Streetwise Professor

November 7, 2009

Cassandra Gets Some Company

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 10:30 am

I welcome Gillian Tett’s recognition that clearing is not the silver bullet–or the “magic wand”–that will make financial crises a thing of the past.  This bit is particularly spot on:

What is notable about the reform debate this year, is that there has been remarkably little public discussion among politicians – or among regulators – about how to guarantee that any future clearing house will be strong enough to withstand future shocks.

In part, that silence may reflect a lack of imagination. Politicians and regulators have never seen a situation where a clearing house has collapsed; leaving aside one small exception in the commodities world a few decades ago [not quite right: the Hong Kong Clearing Association failed in 1987, and the CME and CBT clearinghouses were under extreme stress too], that has never happened before. However, I suspect the silence may also reflect delicate political sensibilities. If politicians were to demand that a clearing house should be so utterly rock solid that it could withstand financial Armageddon, the future members of any clearing platform would have to make massive financial commitments. That would necessarily limit membership to a small cabal of ultra-powerful banks – not something that most politicians wish to encourage.

However, if a clearing house is made more accessible to a wider pool of members, then it will only have credibility if it is backstopped by the government itself to ensure that trades are always settled. Most politicians are not keen to highlight that option either, given the wider sense of public anger about the degree to which the government is bailing out the financial world.

Tett is in fact too kind about the lack of public discussion.  Politicians–most of whom, truth be told, couldn’t explain to you how clearing actually works, and probably hadn’t even heard of it a year ago–have seized on the clearinghouse as a cure all.  There has been virtually no serious discussion of the economics of clearing, or the economic implications of clearing mandates.  Much of the discussion has been notably distorted and misleading; Timothy Geithner and Gary Gensler have been particular guilty of this.  Nobody has answered (and arguably, nobody has seriously asked) why clearing has not been adopted heretofore, and why non-cleared products have grown relative to cleared ones, if clearing is so great.  (And no, I don’t count the superficial “it will cut the banks profits” argument.)  Instead, clearing is a deus ex machina, invoked to resolve all the thorny issues involved in financial market structure.

Tett’s statement that memberships in clearinghouses lacking a government guarantee would limited to a “cabal of ultra-powerful banks” illustrates the inanity of much of the debate.  We need clearing to permit big banks to share counterparty risk because big banks are too interconnected.  Huh?

The alternative she poses–government guarantees of clearing–is truly scary.  We need to find ways of weaning the system off the government guarantees that currently exist, and which are the main source of moral hazard-induced systemic risk, rather than look to find new things to guarantee.

Tett is sympathetic to clearing, as is indicated her invocation of the lack of the failure of a major clearinghouse.  This is a weak argument, however, because the market structure–and crucially, the choice of clearing vs. bilateral arrangements–is endogenous.  Clearing has been adopted where conditions favor it.  The fact that it has worked in these areas does not imply it will work equally well with other products and other participants.  Indeed, it is quite possible that mandating clearing for products/participants for which it is not well adapted (as indicated by the failure to adopt it voluntarily) will make things worse, rather than better.

Tett’s concluding paragraph makes an important point:

One lesson that financial history shows is that the issues which blow up the financial system are not usually those which caused the last crisis; instead, the biggest threats tend to come from the areas swathed in a lazy consensus, or where there is a strong political impetus to clutch at easy solutions. That might yet apply to the clearing houses. In theory, I still believe that clearing houses could – and should – make the derivatives world safer. In practice, though, they could end up creating new dangers if they are not put on a sound footing – particularly if the fact that no clearing house has ever failed before creates a false sense of security.

We need a serious examination of the costs and benefits of alternative market structures.  Sadly, this has been completely absent.  Instead, we have had superficiality masking as deep analysis; cheerleading instead of critical appraisal.  This will not end well, because, as Tett notes, such superficiality leads to the false sense of security that lays the groundwork for the next crisis.

I have been a Cassandra on this issue for some time now.  It’s good to have some company, even if Gillian Tett still has too rosy a view of clearing for my taste.  But the fact that at least somebody is questioning the conventional wisdom is encouraging.

A couple of other clearing stories that deserve mention.  First, incredibly, Barney Frank has endorsed NJ Rep. Stephen Lynch’s amendment to regulate clearinghouse ownership structures:

Mr. Frank said he hopes in part to address potential conflicts of interest at clearinghouses with a provision pushed by Rep. Stephen Lynch (D., Mass.) that would limit big banks’ controlling stake in clearinghouses to 20%. That provision was included in the bill, but hit a procedural hurdle recently and had to be removed.

“We are encountering resistance to that on the part of many, including my colleagues in the House Agriculture Committee,” Mr. Frank said of the Lynch provision. “As I believe it is important to reduce the stake in the clearinghouses of these firms…I continue to support Congressman Lynch’s amendment.”

WTF was I thinking when I said something nice about this dangerous, dangerous man?  The man who, more than any other, is responsible for the Fannie and Freddie fiasco (the costs of which make the expense of AIG pale in comparison).

Second, and an excellent counterpoint to the Lynch-Frank effort to micromanage the ownership of clearinghouses, LCH.Clearnet has completed a restructuring that gives large banks more control:

The clearer said on Friday that with the redemption finalised, large users now owned 63 per cent of the business, up from 37 per cent. LCH.Clearnet defined large users as those which contributed more than 1 per cent towards group clearing fees and which together represented, in aggregate, more than 80 per cent of the group’s clearing revenues.

LCH.Clearnet is now owned 83 per cent by users of its services and 17 per cent by  NYSE Euronext and the London Metal Exchange.

Sixty-five shareholders, including Euroclear Bank, a unit of Euroclear, the settlement services group, have had their shareholdings either redeemed or “significantly reduced”.

The total number of LCH.Clearnet shareholders is now 105, down from an earlier 120.

Most of LCH.Clearnet’s “large” users are also members of the bank consortium – codenamed “Lily” – that abandoned its takeover attempt last month, largely because the LCH.Clearnet scheme largely satisfied its demands for greater control of the clearer.

The consortium had wanted control of LCH.Clearnet largely for its SwapClear interest rate swaps clearing business, turning the clearer for the London Stock Exchange, Euronext and the London Metal Exchange into more of a clearer of OTC derivatives.

Interesting, isn’t it, how market participants with experience and skin in the game are doing the exact opposite of what politicians who don’t want them to do?  This should at least raise questions as to why market participants favor a mutualized structure with a rough equivalence between risk exposure and control.  Could it be because this offers serious efficiency advantages?  But no, all we get from financial sophisticates like Frank and Lynch is superficial bleating about “conflict of interest.”

Reading all this makes this quote from Hayek (which serendipitously Russ Roberts reminded me of yesterday) all the more apropos:

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

When it comes to politicians and regulators, Hayek’s phrase should be amended to say:

The curious task of economics is to demonstrate to politicians and regulators how very, very little they really know about what they imagine they can design.

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