Streetwise Professor

September 21, 2011

After Having Jumped the Fence, the Grass Doesn’t Look So Green All of a Sudden

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 11:23 am

I am in London for the ISDA Annual Europe Conference, where like in the NY version, I moderated a panel on clearing.  Yesterday’s panel was very informative and interactive, and made for some good copy.  As in NY, it was only possible to scratch the surface, but that in itself is revealing because it tells you just how many knotty issues are still unresolved.  Another thing that came through loud and clear was how interconnected these issues are.

The most entertaining debate centered around interoperability.  The looming fragmentation among CCPs has regulators around the world trying to mitigate the cost and risk increasing consequences of fragmentation by pushing for CCPs to interoperate.  The three major clearers represented on the panel–Michael Davie from LCH.Clearnet, Paul Swann from ICE Clear Europe, and Kim Taylor from CME Clearing–were all pretty negative on the idea, with Michael and Paul being adamantly opposed, and Kim only slightly more accepting of the idea.  Michael wins the quip of the day award for his characterization of the idea: “It’s crackers.”

Jurisdictional fragmentation was foreseeable months ago: I discussed the problem in some detail in my 2010 Cato and Journal of Applied Corporate Finance pieces, and again more recently in my ISDA study.  It is on the front page now, with the face-off between the UK and the ECB over the latter’s insistence that any clearer of Euro-denominated derivatives be domiciled in the Eurozone, with access to the European Central Bank.

There is some economic sense to the ECB’s position, but there is also economic sense to having global CCPs that can maximally exploit economies of scale and scope arising from netting and capital efficiency.  But this just illustrates the ill-thought out nature of clearing mandates.  Global banks can access central bank liquidity in a variety of currencies and net efficiently and collateralize efficiently across multiple currencies.  Forcing clearing eliminates some netting and capital efficiencies (but can potentially improve others), but creates thorny issues about access to central bank liquidity that makes global CCPs problematic.

The Canadians are now grappling with the very difficult tradeoff between efficiencies that come from global CCP scope, and the potential systemic fragility that could arise from concentrating so much risk in a single entity.  A Bank of Canada official, Tim Lane, warned:

In carrying out the G20 mandate requiring all OTC derivatives to be centrally cleared, it is essential to ensure that we do not unduly concentrate risk in a relatively small number of institutions that are direct clearing members of global CCPs,” he said.

These were the very institutions that spread and amplified contagion through the global financial system in 2008, Mr Lane told the annual Sibos settlement and payments conference.

Quite a puzzle, no?  Who could have possibly anticipated this?  (You don’t need to answer that.)

And the COO of the DTCC has warned about the difficulties and dangers of clearing CDS.

“We may be creating a much higher level of risk,’’ he said, by requiring swaps to be turned into standardized products, traded on electronic exchanges and where risks are covered by a central counterparty, backing up the two sides of a trade.

He noted, for instance, that a central counterparty failed during the Asian financial crisis of the ‘90s.

Again, who knew?  Again: no need to answer.

Lawrence Sweet, a senior VP at FRBNY replied:

Risk management procedures must be strong and the new systems “sufficiently robust” to guard against failure of central counterparties or firms involved in the trades.

And, he said, those swap contracts that are too complicated or risky to be put into centrally cleared, electronic markets should not be. The question is “how much can we put in there in a safe way,’’ he said.

And the answer is?!?!  [Crickets.]  Stating a set of desiderata without providing a reasonable strategy for getting there is gratuitous, at best, and reminiscent of the Steve Martin “How to Make a Million Dollars Without Paying Taxes” routine.

Why stop now?  From the FT, Jeremy Grant’s article from yesterday (2 SWP bonus quotes) is summarized by the FIA’s news brief as follows: “Complications arise as regulators detail clearing rules.”   I am so shocked that I am speechless.

Witness what the Sorcerer’s Apprentices have wrought.  Perhaps to some clearing mandates sounded like a good idea at the time, but it’s pretty evident that those very same some hadn’t fully thought through the issue.  Everybody is now dealing with the implications of the mandates on the fly, and are learning that the “solution” is just another package of problems.  Gazing across the fence from OTC World into Clearing Land, the grass in the latter seemed so, so much greener.  Now, having jumped, the jumpers are finding plenty of weeds, and plenty of nettles.

Print Friendly, PDF & Email


  1. We are aghast at the ruling of the European Court of Human Rights that Our rebellious servant Vladimir’s persecution of Our junior partner Mikhail was not politically motivated, but that Yukos had made fraudulent use of domestic tax havens to evade taxation. The real crime is that We are subject to taxes in the first place! Putin’s pocket pundits will now have a ready reply when Our fearless journalists write that Our dear
    Mikhail and Our rebellious servant Vladimir should trade places!

    All is NOT well!

    Comment by a — September 21, 2011 @ 5:34 pm

  2. Pleasing as it would be, European Court on Human Rights made no such ruling. While not being able to prove that persecution of Khodorkovsky was politically motivated (which is a rather distant thing from proving it was not), the court has condemned Our loyal servant on numerous violations of Khodorkovsky’s rights. A clear and unabashed opposition by the court to Our rule, We must admin.

    Comment by Ivan — September 21, 2011 @ 11:31 pm

  3. admin -> admit

    Comment by Ivan — September 21, 2011 @ 11:32 pm

  4. Trivialities. What We were interested in was the $98 billion payday, which prospect is now sadly remote.

    Comment by a — September 22, 2011 @ 3:43 am

  5. The most entertaining debate centered around interoperability.

    Not a sentence you hear every day. 🙂

    Comment by Tim Newman — September 22, 2011 @ 11:33 pm

  6. Hi Professor,

    Your link to Edward Lucas’ site is broken. His blog site has moved.

    The correct link is

    Comment by Green as Grass — September 23, 2011 @ 2:11 am

  7. I’ll fix, Green.

    Tim–yeah, I have strange ideas of what constitutes “entertaining.”

    The ProfessorComment by The Professor — September 23, 2011 @ 11:01 am

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress