The mouse-cat-dog-elephant-mouse dialectic is starting to dawn on a select few, especially in Europe. Jeremy Grant of the FT reports that the new head of the London Stock Exchange, Xavier Rolet, has issued a pretty clear warning:
Clearing houses in Europe should be regulated by central banks to guard against the risk of a catastrophic failure by one of them, the London Stock Exchange’schief executive said.
His comments come amid growing concerns that the insistence by policymakers that more financial instruments – such as over-the-counter derivatives – should be processed through clearing houses could overwhelm a clearer and spark a new crisis. [Emphasis added.]
In honor of the new Holmes movie just released on Christmas: no sh*t, Sherlock.
Some other “duh!” moments:
The Financial Services Authority, which regulates clearing houses in the UK, said last week: “The drive to have a significantly greater proportion of OTC derivatives markets centrally cleared will further increase the systemic importance of [clearing houses].”
Mr Rolet said it was possible that a clearing house could be overwhelmed if in the case of a default the clearing house members were unable to cover the margin calls that the clearer would make to cover the losses.
You mean that clearing doesn’t make the risk of default disappear, but just shifts it around in a different–and potentially worse–way? Next, they’ll tell us there’s no Santa Claus. I am so disillusioned.
Sarcasm aside (but never far away ), Rolet has clearly recognized the dialectic that the mandated expansion of clearinghouses will launch:
He said that clearing houses should have access to the funding provided by central banks through their discount window in the case of an emergency.
“This is not about fear-mongering, but where a clearing house has a substantial amount of ‘binary risk’ products that require a potentially huge collateral [margin] call which the [members of the clearing house] are not able to supply then the question is: who funds it?” said Mr Rolet.
“It seems sensible to us that the central banks should have at least a funding relationship to clearing houses.”
He said Europe needed a “harmonised, integrated clearing industry with standardised regulation” and “lending arrangements” with central banks.
In other words, world governments are responding to fears that interconnected financial institutions are too big to fail and will inevitably receive central bank or treasury or central bank + treasury bailouts by creating new interconnected financial institutions that are too big to fail and providing them with a guarantee of central bank support.
The inherent logical disconnect here is as stark as the old line from Vietnam: “We had to burn the village to save it.” The only difference is that the Vietnam line was almost certainly apocryphal (the figment of Peter Arnett’s imagination), whereas what is happening in financial markets is all too real.
This is an improvement? It’s always advisable to start thinking about living with the mice before bringing on the elephants. If we are serious about attacking too big to fail, rather than creating institutions that concentrate risk and establishing new implicit and explicit commitments to support them in a crisis we should be doing the exact opposite. Xavier Rolet is doing a great service by pointing out the logical implications of force-feeding central countperparties. The question is, whether anybody–especially in the US, and particularly in the US Congress (yeah, that means you, Barney & Chris, living, breathing weapons of financial mass destruction)–is paying attention. Or even cares.