Henry Ford once said, the only real mistake is the one from which we learn nothing. Ten years ago this September, the global economy was brought to its knees by the dramatic collapse of Lehman Brothers, as frantic investors sought to unwind their exposures. In a DerivSource Q&A, we spoke with Christian Lee and Stephen Loosley of Catalyst, the specialist consultancy,about their experiences dealing with the fallout of Lehman’s demise at LCH Clearnet, and the lessons learned—or not learned—from the global financial crisis that followed. Listen to related podcast.
Q: Where were you during the Lehman Brother’s default, and what role did you play in that process?
Christian Lee: Ten years ago, I was working at LCH Clearnet as a risk manager responsible for overseeing the SwapClear business. Part of that involved being responsible for the design and implementation of the default management process, which had evolved and that had been practiced over the years as a theoretical exercise and was a big part of how SwapClear was designed.
Ten years ago, when concerns about the financial safety of Lehman Brothers came up over the summer, culminating in the default event over the weekend of September 13 and 14, my specific role was to lead the default management group that was responsible for the unwind of the interest rate swap (IRS) portfolio, which was the riskiest part of the Lehman’s portfolios that LCH Clearnet had on its book.
This portfolio was ring fenced from a lot of the other exposures, and my role in conjunction with Stephen and others, was to ensure that we handled the default of the swaps portfolio.
Stephen Loosley: As Christian said, the IRS book that Lehman left us with at LCH Clearnet was probably the biggest or riskiest product type. It was about 67,000 trades totaling about $9 trillion worth of notional, and we were winning or losing about $6-$7 million dollars per basis point. So that was the extent to which that book was sensitive to movements of rates.
Christian Lee: It was pretty unprecedented. At the time, SwapClear was the only clearing house clearing OTC swaps. The way that the default management process had been designed was quite unique. It was well designed, but theory can be very different to practice, so we were in uncharted territory to a large extent.
Q: In your view, looking back, what were the biggest fears for the industry at the time?
Christian Lee: Our biggest concern was the fact that the default management process for our product set in particular, relied on cooperation and collaboration with the marketplace. This was hardwired into the rules of LCH Clearnet. But having a set of rules and processes is one thing—having that cooperation and collaboration working in practice is quite another.
Our first concern was, would people from the default management group turn up? Without them, we wouldn’t have been able to execute the hedging trades that we needed to perform.
The second aspect was executing those hedge trades. Would we get prices from the marketplace? Would people understand this unique situation where we were trading as principal, as LCH Clearnet? Could we get good prices? And would that be sufficient to mitigate any market risk as a result of the fairly violent moves that were going on?
The third aspect was, would we be able to ultimately auction and sell these portfolios and preserve that margin? And would all the supporting infrastructure provide the necessary information and enable us to complete the process itself?
Stephen Loosely: For me, the biggest fear was that the process wouldn’t work. We had tested and tested this thing. We knew that the system worked, we knew that the governance worked, we knew that in theory, all the analytics worked and that the trading would work. But until you actually test it live, you don’t know what’s going to happen, you don’t know if the traders will show up or if the situation back in their own banks will be too important and take precedence.
Will they actually be able to make trades? Will there be market liquidity and are we going to be able to get the prices that we need or are we going to burn through the margin? Will there be the liquidity for an auction once we’ve packaged up this portfolio? Will we actually be able to dispose of it at any point and really close this out? You can test these things as much as you want theoretically, but nothing’s like live proving, that was my biggest fear.
Q: One of the direct results of the crisis was the G20 mandates of 2009, and from that, new regulation in the form of Dodd Frank and EMIR. These regulations aimed to strengthen the financial system. Do you think they have been successful in doing that?
Christian Lee: By and large, I think they have. The regulatory intent at the time, from policy makers and indeed from politicians themselves, was to avoid the situation where taxpayers’ money would be made available to support financial institutions. There was the desire to avoid the systemic consequences of one bank failing and taking another down, and there was the objective to ensure better regulation and better oversight from regulators.
There was the additional desire to ensure that there was suitable transparency on pricing, avoidance of esoteric and highly leveraged instruments, and finally, the requirement to ensure that retail investors would not be subsidizing investment bank activity. It was a very ambitious program that was put in place and 10 years on, we still haven’t completed the journey.
It hasn’t been perfect. There have been unintended consequences, but by and large, I do believe the regulatory intent has been met and the financial system is a lot safer, albeit carrying a lot more cost with that focus on adequately capitalized and regulated institutions.
Stephen Loosley: I think that’s a really interesting question, because if you look at the product types that a lot of this post-crisis regulation has been aimed at, they are not actually products that had anything to do with the underlying causes of the global financial crisis. So actually, you could really call this a regulatory success, because it’s a rare example of shutting the stable door before the horse bolts.
