Streetwise Professor

September 25, 2010

Clearing Up a (Minor) Disagreement

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:05 pm

Jeff Carter at Points and Figures wrote a nice post on my Cato clearing piece, for which I am appreciative. He is pretty much in agreement with me that mandates are a bad idea.  He is concerned with the command-and-control mindset inherent in Frank-n-Dodd, and supports the development of voluntary “Coasean” approaches.  Hear, hear.

Jeff does take issue with my characterization of the way that CCPs work today:

That meant that if you blew up, and caused major losses you could not afford, the rest of the clearinghouse members would have to pony up cash to cover the loss. If the loss were big enough to blow through all the cash that all the members had, the clearing house would go bankrupt. There hasn’t been a bankrupt clearing operation in the modern day, since 1900, history of trading that I know of.

Exchange clearinghouses are no longer mutually held, and have not been since the last major exchange went public in 2003. Instead, the clearing house takes out an insurance policy to cover potential problems. It also has lines of credit with several different bankers. This simple fact doesn’t change our agreement that government mandated clearing is a poor solution, but it does change the calculus of analysis a little.

I take issue with his taking issue.  Yes, exchanges are demutualized, but counterparty risk is still mutualized.  Take the CME, for instance.  This CME document, in the sections labeled “Default by a Clearing Member” and “Summary of Resources Backing Clearing” beginning on p. 11 demonstrates that the losses of default are borne by other clearing members.  First the CME dips into the guarantee fund–which the clearing members fund.  Then the CME can assess the clearing members.  (The CME also commits up to $100 million of its own capital.)  The assessments are limited to 275 percent of each CM’s original contribution.  The total from the CME contribution, the guarantee fund, and the assessment comes to about $7.5 billion.  The costs of default by a clearing member are thus shared among–mutualized by–other clearing members.

Jeff mentions insurance, but there is no third party insurance that pays in the event of a default at the major exchanges.  (There is no mention of insurance in the CME document.)

Jeff also mentions credit lines, and indeed CCPs have lines with major banks.  In the aftermath of Black Monday, 1987, exchange CCPs realized that they needed a more reliable source of liquidity.  On Black Monday, major banks (the clearing banks) balked at funding big CM margin calls; this is where Fed pressure and liquidity injection was important.  To avoid this problem going forward, the CCPs obtained lines of credit that they could call on to obtain liquidity, just as Jeff says.

It is important to note that these credit lines are just that.  If a CCP draws on the line, it–or more accurately, its members–still owes the bank the money.  The lending bank incurs a loss attributable to a CM default only if the CCP itself becomes insolvent.  That is, the credit line is a source of liquidity: it is not in the first instance a means of sharing the default risk with the bank.  Only if the CCP becomes insolvent do the lending banks suffer any default losses.

The CME document linked above makes that clear.  It calls the credit lines a “Temporary Liquidity Facility.”  It’s a source of liquidity to be used in extremis: it’s not a form of insurance.

There’s an irony, here, of course, and one that gives the lie to many of the claims in support of clearing.  Clearing mandate advocates, notably Gensler, talk about clearing reducing financial interconnectedness, and reducing the potential for contagion.  But clearing in times of stress demands ready access to liquidity.  This inevitably requires a connection between the clearing and banking systems.  It can’t be avoided.  If a clearinghouse runs into a big problem, and draws the credit line, it is possible that the CCP will not be able to pay it back.  In the event, the CCP problem would become a banking problem, and the lending banks would bear some of the default loss.  (Of course, to the extent that banks are clearing members, they will bear default losses too.)

The credit lines also expose the CCPs to bank credit.  If the bank extending the line is itself in financial difficulty, which may well be the case during the kind of crisis that would necessitate the CCP to call on its line, the clearinghouse may not actually obtain the needed liquidity.  So the contagion can work both ways.  From the CCP to the bank, or the bank to the CCP.

Again, the point is that clearing changes the topology of the network of connections among financial institutions: it doesn’t eliminate these interconnections.  One way or another, derivatives default losses are ultimately borne by major financial institutions, clearing or no.  No two ways about it.

May 14, 2010

You Mean That Clearinghouses Aren’t Magic Boxes That Make Credit Risk Disappear?

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 3:30 pm

S&P has put LCH.Clearnet on a credit watch for a potential downgrade.  The rating agency did so in response to NYSE Euronext’s decision to set up its own clearing operations, rather than use LCH’s.

This is a very useful reminder that CCPs do not make counterparty risk disappear, as certain people are wont to assert.  (You know who they are.)

But there is another important lesson here.  Nobody knows exactly how the market is going to evolve after the imposition of clearing mandates.  In particular, the structure that will evolve for the clearing business is subject to huge uncertainty.  As the NYSE-Euronext decision illustrates, and as the ICE decision to clear for itself before that,  and as did the decision of the SWX to clear for itself before that, clearing structure is a strategic choice for exchanges.  I wrote about this aspect of clearing ad nauseum before the financial crisis.  At the same time, there are strong scope economies to clearing across multiple instruments.   The push of strategic incentives to vertically integrate and the pull of incentives to exploit scope economies by using multi-exchange platforms like LCH make it very difficult to predict what the configuration of the market will look like.  This, in turn, makes it virtually impossible to understand what the systemic risks will be, and what measures will be necessary to mitigate the systemic risks inherent in clearing.

