Streetwise Professor

Tyler Cowen wrote a post about my Cato clearing piece, for which I am grateful.  Tyler was tepid in his appraisal: and I am tepid of my appraisal of his appraisal.

On a minor point, he says I say “not necessarily” too often.  Well, I am primarily responding to arguments that say or assume things to be necessary when they are not.  Moreover, even when things are not necessarily true, they may be true, and it would be overstatement to say otherwise.  I tried to be precise in my evaluations, and neither overstate nor understate the case.

More substantively, Tyler makes the two arguments that are least likely to persuade me: arguendo ad AIG, and “look, the CME did just fine during the crisis.”  Regarding the former, I think that (a) Tyler is guilty of hindsight bias, assuming that CCPs would have seen AIG’s positions to be exceptionally risky when nobody else did; (b) this is a red herring, as AIG positions would never have been cleared; and (c) the AIG case is far more complicated, as I argued extensively on SWP many moons ago.  With regard to the latter: (a) things at CME were dicier that he lets on, something else I’ve written about, and (b) this argument is fraught with selection bias, as CME cleared the stuff that was easiest to be cleared.  Even Tyler admits that clearing CDS with their jump to default risk would be very difficult; this is true of other instruments currently traded OTC too.

My biggest objection is that Tyler really doesn’t come to grips with any of the substantive arguments in the paper, including inter alia those relating to: (a) the question of how a putatively and seriously inefficient market structure could not just survive  but thrive and grow relative to the putatively more efficient alternative; (b) the information regarding default risk and the incentives of CCPs vis a vis dealers; (c) relatedly, moral hazard and adverse selection issues; (d) the differences in costs that hedgers will bear due to cash management costs, etc., (e) the potential loss of netting economies in clearing due to fragmentation; (f) relatedly, the possibility that the industry will evolve inefficiently due to the effects of strong scope and scale economies, jurisdictional issues, and the use of clearing for strategic purposes by exchanges; (g) the ability of affected firms to alter their financial contracting (capital structures) to undo most if not all of the leverage-reducing that is purportedly one of the benefits of CCPs and more restrictive collateralization; and (h) most importantly, the potential for systemic risk arising from CCPs.  I could go on, but these are the biggies.

Tyler does, in a way, address (h), but unpersuasively, IMO.  For instance, he says: “it seems to me that clearinghouses would have had a strong profit incentive to monitor or limit the kind of risk-taking which led to the A.I.G. debacle.”  Even overlooking the AIG reference, this is problematic.  There are two cases.

The first is that CCPs are mutual organizations or effectively mutual organizations, dominated by large financial intermediaries.  In that case, the CCPs would effectively inherit the incentives of these intermediaries, which Tyler apparently thinks are inadequate to induce them to police risks efficiently.  In addition, there would be all the problems associated with moral hazard, cooperative governance, and agency problems associated with multiple principals.  (Ironically, Tyler effectively concedes this point in one of his older posts that he links to where he expresses reservations about ICE Trust.)

The second case is that CCPs are for profit firms, collecting fees, potentially in competition with one another, and taking on tail risk.  Indeed, the entire business of a CCP is taking on tail risk.  But we know that pricing that risk is hard, and that moreover, shareholder incentives often lead financial institutions to underprice that risk, or to take on too much of it (which amounts to the same thing).

So Tyler, in effect, is reduced to arguing that CCPs are easier to regulate: “The key point is that a clearinghouse can more easily be forced to carry heavy capitalization and said capitalization, unlike with a current bank, cannot so easily be undone by off-balance sheet transactions or hidden leverage.  The clearinghouse has different incentives and is much easier to regulate and therefore we should put some more trust in them.”

Somehow, putting more trust in regulators is hardly calculated to build confidence.  The point that CCPs are likely to have simpler capital structures that make it harder to take on hidden leverage is a good one, but in many respects the portfolio of risks a CCP takes on is very complicated and difficult for a regulator to appraise properly.  Again, it is all tail risk, and in a mandated environment, said risk will involve more complicated, less liquid, more difficult to evaluate instruments, and crucially, will also depend on the balance sheet risks posed by the firms it clears.  These firms can take on hidden leverage, off-balance sheet transactions, etc., so regulators have to look through the CCP back to the same institutions that allegedly are the problem in the incumbent structure.

Furthermore, as I argue above, CCP incentives are far more problematic than Tyler lets on.  Moreover, CCPs, whether for-profit firms or mutuals, have the incentive to influence regulators in the same way banks do.  Putting all this together, I don’t think it is quite as easy as Tyler does to determine the right level of CCP capital or to monitor its operations.

I’ve written many times that I do not know for sure what the optimal organization of counterparty risk allocation and pricing mechanisms is.  Nobody does.  I have often emphasized that I intend to raise issues and arguments that are grounded in good economics but which have gone unraised and unanswered in the conventional paeans to clearing.  If advocates of clearing have a good case, they could meet these arguments head on, which they have not done so far.

After reading Tyler’s piece, I have to say that most of the substantive arguments I’ve raised still remain unengaged.  So skeptical I remain.  I appreciate Tyler’s taking the time to take my piece seriously, and am encouraged that he recognizes the need for a comparative approach., but would respectfully suggest that he should take a harder look at the real problems that CCPs must confront.  I think if he does that, he’ll have more concerns about clearing mandates than he has expressed heretofore.