"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."
"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."
