Can risk-sharing via derivatives perversely lead to risk-taking by financial institutions? As part of his ‘Trading and Post Trading’ project, which was awarded a senior European Research Council grant in 2012, TSE’s Bruno Biais has published a paper in ‘The Journal of Finance’ which shows how margin deposits and clearing arrangements can be designed to mitigate risk. Together with Florian Heider and Marie Hoerova, his co-authors from the European Central Bank, he also provides new empirical predictions about the extent and risks of derivatives activity.
Why have derivatives drawn the attention of policymakers and researchers?
Derivatives activity has grown strongly over the past 15 years. For example, the face value of credit default swaps (CDS), which are bilateral over-the-counter contracts used to insure credit risk, increased from around $180 billion in 1998 to more than $60 trillion by mid-2008. But the insurance provided by derivatives is effective only if counterparties can honor their contractual obligations. When Lehman Brothers filed for bankruptcy, it froze the positions of more than 900,000 derivative contracts (about 5% of all derivative transactions globally).
How do you simulate the tensions involved in these complex financial arrangements?
Our model features risk-averse protection buyers who want to insure against a common exposure to risk. These buyers contact protection sellers whose assets can be risky, but who are not directly exposed to the risk that the buyers want to insure. The sellers can prevent downside risk, maintaining sufficient value for their assets, by exerting costly effort such as scrutiny of potential investments. Alternatively, sellers can “shirk” the cost of scrutiny by relying on external, ready-made credit ratings or simple backward-looking measures of risk. Failure by sellers to exert risk-prevention effort (which we call “risk-taking”) leads to counterparty risk for protection buyers. Since financial institutions’ activities are opaque and complex, risk-taking is difficult for outsiders to detect. This creates a moral-hazard problem for sellers, the key friction in our model.
Why does this risk-sharing breed risk-taking?
One of our key insights is that a large derivative exposure undermines a protection seller’s incentives to exert the risk-prevention effort when new information makes the derivative position an expected liability. In that case, the seller bears the full cost of the risk-prevention effort while the benefit of this effort partly accrues to the counterparty in the form of payments from the derivative contract.
The optimal contract takes one of two forms, depending on the severity of the moral-hazard problem. Either the contract maintains protection sellers’ risk-prevention incentives, at the cost of less ex ante risk-sharing for protection buyers, or it promises more risk-sharing but gives up on risk-prevention incentives, which creates counterparty risk for protection buyers. So the risk-sharing potential of derivative contracts is limited by the potential or actual presence of endogenous counterparty risk.
Can derivatives generate contagion between asset classes?
With moral hazard, bad news about protection-buyer assets can increase the likelihood of low pay-offs from protection-seller assets, because bad news undermines sellers’ risk-prevention incentives. For example, before the recent crisis banks frequently reduced their capital requirements by purchasing derivatives. Our model predicts that financial institutions with larger short CDS positions exposed their balance sheets more to downside risks as bad news about the housing market emerged. Importantly, this exposure is a calculated choice, not the consequence of mistakes or incompetence.
How can we create safer financial markets?
The main focus of our paper is to characterize the optimal design of margin calls and central clearing platforms (CCPs). These institutional arrangements aim to mitigate counterparty risk and were adopted by both US and European regulators following the 2008 financial crisis. Our model features a CCP that pools the resources from all protection sellers. Any losses from the default of individual sellers are therefore shared across all buyers.
The CCP is also in charge of implementing margin calls. The party subject to a margin call must hand over control of assets to the CCP, “ring-fencing” them from moral hazard. With fewer assets, the cost of risk-prevention effort is lower, which improves risk-prevention incentives. But safe assets on a margin account earn less than risky assets left on financial institutions’ balance sheets. Margins will therefore be used only when the ring-fencing benefit outweighs the cost: for example, when the moral hazard problem is severe; or when the opportunity cost of depositing assets in the margin account is not too large.
What are the policy implications?
Our analysis implies that margins can be an attractive substitute to equity capital. Ring-fenced from moral hazard, assets can support larger liabilities. Consequently, margins allow protection sellers to engage in incentive-compatible derivative trading with less equity. An advantage of margins is their contingent nature. They are called only when individual derivative positions deteriorate.
Our research clarifies how margins and central clearing interact and the need for them to be designed together. While central clearing mutualizes counterparty risk, margins provide incentives to avoid counterparty risk. Without margins, CCPs would bear too much risk; without a CCP, contracting parties would have to put up higher margins. And it is the CCP which must design and mandate the margin calls. Otherwise, there would be free-riding on the insurance it offers.
FIND OUT MORE: ‘Risk-sharing or risk-taking? Counterparty risk, incentives and margins’ by Bruno Biais, Florian Heider and Marie Hoerova was published in ‘The Journal of Finance’ in August 2016.
Extract of the TSE Mag #17 Summer 2018