Streetwise Professor

The House financial regulation “reform” bill passed last year includes the Lynch Amendment, which puts limits on the ownership of central counterparties/clearinghouses by financial intermediaries.  I blogged about this a bit.  The essence of my argument was that although there are potentially competitive concerns arising from dealer control of CCPs, there must be an alignment between economic interest and ownership structure.  Whoever bears the default risk is going to demand an influence over the governance of the CCP.  If you expect the big banks to bear the risk, they are going to require some control over the operations of the clearinghouse.  If you deny them this control, you have to find somebody else to bear the risk.  Competitive concerns are best addressed through anti-trust tools.

Sad to say, the “thinking” behind the Lynch Amendment has jumped the Atlantic, and the European Parliament is contemplating a similar restriction on dealer ownership:

Derivatives dealers should not be allowed to own stakes in central counterparties (CCPs) or their risk management systems – and CCPs should not be allowed to compete with each other, according to advice from the European Parliament’s committee on economic and monetary affairs (Econ).

The (anonymous) reactions of a European banker are spot on, and echo my earlier analysis:

“It’s ludicrous. Clearing houses were mutual organisations. They were originally mutually-owned and their job is to mutualise risk, so to say that users shouldn’t have any influence or ownership of governance or direction – it just betrays complete ignorance of what the function of a clearing house is and how a clearing house can be built and become operational,” says one head of market structure at a European bank.

. . . .

“It is our money in the default fund of the clearing house. For dealers to have some kind of oversight or some kind of say in the functioning of the clearing house is entirely reasonable. We’re not going to support a clearing house if we’re not satisfied with the risk management processes it operates. To think that the smart way to make this all happen is to remove the big dealers from the process is just dumb,” says the head of market structure.

“Complete ignorance.”  “Just dumb.”  That’s about right.

There’s a very simple choice here.  If you don’t want banks to exercise control over a clearinghouse, don’t look to them to bear the default risk.  If you want them to bear the default risk, you’ll have to give them considerable influence, and arguably de facto control.  And if you choose the first alternative, you need to answer: who is going to bear the default risk, and what price are they going to charge to do so?  And if you’re worried about competition, you should worry that the price this non-bank-owned CCP is going to charge, because it will almost certainly have market power.

The Lynch Amendment and its proposed European cousin both reflect a fundamental misunderstanding of just what clearing is about.  It is a risk allocation mechanism.  Which immediately should raise the question: who is going to bear the risk?  Clearing is not a risk fairy that makes risk disappear.  Those that bear the risk will almost certainly demand an active role in the organization that measures and manages it.  So if you make a governance and ownership choice, you’ve ruled out some risk allocation choices.  Our Solons, and Europe, apparently haven’t figured that out; they haven’t provided any idea on whom they expect to bear the risk, and are mandating or threatening to mandate models that have seldom, if ever, been tried in practice.  Which is very scary.