Warwick Law School’s Dr Stephen Connelly has been asked for comment after a Norwegian trader blew a €114m hole in protections for European power derivatives market.

“The way in which a single energy trader managed to burn through the NASDAQ power exchange’s risk default fund raises wider questions about the role of exchanges in the post-2008 regulatory architecture. Derivatives exchanges – or Central Counterparties (CCPs) – constitute systemically important financial market infrastructure. If they fail then the contagion of illiquidity can spread quickly through the system and credit crunch conditions can occur.

Regulators have placed great store in the notion that CCPs should operate as circuit breakers to stop contagion. They have developed a hub and spoke concept for CCPs, in which CCPs only deal with a select group of Client Members, and everyone else must go through a Client Member to trade. The idea is that Client Members acts as gatekeepers to risky traders, while CCPs select only the best Client Members as gatekeepers. Any problems should hit Client Members first, and CCPs should be able to drop a defaulting Client Member and replace them while keeping the exchange running.

In the recent case of NASDAQ’s power exchange, it appears that NASDAQ inherited a legacy client member in the high profile trader Einar Aas. Really this individual should have been operating outside of the hub and spoke system, but was allowed to set up and clear trades himself. There is a serious question about whether falling liquidity at this particular exchange, and the relative trading volume generated by Mr Aas, clouded the CCP’s judgement in allowing Mr Aas such freedom. The result is that NASDAQ took a massive hit, and while it survived, it has only been able to continue through recapitalisation by other Client Members.

These events have serious policy indications. Many such exchanges are regarded as systemically important. Additionally, the European Market Infrastructure Regulation forced many OTC derivatives to be cleared through CCPs to further enhance market stability. Yet all this appears to assume that CCPs are neutral actors, primarily motived by public duty. Yet following the case of Einar Aas, regulators may well ask if CCPs have conflicting loyalties: financial stability versus exchange viability.

Another exchange, the OCC in the US, this week announced a return of capital to client members. Interestingly client members have expressed their concern that an exchange created as a mutual and operating as a utility for its members, has become a profit-focused entity with duties to its shareholders. Again a conflict of interest?

CCPs benefit directly from regulatory approval and particularly the requirement that many trades be cleared through them. Given this, regulators should ask themselves whether CCPs should be held to a higher, overriding standard of public duty. In short, should CCPs be required to be ‘boring’, with risk-taking being left to financial institutions who play the role (and pay their way) as Client Members?”

Stephen was quoted in the following articles:

Financial Times: How clearing houses aim to avert market disasters

Bloomberg: How Star Power Trader Cleared Own Trades and Lost Millions