Q: Christian, you mentioned unintended consequences, is there a new risk to the market or to the industry that we have to deal with?
Christian Lee: Yes, there are new risks and some of them are very clear to all participants. We are now in a situation where the CCPs—certainly the international CCPs and clearing houses—are categorized as too big to fail. That has entailed additional work on what happens in the event of a CCP being in trouble using the recovery and resolution framework. This is still very much a work in progress, and we have essentially shifted the risks from one group of participants to another. But the CCPs remit is very different to investment banks chasing profit as they were 10 years ago.
On the unintended side of things, we do have a bit more concentration with the larger players. The clearing broker market, for example, is not as widely populated as would be desirable, which has consequences for the smaller and medium players.
It does mean that if you are a light user of derivatives, it’s sometimes questionable whether it’s worth having that activity at all. There is still some fine tuning to be done, some of the capital rules will need to be revised to make sure that the incentives are appropriately balanced.
To answer your question, yes, we do have a new set of risks, but most of them are out in the open and policy makers and others are working to try and ensure that there are at least mitigants in place.
Stephen Loosley: I think the regulation has introduced new risks. The concentration risk at CCPs is obvious these days, although I would say I don’t think it’s as big as people think it is. Multilateral netting actually means that the net amount of cleared risk is much smaller and easier to deal with than the gross amount of having all those trades in a bilateral web between all the original counterparties.
Having said that, I think it is obvious that there are some CCPs you might consider in the risk of being too big to fail, but then the regulation is dealing with its own consequences, with things like the recovery and resolution edicts and the importance of portability—how you move client portfolios, and how you move the portfolios of a defaulted CCP. I think regulation is doing pretty well in that respect.
Q: There has been some talk of possibly loosening some of the regulatory rules that have already been put in place, namely, under Dodd Frank from the U.S. regulators. Do you think that this is a possibility and a good idea?
Christian Lee: I can see that there is a case to be made to have exemptions in place for certain participants and users in markets. But I would be very wary of looking to roll back anything material from Dodd Frank. A huge amount of investment has been made to comply and implement it. I think the market has—reluctantly in some cases—fallen into line as far as making sure that it complies with the material aspects of Dodd Frank. I think it would be potentially a little dangerous to roll back anything material from that.
The other important point is to avoid regulatory arbitrage between different jurisdictions. There is the danger that if you loosen things in one area, then that level playing field doesn’t exist. And that could tilt the scales of risk in a potentially dangerous way by putting too much concentration in one area because of this regulatory arbitrage.
Stephen Loosley: To follow up on Christian’s point on regulatory arbitrage, the kind of regulations that they’re talking about rolling back in the U.S. at the moment in terms of the Made Available to Trade (MAT) regulations and the platform trading on SEFs, this is actually regulation that came out in the U.S. first. Europe is now catching up with the requirement to trade on platform, to be more transparent, to be more client-friendly with the likes of the regulations in MiFID II on OTFs and MTFs. So actually, if you were to roll back that regulation in the U.S., you’d be creating regulatory arbitrage now in the other direction.
Q: And finally looking ahead, is there a lesson the market has yet to learn? And what do you think the industry should continue to focus on going forward?
Christian Lee: I think there’s always a danger of the market having a too short-term memory. We have, fortunately or not, avoided a major crisis since Lehman’s happened 10 years ago. We had a few issues in Europe with sovereign concerns, but we seem to have got through those, and apart from that there hasn’t really been a major event.
My concern is that it’s very easy for complacency to return to the market. It was very fair weather in many people’s eyes 10 years ago or so, and it was that desire to chase profits, chase yields, neglecting the fundamentals of business and risk management, that we’ve seen repeated over the decades in one form or another. So, anything such as looking to roll back or relax, looking to create new products, get around or avoid regulation in itself, can store up issues and unforeseen risks.
The market learns from events and crises, so I do hope that the new managers and business heads are able to heed the lessons from history, and from Lehman’s in particular. Certainly in my long career, it was the biggest event—but not the only event. There were many other events, but that was the one where capitalism was on the brink, the whole basis of the banking system was on the brink, and they were unprecedented times in many, many ways.
Stephen Loosley: I think lessons have been learned, but in risk management, there’s this classic concept of disaster myopia, which means the more the last crisis recedes, the less focus you put on anticipating the next one.
It feels to me like because we focused on regulatory reporting primarily in all of the post-crisis regulation, we’ve perhaps not given the same weight or precedence to regulations that might really change how the banks behave and how they actually measure, price, attribute, aggregate and report up to their executives the real risks that they’re undertaking.
Only when we do that—when regulations like FRTB and the BCBS 239 rulesare finished and implemented—will we really start to see changes in behaviour, rather than just the changes in transparency that some of the bigger regulations like MiFID II have wrought.