScience Podcast here, and read the full transcript below.
Jacob Bettany: Could you begin by telling us a little bit about your background and how you formed an interest in this topic?
Jon Gregory: I have a rather unusual background in that I was a mathematician and scientist in my early years and academic life. I did a PhD in theoretical chemistry around 20 years ago whereupon I moved to Finance on the quantitative side. My career in Finance was broadly speaking in the area of Credit Risk so I had a very busy time in banking during the years it was most exciting time to be working in this area. I left in 2008 and have ever since been essentially working on a freelance basis for myself which I find interesting as I can work for several clients potentially of different types with different needs and requirements. As is probably not surprising, most of my clients are banks but I also do work with regulators and other third parties.
JB: Why did you write this book, how does it build on your previous work?
JG: When I left banking in 2008 it was clear that things were changing very rapidly and the things that had been interesting for the last few years would not necessarily continue to be of interest. So I thought carefully about what in the area of credit risk I would advise and consult on. Something that I had spent a lot of time on at various points in my career was counterparty risk, which at that time wasn’t a particularly big thing because there had been a view of the market for a number of years that large counterparties would not be allowed to fail. So I left my last banking job in 2008 based on this idea that counterparty risk may become a fairly big topic and three months later Lehman happened which obviously showed us that large counterparties would or could fail and really was one of the major catalysts for counterparty credit risk being such a hot topic. So I wrote a book on counterparty credit risk which was published through Wiley in 2009. It has become very well read and is now in its second edition since the area was moving rather rapidly and continues to evolve. A parallel area has developed in the last 2-3 years, that of central clearing and central counterparties which is the topic of my second Wiley book and that came about for a couple of reasons, one it was something I was being asked a lot about by clients and two, it was an area that I was very interested in. The advantage of being your own boss is that if you decide you’d like to take some time to research and write a book then you can do that! I think like the first book it is hopefully quite a timely book because central counterparties within the OTC derivatives are going to become a fairly big deal over the next few years. That is really due to the regulations as one of the reactions to the financial crisis from politicians and so on as non-specialists was to say that central clearing could be a way to tame the OTC derivatives market, but of course it’s a very complex story because you make some things more efficient and less risky but you possibly create other inefficiencies and also possibly other risks. So I was trying to explain the theory and practice so that someone reading this book would be able to understand what the balance was; what things get better, what things get worse and so on.
JB: And who do you aim to reach with this message, who are your target audience for this book?
JG: It’s possibly quite broad – as the title makes clear, it’s very much about central clearing and requirements for the OTC derivatives market, so potentially anyone with an interest in OTC derivatives, which obviously includes banks of all types from large to small. Also the so-called end users of OTC derivatives are also relevant so those end users would be other institutions like pension funds and asset managers they would also potentially move to non-financial corporates, supra nationals and sovereigns and so on. There is an exemption that means some of these non-financial end users won’t necessarily have to clear their trades, but in my experience a lot of them are nevertheless still thinking about it. To a large degree it would be financial institutions who would be interested in this topic but there are some non-financial ones who would be interested as well. It is quite a wide topic which is reflected in the people who attend the courses I’ve been giving. Regulators are interested in this area because it’s a fairly dramatic piece of regulation that is forcing more of these derivatives under central clearing and not surprisingly regulators are very keen to understand the potential impact of that.
JB: The book adds some historical context to the overview of the current marketplace, are you able to provide a brief summary of this history?
