Starting with my earliest post-crisis writings on clearing, I have pointed out repeatedly that the supposed virtues of clearing–netting and greater collateralization–look far different when you examine the nexus of financial contracts as a whole, rather than focusing on derivatives alone. A primary effect of netting and greater collateralization is to increase the seniority of derivatives in bankruptcy. But if you increase the seniority of one claim, the seniority of other claims is reduced. Sure, you can make derivatives more secure, but at a cost of making other claims less secure.
The systemic implications of this are ambiguous. The implicit presumption seems to be that derivatives are somehow uniquely threatening to the stability of the financial system. I say “implicit” because the clearing pom-pom squad has never discussed explicitly the distributive aspects of reshuffling priority via regulation, so I don’t even know if they are even aware of it.
But it is not hard to imagine scenarios in which giving derivatives even greater advantages in bankruptcy (due to safe-harbor provisions they already have a lot) can cause a systemic problem, but through another channel. For instance, derivatives counterparties of a firm teetering on the brink of failure may rest easy given their priority status, especially if the CCP is considered safe. But other claimants may not be so serene. For instance, consider money market mutual funds that invest in the paper of the dodgy firm. Realizing that they will be totally hammered in bankruptcy, the investors in the money market fund may run. That would not be pretty.
It’s even more complicated than that, because given the new seniority rules, there is likely to be widespread alterations in capital structures of derivatives market participants, and repricing of those claims. Who knows how that is going to play out, and what new fragilities will be baked into the new structures?
This point is finally dawning on people. One person who caught on long ago is Harvard’s Mark Roe. Today, he published an oped that makes the point clearly and forcefully. It is definitely worth a read.
Equally problematic is the fact that, while the clearinghouse and its participants can net wins and losses to reduce risk for those inside the clearinghouse, the clearinghouse does not assuredly eliminate the basic risk facing the entire financial system. Often, it merely transfers that risk to creditors outside the clearinghouse.
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Whether the clearinghouse reduces systemic risk depends on the relative systemic importance of those inside and those outside the clearinghouse – AIG versus Citibank in this basic example – not on the clearinghouse’s capacity to reduce risk among its members. In this example, if Citibank is precarious and is as systemically vital as AIG, the clearinghouse has obscured that it has saved AIG only by transferring risk from the clearinghouse to Citibank, which then fails.
Much recent regulatory activity has focused on enabling, enhancing, and requiring clearinghouses for these kinds of financing arrangements. Yes, clearinghouses offer many benefits, including greater transparency, better pricing, and better regulatory focus, and we should try to make them viable. But regulators world have overestimated their overall benefit. Too much of what is justified as reducing systemic risk is really just offloading risk onto others.
Reading Mark’s piece brought to mind Bernanke’s quoting of Puddin’ Head Wilson in his discussion of CCPs. Bernanke said if you are going to put all your eggs in one basket, keep a very close eye on that basket.
One of my problems with the whole CCP debate is that too often the tendency is to treat derivatives as the only eggs that matter. But if you pay attention only to the basket with the derivatives eggs, you will not pay attention to other ones that are as valuable, or moreso.
To change metaphors, target fixation all too often leads one to miss the bogey that just jumped your six, with fatal results. The obsessive focus on derivatives, and clearing, is a form of target fixation. It risks diverting attention from other potentially mortal dangers. You need to have a system-wide perspective to truly understand systemic risk.
Mark is generally negative on giving derivatives any priority. He has written things very critical of safe harbors. He and I have discussed this, and have agreed to disagree: I can see reasons for differentiating the treatment of derivatives from other claims. But the important point is to understand that this is an issue, and one that has to be examined from a system-wide perspective, because seniority rules shift risk around.
Mark gets that, and makes serious arguments about what the right rules should be. Unfortunately, all too many of those who make the decisions and the rules don’t appear to get it.