The Cost of Collateral Management in a New CCP Environment

by Craig Pirrong
Feb 1, 2012 Share this! LinkedIn logo Facebook logo Twitter logo Reddit logo Google+ logo

Prof Craig Pirrong offers his take on the biggest concerns for cost and collateral management in 2012 and as the push to central clearing progresses. Comments based on “The Cost of Clearing” podcast in November 2011.

There is going to be tremendous pressure in 2012 to try to find ways to economise margin management. The biggest change with collateral management and central clearing is that firms that previously have not been required to post margin are going to be required to do so. And if they are trading in a variety of instruments that are cleared through multiple clearing houses, substantial sums of capital will be tied up in margin.

All the potential ways in which firms will try to economise margin management will require a lot of coordination among central counterparties (CCPs) including cross margining across different clearing houses. This means if a firm has risk positions that are off-setting or hedging one another but are housed in different clearing houses, it can it take advantage of that through some sort of cross-margining arrangement to reduce the amount of margin to reflect the amount of overall risk that it brings into the system as opposed to the risk associated with the individual legs of the transactions.

Interoperability is also a potential way of economising margin at the CCP level but I think that is likely to be a non-starter because of the reluctance of CCPs to accept risk from other CCPs. 

The cost of margin management will also be affected both directly and indirectly by how that margin is held. Segregation is a collateral issue that is also going to be brought back to the fore after the MF Global problems of late 2011 and it will be a very important issue going forward.

There will also be tremendous demand for liquidity in order to meet the increased collateral and margining needs. Questions around what kind of assets will be usable as collateral and what sort of services big financial intermediaries will offer their customers to try to transform non-CCP eligible assets into eligible collateral for posting to the CCPs still need to be answered. Also, I think CCPs are going to be under tremendous pressure to expand the set of assets that they are willing to take as collateral and that raises all sorts of risk issues.

In short, as we start pulling on this collateral management string, all the issues and risks that arise from this move to central clearing and the initial margin requirements will reveal themselves. This year many of these issues will come to the fore for the industry at large.


Image of Craig Pirrong

"Streetwise Professor" is the web persona of me, who happens to be Craig Pirrong.* My day job (to the extent that I have a real job) is as Professor of Finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston. I have been in academia since 1989–shortly before the Ferruzzi soybean squeeze on the Chicago Board of Trade in July of that year, which was quite propitious and which had a big impact on the trajectory of my career. I have a PhD in Business Economics from the Graduate School of Business at the University of Chicago.

Looking at my cv one might have a hard time identifying a common thread, but it is there. My formal training is as an industrial organization economist, but I took the PhD finance sequence at Chicago. My thesis was on an application of core theory, completed under the tutelage of a great economist, Lester Telser. I think core theory is an extremely valuable tool, but the profession is not quite so enthusiastic. During my first academic job in the Business Economics Group at the Michigan Business School, recognizing that core theory was not my road to academic success, I was casting around for a new research direction, and Ferruzzi provided it. Through a series of serendipitous events, I had the opportunity to work on a project evaluating how to re-design the Chicago Board of Trade Markets to reduce the likelihood of a repeat of the events of July, 1989. This led to many academic spinoffs.

Specifically, the Ferruzzi episode and my work on the CBT project made me aware of many interesting points of contact between finance and IO, and much of my research has explored that nexus. I’ve written a good deal on manipulation in financial markets–manipulation is a manifestation of market power, which is a core concept in IO. Since exchanges have some legal responsibility to prevent and deter manipulation in financial markets, I became interested in the incentives that exchanges face in carrying out such tasks. This in turn required an analysis of the organization of governance of exchanges–another IO-related subject. Moreover, it soon became clear that the incentives of exchanges to adopt efficiency enhancing measures also depends on the nature of competition between them, the analysis of which resulted in several articles on the “macrostructure”–the industrial organization– of financial markets.

Along the way, the study of commodity markets like soybeans or oil which have been manipulated from time to time sparked an interest in commodity price formation and commodity price dynamics, and their implications for derivatives pricing. My most active research in this area focuses on electricity prices and electricity derivatives, but I am also working on models applicable to storable commodities.

My academic work has also allowed me to serve as an expert in legal cases involving commodities and derivatives.

Outside of academia and litigation consulting my time is spent primarily with my family–my wife Terry, and my daughters Renee and Genevieve. I have a deep interest in history–particularly the history of the US Civil War–that dates back to my childhood, and that I continue to pursue through reading and travel; I would have become a historian if I had been independently wealthy. I am also a big Chicago sports fan, although I have to say that the Cubs’ persistent ineptitude is slowly draining me of my interest in baseball, and the Bulls–oy. The Blackhawks–double oy. The Bears, you say? Well, we’ll see if they’re for real or not soon.

* The original version of this page didn’t include my name. Never really thought about it. I wrote it in haste late one night in January, 2006, and didn’t really look at it after it was originally posted. I didn’t intend for this to be an anonymous blog, and I certainly gave enough biographical and photographic evidence to let anyone interested figure out who I am. Indeed, many people figured it out, and I also gave out the blog name to a lot of folks. I’ve edited this bio page to include my name because a reporter who has interviewed me from time to time in the past came across it, and thought that the blogger sounded familiar, but wasn’t sure it was me. So, now there’s no possibility for confusion.