JG:Well when we all learnt about how financial markets worked and we learnt about exchange traded derivatives, things like futures, we learnt that they trade on exchanges and because of that you don’t really have any risk of anyone defaulting because the exchange essentially guarantees that won’t happen. In reality what is really happening is that over many decades exchanges have adopted a central clearing function and this basically guarantees that if someone on the exchange fails then there won’t be a horrible mess where lots of people end up without a contract; the exchange will make good on their contracts as long as of course the exchange or the central clearing function of the exchange doesn’t fail. Now, that’s the exchange traded world which of course is quite small compared to the enormous OTC derivatives market. Over the last 20-30 years a massive OTC derivatives market has developed to make the exchange trading market look rather small in comparison and in the aftermath of the last crisis, policy makers were looking around saying well, you’ve got all these OTC derivatives which can be extremely risky such as the credit derivatives which were a major cause of some of the problems. So essentially what the regulation is saying is, let’s try and make OTC derivatives more like exchange traded derivatives, which are safer and have this central clearing function. At first glance that seems like a fairly sensible idea, but what you’ve got to bear in mind is there are some very fundamental differences between exchange traded derivatives and OTC derivatives, such as, if I trade on an exchange I might be buying a contract with a maturity of one week. If I go into the OTC derivatives market to an inflation swap the maturity might be 50 years, so just saying we’ll do the same to one as we do to the other is not a complete no-brainer because there are plenty of risks embedded in the OTC world which may not be well mitigated by central clearing, but that’s essentially what is happening. The mandate will be phased in, so the mandate’s not suddenly going to start and say you’ve got to clear all your OTC derivatives, but it is saying you’ve got to clear all your OTC derivatives of a certain type and then eventually we may be asked to clear others as well. In the interest rate world, most interest rate swaps are already suitable for clearing. Interest rate swaptions are not quite there yet, and anything more exotic than that definitely isn’t there. In the credit derivatives world, credit default swaps on indices are cleared already, single names not so but not far off and anything more complex than that definitely not. So in all sorts of expanding mandates it won’t ever cover everything, but it might not need to cover everything because you might manage to clear three quarters of the entire market and think well that’s probably enough.
JB: Where does the responsibility lie in terms of implementation of this on the technology side?
JG: There are two possible implementations. One example is SwapClear which is owned by LCH.Clearnet. Swap clearing was an initiative essentially put together by large banks to clear interest rate swaps and that happened even before the last crisis. So, taking the idea that in the OTC derivatives market a lot of things are dominated by just a small number of counterparties – if those small number of counterparties get together they could essentially set up their own clearing house and that’s what happened with SwapClear largely owned by some of the big members. Now the other thing that can happen is that you take, say, CME the Chicago Mercantile Exchange which of course has been around for decades as an exchange and has therefore had a central clearing function and the CME can say, well we’ve been clearing interest rate futures contracts for years and years, now let’s also offer to clear interest rate swaps.
I think those are the two ways in which it will happen. You’re only going to clear a product if you think you can make money out of that so you’re probably not going to clear an OTC derivative when you think the market is very small and you would have to invest quite a lot in your product development process, and then really the market simply isn’t big enough for you to make the money back on doing that. So clearing interest rate swaps is an absolute no-brainer because once you’ve got your product offering then you know in the world of OTC derivatives interest rate swaps are extremely dominant. Credit rate swaps likewise, it’s a fairly big market but obviously at some point you’re going to decide that you won’t clear any more, and so I think we’re looking at a world where there might only be a handful of OTC products that actually ever get cleared. On the other hand you can still clear maybe three quarters of the market because it is very dominated by those products. So I don’t think we’re going to see a central clearing for exotic interest rate products – but having said that, exotic products are not as common as they used to be. As something becomes more complex you have two problems; one is they become more difficult to clear, and secondly the underlying market for it is diminished. So that’s really what would prevent someone from clearing some of the more complicated products.
JB: How did you choose to structure this book and what challenges did you face when writing?
JG: I think for me it’s all about theory and practice. I think what’s interesting about a topic like this is that you have the underlying requirements, the regulations and I think the first thing someone wants to know is what all the regulatory requirements are. While that is a moving target, it is possible to describe and that is a bit of a challenge as you have to go through an enormous amount of reading to work out what all the regulatory requirements are and to know that in the US there is a rule that is slightly different than the rule in Europe, etc. The first thing I wanted to cover was the requirements and what you have to do, so if you are a pension fund and you pick up the book you would read well this is the situation we’re in, which is actually again quite a confusing one, but nevertheless you would be able to read about that.
