Russell Clark is the former chief investment officer of Horseman Capital, and now the author of the Capital Flows and Asset Markets newsletter, where a version of the below initially ran. We’re a sucker for a good clearinghouse rant, so we asked him if we could cross-publish it here.
I personally do not think LDI investing and pension funds are to blame for the recent gilt market turbulence.
In a world where Japan still has negative interest rates, do you really think there are not funds available to buy 30-year gilts at 5 per cent yield? Or even domestic UK institutions that would be happy to look in sizeable capital gains?
No, the answer lies in chronic risk mismanagement at the LCH. LCH is the largest interest rate derivative clearinghouse in the world. It dominates European interest rate derivatives and has a sizeable position in US markets as well.
So how did LSE-owned LCH ruin the bond market? Just a quick recap. Prior to around 2011 or so most interest rate derivatives were traded bank to bank. But regulatory reform forced banks to push all trades through a clearinghouse.
As more and more trades became centrally cleared, LCH became aware of more and more circular trades. That is Bank A might have a trade with bank B, and Bank B would have an identical trade with Bank C, and Bank C had an identical trade with Bank A.
LCH would then call up the banks and basically say “hey guys, you don’t need these trades anymore, we can just cancel them and return the risk capital we held against the trades to you”. This is a great idea in principle, and the banks and regulators all engaged in this. These trades are called compression trades, and LCH was happy to report that it has grown this business from $200tn to near $900tn in 2019.
This compares to a notional outstanding of $400tn. Note that the actual gilt market is only $1.5tn, so you can see how derivatives can dominate the real cash market here.
If you talk to LCH or hedge funds or traders, they all love compression. It simplifies the market and frees up capital and initial margin. But if you step back and have a think about it, you can see where the problem comes from.
When a pension fund or a hedge fund agrees to a compression trade, is that fund actually reducing the bets it has on the market? Are they actually reducing the capital at risk of their position? No, they are not. But they are reducing the amount of capital in the system.
So if risk is not being reduced, but the amount of capital in the system is being reduced, is the system becoming more or less stable? Of course it is the latter. These are simple questions that somehow regulators forgot to ask.
The first problem with clearinghouses is that they basically removed risk capital from the system. The second problem is that clearinghouse only price risk based on past performance, and with no reference to value.
Most clearinghouse price risk on a 7-10 year look back. Which means that the risk (or capital that traders need to trade gilts) coming into 2022 would be quite low, as the gilt yield had fallen in a slow and predictable manner for the past decade.
So why does the Bank of England have to buy gilts? Because clearinghouses, being brain-dead, idiotic machines, now simply look at the price history of gilts and say: “These are no longer safe assets — everyone needs to place huge margin to trade these things” When in reality, at close to a 5 per cent yield they are probably near to being correctly priced.
That is clearinghouses are now physically stopping the financial system from buying bonds. Of all the post-financial crisis reforms, placing clearinghouses at the centre of the global financial system has to be the dumbest. End Rant.
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