Is the legislation currently working its way through Congress. According to The Hill, Harry Reid wants the Lincoln derivatives bill incorporated into the Dodd legislation (replacing the “place-holder” derivatives title of the Dodd bill). Great.
There are many bad features in the Lincoln bill. Arguably the worst (though the competition is stiff!) is the proscription on any “Federal assistance”, including Fed lending, to financial institutions that trade derivatives, including clearinghouses. Especially when combined with the mandated expansion of clearing, this is extremely dangerous.
Clearinghouses can blow up. It has happened historically, and it almost happened with disastrous effects during the ’87 crash. Arguably the only thing that prevented that from happening was the intervention of the Fed. I strongly suggest that Lincoln, or her staff, read the Brady report on the Crash to get some understanding of that. Or better yet, read Bernanke’s “Clearing and Settlement During the Crash” (3 Rev. Financial Stud. 1990 at 133). A few telling excerpts:
Let us put aside the possibility of government intervention for the moment. Then there seems to be a potential structural problem with the clearinghouse arrangement. The problem is not that some traders who thought they had a guaranteed contract would end up not being paid off; as we have said, perfect insurance against systemwide shocks is not possible. Rather, the problem is that a shock large enough to exhaust the clearinghouse’s capital and assessment powers would have a serious prospective effect on the ability of the clearinghouse and thus of the futures market itself to function. Presumably, over a period of time reorganization and recapitalization would occur. But in the shorter run the poor functioning or shutdown of the futures market might exacerbate the adverse conditions that precipitated the problem in the first place.
That is, the potential for failure of a clearinghouse–just the potential–can lead to a positive feedback mechanism that worsens the crisis.
Bernanke discusses the essential role of the Fed on 19-20 October:
The malfunctioning of the banking side of the clearing and settlements systems during this period is indisputable. [Emphasis added.]
. . . .
The official reports and other observers generally agree that the Federal Reserve’s attempts to alleviate the crisis were very constructive. On Tuesday morning, October 20, the Fed issued a brief statement: “The Federal Reserve, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the financial and economic system.” This statement was backed up by three types of actions: First, the Fed reversed its tight monetary stance of the previous weeks and flooded the system with liquidity. Second, the Fed “persuaded” the banks, particularly the big New York banks, to lend freely, promising whatever support was necessary. (The 10 largest New York banks nearly doubled their lending to securities firms during the week of October 19.) Finally, the Fed monitored the situation and took some direct actions where necessary, notably in the case of First Options of Chicago. When that large clearing firm was in danger of defaulting, Fed Chairman Greenspan acted quickly to enable its parent firm, Continental Illinois, to inject funds into its subsidiary; according to some observers, this action may have helped avoid the closing of the options exchange.
. . . .
In retrospect we may ask, what really were the dangers to the integrity of the financial markets posed by the crash? And what were
the benefits of the Federal Reserve’s actions? The technological problems of communications and information availability that plagued the system, while serious, did not in and of themselves threaten to bring down the markets. For the most part, information availability was a critical issue during the crash only in the sense that illiquidity is essentially a problem of imperfect information. (Clearly, though, improvements in these technologies should be made.)
It was the financial problems-the possibility of insolvency by major players-that were potentially the more serious. As we have emphasized, financial problems impaired the market’s functioning in at least two ways. First, concerns about solvency impeded the operation of the payments and clearing systems, contributing to financial “gridlock.” Second, the fear that major brokers, FCMs, or clearinghouses might default created uncertainty about the contract performance guarantee. Both aspects reduced market liquidity and disrupted trading. Conceivably these problems could have forced a market shutdown.
In response to this situation, the Federal Reserve, in its lender-of- last-resort capacity, performed an important protective function. The Fed’s key action was to induce the banks (by suasion and by the supply of liquidity) to make loans, on customary terms, despite chaotic conditions and the possibility of severe adverse selection of borrowers. In expectation, making these loans must have been a money-losing strategy from the point of view of the banks (and the Fed); otherwise, Fed persuasion would not have been needed. But lending was a good strategy for the preservation of the system as a whole.
The principal effect of the loans was to transfer some trader default risk from the clearinghouses and their members to money-center
banks. Under the presumption that the money-center banks were well capitalized, and that in any event their solvency would be guaranteed by the government, this transfer of risk reduced the overall hreat of insolvencies in the system. This allowed the payments process to begin to normalize; it also restored confidence in the clear- inghouse’s guarantee of futures contract performance. The resulting stabilization of the markets served the interest of the banks and the Fed in a wider sense, by avoiding any potential costs that a market breakdown might have imposed on the banking system and the general economy.
In performing its lender-of-last-resort function, the Fed redistributed risks in the system in a socially beneficial way. Conceptually, it
is as if the Fed had provided ex post insurance to the clearinghouse against a shock that it seemed possible would exhaust the insurance capability of the clearinghouse itself. Thus the Fed became the “insurer of last resort.”
What, pray tell, would have happened absent the Fed supplying liquidity to the system? A disaster.
Note that Bernanke’s analysis recognizes that a clearinghouse’s financial resources are limited. Would it that those flogging the clearinghouse cure would recognize this, and grapple with its implications in a serious way (as Bernanke did), rather than ignoring this brute fact as they do routinely: no, reflexively.
A dramatic expansion of clearing will increase, in a commensurately dramatic way, the potential for operational and financial failures in the clearing and payment system (like those observed in ’87) during a large price move. Any policy of mandates MUST acknowledge this, and make sure that mechanisms are in place to address this reality. By cutting out derivatives, and clearinghouses, from the lender of last resort mechanism, but providing no replacement, the Lincoln bill is courting financial Armageddon.
(Perhaps the Fed would be able to intervene indirectly, by supporting banks and inducing them to support the clearinghouses financially, but constraining the means by which the Fed can supply liquidity to the clearing system increases the likelihood of a failure.)
Bernanke argued in his 1990 article that the Fed has a role in ensuring the integrated banking, clearing, and settlement systems can survive a shock like a stock market crash. (Again–it is integrated: interconnected.) Although the Lincoln bill attempts to hive off the derivatives markets from the broader financial system, this is an impossibility. No, it is worse: it is an absurdity. The banking and derivatives trading systems are inextricably linked. Policy must be predicated on that fact.
Maybe the Fed is a flawed institution, but it’s the institution we have. If Lincoln gets her way, and constrains the ability of the Fed to perform its LOLR function in support of a vastly expanded clearing system, without providing any alternative, she is indeed “reforming” derivatives markets in the worst way.