Secondly there is the theory or the concepts, and how all the different aspects of clearing work, and all the different choices that can be made, and that links in to the regulation because there are different choices. For example if you clear the trade of a client they have a choice of different account structures and how their money might be protected and so theoretically you want to go through all the ways it could be structured and point out the positives and negatives of each one. There is also a little bit of history around everything, for instance when was the first CCP ever created – and the answer is essentially a very long time ago – but how did they develop historically through time and how did we get to where we are now and how did the OTC derivatives market develop? Finally, what is going to happen in the future? What are the risks of what’s going on now and where will the next crisis be, will we have another Lehman crisis or would it be a different crisis? Maybe a crisis involving a CCP itself? And so you analyse the different risks. So those were all the different angles I was aiming to achieve. In terms of book structure I think you just look to build sequentially and have chapters on all the different things. I’ve had a couple of emails from people who’ve expressed surprise – I think surprise and hopefully also delight – that it’s possible to buy an entire book on this subject! It’s frightening how quickly you can expand the subject once you’ve looked at all the little difficulties and the intricacies, and you find it is possible to have a whole book covering this. If you take one example of client clearing, essentially where you are not a member of a CCP yourself but you are clearing through someone who is a member, it may be that a very large bank is a member of SwapClear and they actually clear for one of their clients and their client is not a member of SwapClear – you can probably guess that you need quite a significant amount of space to describe every single aspect of that!
JB: So you find yourself having to be as succinct as possible when you have so much ground to cover.
JG: I like the challenge of explaining things, analysing and presenting them as well as I can. There is a balance where you don’t want to go into too much detail and talk about things which are too theoretical or too wordy, but yes I spent a lot of time trying to think about the best way to put things across and whether lots of pictures are helpful or not, and trying also to link concepts with actual practice.
JB: Is there much Math in the book?
JG: No, none. With my first book on Counterparty Risk the first edition I put all the maths pretty much in appendices at the end of each chapter. With the second edition the appendices are online on my website and the book itself probably has about seven equations in just where they are absolutely needed. With a book on central counterparties, unless you are trying to present any sort of theoretical analysis or risk or whatever, there is no maths. I find that that also makes the book have a broader appeal. There will always be people who would prefer to have lots of maths there but most are happy with less rather than more! It’s not a mathematical book which is a bit unusual for me because I started off very much as a theoretician within the world of Finance and did very quantitative things and as I’ve gone through and written articles and books and so on every single or book I write seems to have less maths in it until eventually my last book has none! I’d like to think that’s a good thing!
JB: The current market has been reshaped significantly since the financial crisis, can you identify some of the key developments? How optimistic do you feel that the new regulatory environments and Basel III adequately address the issues raised by the financial crisis?
JG: Well, first of all I’m a bit cynical on regulations – I’m not cynical about regulators but I am cynical about regulation. I think it’s very hard for regulation to ever solve problems as efficiently as you would like and I think financial market regulation is probably tougher than most regulation as participants in the market will try and find every single loophole in the regulation that they possibly can and arbitrage it if at all possible. I don’t think that all the regulation which has been devised since the last crisis is necessarily going to prevent us having another crisis. I don’t subscribe to the view that regulation is capable of giving us that. Overall I think one of the problems we have is huge amounts of different regulation. Even in my particular area there is regulation around the CVA counterparty risk capital charge which is a new capital charge introduced for CVA, which has created enormous amounts of problems for reasons probably too technical to go into, and we’ve got regulation with the move to central clearing, and that doesn’t even touch on things like the LCR and so on which in some sense are regulation all designed to do similar things. The fundamental problem is that you don’t want financial institutions to be too highly leveraged and you don’t want all sorts of problems that can make crises worse when they actually happen. I think what regulation seems to be doing is coming up with a huge number of different things that banks have to comply with and relaxing regulation where it seems that it might be too punitive. Often people have a view that regulation is just going to kill the entire OTC derivatives market. I tend to take a slightly different view which is I think that regulation’s starting point is a point where it would essentially kill the entire market and then it is relaxed just enough to avoid that happening. I think one of the most interesting things over the coming years is to what degree banks have to move away from some of these areas, which they have been doing, and to what extent a relaxation of regulation and the ability to find optimisations and loopholes allows banks to start to return to some of the good old days as some of them might refer to them as now!
JB: There’s a risk with regulation that you get unintended consequences. Warren Buffet famously described derivatives as “financial weapons of mass destruction” – to what extent was this hyperbole, or do derivatives pose a real and present systemic risk to financial markets?
