Streetwise Professor

In what will hopefully be the continuation of a spirited and thoughtful exchange of views on OTC derivatives markets, John Parsons and Antonio Mello at Betting the Business respond to my response to their response to my post on Gensler’s beliefs about the efficacy of central counterparties.  Or something like that.

We agree on some key issues, namely, (a) the amount of margin is not the measure of the total amount of credit firms use up when moving from bilateral to cleared trades, and (b) systemic risk is the crucial issue when evaluating the effects of clearing mandates.

I think we also disagree on some issues.

Netting, for one.  MP state:

The reliance on bilateral arrangements meant that exposures that offset one another at the system level were not offset. Individual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures. A major objective of the reform is to encourage the canceling of offsetting exposures and reducing systemic risk by substituting standardized instruments and clearing, among other things, where possible.

As I’ve written repeatedly before, multilateral netting primarily effects priority; netting effectively places derivatives counterparties in front of other creditors in the event that a firm goes bankrupt.  The systemic consequences of this are ambiguous: yes, derivatives counterparties may be systemically important, but other creditors may be too, meaning that it is not obvious whether this reordering of priorities improves stability.

Insofar as the other claims are concerned, I am somewhat puzzled by the statement that “[i]ndividual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures.”  With respect to bilateral offsetting exposures, presumably market makers relied on set-offs in bankruptcy.  With respect to multilateral exposures, market participants internalized any improvements in capital efficiency from netting (or compression).  They also internalized any benefits that resulted from lower risk of replacing defaulted positions with counterparty A that were offset by non-defaulted trades with B, C, D, etc.  Crucially, they recognized that capturing some netting efficiencies multilaterally could undermine some bilateral netting for deals that could not be compressed or cleared because of the nature of these contracts or their liquidity; they internalized these various netting efficiencies.  They internalized the benefits of customization.  They would have internalized the transfer of wealth arising from the shift in priorities inherent in multilateral netting.  Thus, they could trade-off these various effects and internalize the resulting costs and benefits.  Maybe some costs and benefits were not internalized, so it is literally true that the incentives were not sufficient to lead to a completely efficient outcome, but I don’t consider insufficient netting to be the first order problem.  Indeed, to the extent that netting transfers wealth, there can be too much netting.

I’d also note, as was recognized when the CBT was considering whether to adopt clearing in the early-20th century, that by improving the efficiency of capital utilization (by freeing up credit committed to offsetting positions with different counterparties), netting can also lead to increases in the size of net positions and net risk exposures. (This was also an objection to clearing that was raised vociferously in the aftermath of Black Friday in 1869.)  This can increase systemic risks.

MP also criticize the opacity of OTC markets, and suggest that clearing would make things more transparent:

It lacked transparency. Neither the end-users nor the public authorities had adequate information about the market. This lack of information has handicapped end-users in getting good prices. The lack of transparency has hampered competition. The lack of transparency promoted unsound accounting. Opacity perverted incentives. It distorted compensations. We could go on… It also handicapped the authorities in supervising the marketplace. A major objective of the reform is creating transparency, which will then make it possible to improve the functioning of the market.

Transparency is used in different ways here.  It is used to refer to price transparency and position transparency.  There is another type of transparency–counterparty transparency–that MP don’t discuss but which is relevant to the issues they raise.

With respect to position transparency, this is a bad argument in favor of clearing.  It is possible to achieve such transparency via reporting to repositories without the problematic risk sharing and risk pricing aspects of central clearing.  Indeed, a single trade repository is required because (a) there will be multiple clearinghouses, and (b) some products will not be cleared.  If it’s position visibility that you want (especially to regulators), that should be achieved via reporting to a single repository, not by having multiple CCPs.

With respect to price transparency, I think that MP overstate the lack of competition and price information, especially for the more liquid products that are likely to be traded most actively on SEFs.  Most end users I’ve heard discuss the subject state that they have been able to get good price quotes from multiple dealers.  ISDA recently ran an experiment which found that spreads for liquid products are extremely tight–in the .5bp-1bp range.  Moreover, with respect to many standardized OTC products, end users can compare the bids and offers they get to the prices of exchange traded instruments (e.g., Eurodollar futures, crude oil futures) to determine the quality of a dealer’s quotes.  End users also have the ability to utilize those products–to the extent they don’t, that means that the bundle of services provided by the dealer is more valuable to end users than the different bundle available on exchanges.

Moreover, as I’ve written before, trading in a non-anonymous way by soliciting quotes from dealers can actually be cheaper for end users than trading in an anonymous exchange or exchange-like (i.e., SEF) environment with pre-trade transparency.  The verifiably uninformed are typically going to get better prices in non-anonymous settings than in anonymous ones, where spreads are widened and depths reduced in order to protect quoters against being picked off by the informed.

All of this is not to say that OTC bilateral markets were perfect.  Too big to fail provided perverse incentives.  Uncoordinated replacement and hedging of defaulted positions exacerbates price moves.  But clearing presents its own difficulties, so just inventorying the defects of bilateral markets is not sufficient to prove the superiority of clearing.  You have the Churchill democracy issue: something can be the worst thing ever, except for all alternatives that have been tried from time to time.  Moreover, I don’t consider the defects that MP identify to be nearly as problematic as they do.

Thus, it still comes down to a comparative analysis which must make comparisons along numerous dimensions; some of these comparisons may cut one way (e.g., favoring centralized clearing), others may cut the opposite way (favoring bilateral mechanisms).  Moreover, when discussing policy it is important to recognize that clearing bundles many services–risk pricing, risk sharing, netting/compression, default risk management, position reporting–that may be better provided separately.

I still think that a crucial issue that relates to one of my areas of agreement with MP–that firms subject to a clearing mandate will substitute one form of credit for another–deserves further analysis.  I hope that they respond more fully to my analysis of the implications of the degree of substitutibility of different forms of credit.  In my view, that will have very important implications for the effects of clearing mandates.