These systemic risks will depend on the topology of the clearing networks, and this topology will be determined by a complex interaction of incentives to integrate and dis-integrate.  Moreover, the topology is unlikely to be static, as the factors driving the costs/benefits of integration and disintegration will not be static either.  Thus, the interconnections in the system will be quite fluid, and as the financial crisis and the flash crash demonstrate, these interconnections can be the sources of systemic risk, if not understood and managed properly.  Force feeding clearing will only heighten the salience of these interconnections.  It will be a challenge to understand, let alone to manage, this system as would be necessary to realize the happy predictions of those who look on clearing as the cure.

Are the regulators ready for this?  Do the legislators who are enamored with clearing understand this?

April 21, 2010

Will Somebody Please Call Bullshit on Gensler?

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:24 pm

So I don’t have to?  Because it’s getting tiresome.

But it has to be done, so here goes.

Jeremiah’s latest gurgling appears on the oped page of today’s WSJ.  It starts with a non-sequitur, and careens downhill from there.  Gensler tells a story about his role in the LTCM situation, and then claims that to prevent a recurrence, or a repeat of AIG, it is necessary to reduce the “cancerous interconnections” (Jeremiah Recycled Bad Metaphor Alert!) in the financial system by, you guessed it, mandatory clearing.

Look.  This is very basic.  Do I have to repeat it?  CLEARING DOES NOT ELIMINATE INTERCONNECTIONS AMONG FINANCIAL INSTITUTIONS.  At most, it reconfigures the topology of the network of interconnections.  Anyone who argues otherwise is not competent to weigh in on the subject, let alone to have regulatory responsibility over a vastly expanded clearing system.  At most you can argue that the interconnections in a cleared system are better in some ways than the interconnections in the current OTC structure.  But Gensler doesn’t do that.   He just makes unsupported assertion after unsupported assertion.

If you have any doubts about how interconnected a clearing system is with the banks, just look in detail at what happened on 19-20 October, 1987.

Don’t believe me?  Then consider what Ben Bernanke wrote as an academic in his “Clearing and Settlement During the Crash” (3 Rev. Financial Stud. 1990 at 133):

A prominent part of the institutional structure is the interconnection of the clearing and settlement systems with the banking system.  This interconnection exists at several points.  First, banks are operationally a part of the clearing process. Clearinghouses typically maintain accounts at a number of “clearing banks. Member FCMs are required to maintain an account at a minimum of one of these banks and to authorize the bank to make debits or credits to the account in accord with the clearinghouse’s instructions. This facilitates the settling of accounts and the making of margin calls. Note that the bank’s role may exceed simple accounting if, for example, it must decide whether to permit an overdraft on an FCM’s account.

Second, banks are a major source of credit, especially very short-term credit, to all of the parties, including the customers, the FCMs, and the clearinghouse itself. As was noted above, bank letters of credit can in some cases be used as initial margin. Customers and FCMs often rely on bank credit to facilitate the speedy posting of variation margin, and FCMs would typically have to turn to banks to finance payments made necessary by customers’ defaults or slow payment. In equity markets, banks are often the ultimate source of credit for the purchase of securities on credit.

Finally, it should be noted that while, in the conventional language, most margin postings and settlement payments are made in “cash,” these transactions are, of course, not really made in cash but by the transfer of bank deposits. Thus, the smooth operation of the financial market clearing and settlement system is based at all times on the presumption that the banking system is sound and can satisfy demands for withdrawals of funds.

“A prominent part of the institutional structure is the interconnection of the clearing and settlement systems with the banking system.”  Does it get any clearer?  (No pun intended.)

Ben, would you please drop the “Gentle Ben” demeanor and slap some sense into Gensler?  You actually know something about the subject.  You’re a former educator.  And somebody needs some educatin’.

And consider the implications of a dramatic increase in the scope of the clearing system, including the clearing of many products with unique tail/jump to default risks that have not been cleared before, on the magnitude of the interdependence between the clearing system and the banking and payment systems.  The potential for operational and financial gridlock in the face of a substantial price shock will be greatly amplified if clearing is greatly expanded.

Bernanke goes on to argue that the systemic centrality of the clearing system means that it is highly desirable for the Fed to serve as the “insurer of last resort” to prevent the failure of a clearinghouse or clearinghouses.  So much for Gensler’s assertion that clearing would “greatly reduce . . . the need for future bailouts.”

This is very serious business.  Very serious.  It deserves serious consideration of the real implications of the effects of a vast expansion of clearing.  That consideration must be predicated on an understanding of the real interconnections inherent in a clearing system, not on unsupported and unsupportable denials of the existence of such interconnections.

If the basis for the policies Gensler advocates, and which Congress seems hell-bent on implementing, is a belief that clearing does not entail an intricate web of interconnections (and potentially fragile interconnections) among financial firms, then they are policies built on lies.  And all that a policy based on lies will do is sow the seeds for the next crisis.

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