JG: I absolutely agree with that statement, and as a general statement I think most people would. I think it is important to mention, keeping things general, that without OTC derivatives the financial markets and therefore the economy would not have developed in the way they have. Yes they are potentially very dangerous, but we wouldn’t want to get rid of them completely. It’s a bit like air travel which has certain risks but would we want to say we can guarantee that no-one will ever get killed in a plane crash again, we’ll just ban air travel? OTC derivatives have risks but we allow them to exist within a very safe framework where we’re not worried about them actually creating a financial crisis. Unintended consequences are interesting because I think what we could end up with is a situation where regulators do make these OTC derivatives markets safe to a large extent by just driving banks away from them and making it very difficult to do anything like as much volume as you used to do. In doing so they open up potential frailties in other areas of financial markets.
I think that’s just the obvious problem of regulation, that OTC derivatives are perceived as being very evil and they at the very least catalysed on a lot of things that went wrong over the last few years, so you sort them out and then realise that the next crisis isn’t really perhaps related to them but it’s something else possibly that came about as a result of the regulation that you brought in… to give an example of how that might play out: one of the most important things about central counterparties and the so-called bilateral margin rules which are being brought in to make OTC markets much safer is that they require a lot more margin, or what we commonly refer to as collateral. If financial institutions need to post a lot more collateral they’re going to need methods for getting that collateral and also maybe taking a form of collateral which you cannot give to someone like a corporate bond and converting it into somethingthat you can give to someone, like cash. So what kind of market do you rely on to do stuff like that? Well, one example is the repo market. Does the repo market work extremely well in a crisis scenario? Well, judging from the last crisis, no. So are we potentially putting more strain on another market which we’ve not seen as an OTC derivative market, and could that market be more susceptible to problems in the future? I would certainly not ever try and imply that I know that’s going to happen. I would think that the thing to be concerned about is not necessarily the things that have been problematic in the past but the things that may become problematic as a result of a lot of the regulation that’s been introduced. I think you can predict some problems and I sound a bit old and cynical because I’ve been in Finance for 20 years now and I wouldn’t have taken these views when I was younger in the early stage of my career but I think that experienced and knowledgeable people can predict them. I wouldn’t expect someone who’s been working in financial markets for five years would be able to predict these things, but some of the most interesting conversations I have are with people who’ve been around the block a few times and they do have the ability to think these things through and to say well, yes, there are a lot of unintended consequences and it’s impossible to predict the future, but we can make some educated guesses about where there might be more frailty in the future and we can suggest which elements of regulation are poorly thought through and which are not. There is regulation that makes sense and seems to be reasonably well thought out, and there is regulation that isn’t well thought out because it might not solve the problems it intends to solve or the problems it might create could be even worse than the problems it’s intending to solve.
JB: Well I was just about to ask if you would like to try and predict the future for this area, say in the next 5-10 years?
JG: Well one thing I will comment on is that I think we are going to see a reversal – a bit like going back in time – in the world of OTC derivatives. We have already seen some of this happening as exotics are of course of less interest since the crisis and regulation will make that even more so, and I think more standardised OTC derivatives will become increasingly dominant and real bespoke contracts will become less dominant. To a large extent that’s good, to some extent that’s not good. If I look at different participants in the market I can see in some cases it would make sense. In the case of hedge funds for example there’s no real need for them to have long-dated illiquid OTC derivatives in some cases. To express an opinion, they could easily trade on an exchange with more short dated liquid instruments. On the other hand if I was a pension fund and I wanted to do a thirty year inflation swap, often it’s difficult that the more liquid things are the much shorter tenure and so on, that’s the opposite scenario, so I think regulation is forcing the market to become much more standardised and less complex and that’s to some extent obvious and to some extent good but I think we have to remember that one of the real benefits of OTC derivatives is that they are bespoke, and that offers a lot of advantages to financial and non-financial institutions.
JB: You are a prolific educator, what do you plan to work on next?
JG: The next big project to is produce the third edition of my first book on counterparty risk and focus on that and try and bring everything together. When I work on a book I find that a lot of smaller things come up that tend to be more useful for academic papers or short papers so as I start to do that I’ll be thinking about those things. At the moment I am looking at applying utility theory to the waterfall of a CCP but I won’t bore you with the details!
JB: Thank you for speaking to us Jon.