Dr Stephen Connelly of Warwick Law School comments:

"Post-Lehman, regulators have chosen to install circuit-breakers in the financial markets, especially where derivatives are traded and closed out. They are supposed to work as three concentric circles: the centre is the Central Counterparty (or CCP) which is in effect the place where trades occur, but around this is a defensive ring of brokers who mediate trades between the CCP and actual traders.

"The CCP and the brokers are supposed to keep default funds and collateral (margin). If a party cannot pay its ultimate counterparty, because it is bankrupt for example, the counterparty does not suffer immediate loss which spreads through the financial system, but may receive some satisfaction from the default fund and collateral.

"In this case, for reasons yet to be explained, a wealthy individual, Einar Aas of Norway, was permitted to trade without the broker intermediary. This has happened in the past in other markets (the London Metal Exchange) but I would say it is rather undesirable, and what has happened he is just one reason why.

"Essentially Mr Aas’s bets that the Nordic and German energy market price difference would narrow were wrong, and the difference ended up diverging by a factor of 17. The kind of derivative Mr Aas had agreed to meant that he had to pay out to a counterparty for as much as this divergence exceeded the bet he had made. He evidently burnt through his own money and the CCP had to step in and meet the shortfall with its own default funds reserved for this purpose.

"The first issue this raises is why, given the modern regulatory architecture, Mr Aas was allowed to avoid using a broker thus circumventing one of the system’s circuit breakers. One might also add that a broker ‘may’ well have poured cold water on Mr Aas’ bets, if only by demanding additional collateral. That too could have mitigated losses.

"The second issue runs deeper. The reserves CCPs put in place are calculated according to the probability of trades like this happening. The problem is that financial markets have ‘long tails’, which is statistical jargon for: normally highly improbable events like crashes happen with uncommon regularity. In this case the CCP has taken a huge hit from Mr Aas’s trades and may not be able to take another such hit if a similar event asks tomorrow.

"There is thus a bigger question mark for European regulators about how reserves are calculated and whether, in a cascading scenario of defaults and credit-freezes such as we saw with Lehman Bros, these reserves will really be enough to break the circuit to isolate a defaulting trader, and so keep the system liquid."

14 September 2018

 

 

 

 

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