Last month, I wrote about bond-market illiquidity — the problem that it’s incredibly difficult to buy and sell bonds in any kind of volume, especially if they’re not Treasuries. That’s a big issue — but it turns out there’s an even bigger issue hiding in the same vicinity.

The problem is that there’s only a certain amount of liquidity to go around — and under Dodd-Frank rules, a huge proportion of that liquidity has to be available to exchanges and clearinghouses, the hubs which sit in the middle of the derivatives market and act as an insulating buffer, making sure that the failure of one entity doesn’t cascade through the entire system.

Craig Pirrong has a good overview of what’s going on, and I’m glad to say that Thomson Reuters is leading the charge in terms of reporting about all this: see, for instance, recent pieces by Karen Brettell, Christopher Whittall, and Helen Bartholomew. The problem is that it’s not an easy subject to understand, and most of the coverage of the issue tends to assume a lot of background knowledge. So, let me try to (over)simplify a little.

During the financial crisis, everybody became familiar with the idea that a bank could be “too interconnected to fail”. The problem arises from the way that derivatives tend to accumulate: if you have a certain position with a certain counterparty, and you want to unwind that position, then you can try to negotiate with your original counterparty — but they might not be particularly inclined to give you the best price. So instead you enter into an offsetting position with a different counterparty. You now have two derivatives positions, rather than one. The profits on one should offset any losses on the other — but your counterparty risk has doubled. As a result, total counterparty risk only ever goes up, and when a bank like Lehman Brothers fails, the entire financial system gets put at risk.

There are two solutions to this problem. One is bilateral netting — a system whereby banks look at the various contracts they have outstanding with each of their counterparties, and simply tear them up where they offset each other. That can be quite effective, especially in credit derivatives. The second solution is to force banks to move more of their derivatives business to centralized exchanges. If there’s a single central counterparty who faces everyone, then the problem of ever-growing derivatives books goes away naturally.

Of course, if everybody faces a central counterparty, then it’s of paramount importance to ensure that the clearinghouse in question will itself never fail. Naturally, the clearinghouse doesn’t own any positions, but on top of that it has to be able to cope with its own counterparties failing. Typically, the way it does that — and we saw this during MF Global’s collapse — is to demand ever-increasing amounts of collateral whenever there’s a sign of trouble.

Such demands have two effects of their own. The first, and most important, effect is that they really do protect the central clearinghouse from going bust. But the secondary effect is that they increase the amount of stress everywhere else in the system. (MF Global might have ended up going bust anyway, but all those extra collateral demands certainly served to accelerate its downfall.) Pirrong calls this “the levee effect”:

Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a central counterparty (CCP) can redistribute shocks elsewhere in the system in a highly destabilizing way. CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects. Indeed, greater reliance on CCPs increases the tightness of the coupling of the financial system, which can be highly problematic under stressed conditions.

Essentially, when markets start getting stressed, liquidity and collateral will start flowing in very large quantities from banks to clearinghouses. Indeed, to be on the safe side, central clearinghouses are likely to demand very large amounts of collateral — as much as $5 trillion, according to some estimates — even during relatively benign market conditions. That is good for the clearinghouses, and bad for the banks. And while it’s important that the clearinghouses don’t go bust, it’s equally important that the banks don’t all end up forced into a massive liquidity crunch as a result of the clearinghouses’ attempts at self-preservation.

The banks, of course, will look after themselves first — especially as the new Basel III liquidity requirements start to bite. If they need to retain a lot of liquid assets for themselves, and they also need to ship a lot of liquid assets over to clearinghouses, then there won’t be anything left for their clients. Historically, when clients have needed to post collateral, they’ve been able to get it from the banks. But under Basel III, the banks are likely to be unable or unwilling to provide that collateral.

So where will clients turn? These are truly enormous businesses which might need to be replaced: Barclays has cleared some $26.5 trillion of client trades, while JP Morgan sees an extra half a billion dollars a year in revenue from clearing and collateral management.

Just as in the bond markets, one option is that the clients — the buy-side investors — will turn to each other for collateral, instead of always turning to intermediary banks. That’s already beginning to happen: some 10% to 15% of collateral trades already involve non-banking counterparties. But it’s still very unclear how far this trend can be pushed:

While corporates and buysiders might be comfortable sharing confidential information with their banking counterparties, shifting to a customer-to-customer model is a big step. “The problem is that buyside firms have to open up their credit credentials to each other to get a credit line in place. I always felt that was an impediment to customer-to-customer business, but the combined impact of new rules changed that,” said Osborne.

Osborne, here, is Newedge’s Angela Osborne; her job is to start replacing banks in the collateral-management business. Once you adjust for Osborne talking her own book, it’s clear that there’s still a very long way to go before the banks will realistically be able to step back from this market.

After all, it’s not as though the banks’ buy-side clients themselves have unlimited amounts of collateral which they can happily post at a moment’s notice. It’s true that they aren’t as leveraged as the banks are. But they themselves have investors, who can generally ask for their money back at any time — normally, when doing so is most inconvenient for the fund in question. If they tie up assets posting collateral for themselves or others, that makes it much harder for them to meet potential redemption requests.

All of which means that as we move to a system of central clearinghouses, a new systemic risk is emerging: “fire sale risk” is the term of art. If a market becomes stressed, and the clearinghouses raise their margin requirements, then the consequences can be huge. In the bond market, the death spiral is all too well known: a sovereign starts looking risky, the margin on its bonds is hiked, which in turn triggers a sell-off in that country’s bonds, which makes them seem even riskier, which triggers another margin hike, and so on. This can happen in any asset class, but derivatives are in many ways the most dangerous, just because they’re inherently leveraged, and the amount of leverage that the clearinghouses allow can be changed at a moment’s notice.

Do the world’s macroprudential regulators have a clear plan to stop this from happening? Do they have any plan to resolve the inherent tension involved in demanding that banks retain large amounts of ready liquidity, even as they also allow clearinghouses to demand unlimited amounts of liquidity from the very same banks? The answers to those questions are — at least for the time being — very unclear. But the risk is very real, and it makes sense that regulators should do something to try to mitigate it.