Streetwise Professor

I like Jeremy Grant of the FT, and his colleague Gillian Tett is a media darling right now, flogging her book on the financial crisis.  But in their article on the Geithner derivatives proposals (along with Aline van Duyn), they laid an egg.  They repeat the conventional wisdom on clearing, and the supposed benefits of forcing OTC trading onto exchanges.  Actually, it would be more accurate to say that they repeat the conventional ignorance on the subject.

They say that on exchanges “[t]rades are then ‘cleared’ on a central platform, which completes a deal even if one counterparty collapses.”  Similarly, they say that in OTC markets, “[t]hat means in many cases there is no centralised system to monitor prices or deals nor any third party to ensure a trade is completed if a counterparty fails.”  These quotes suggest that counterparty risk does not exist in a cleared market like it does in an OTC market.  This is wrong, because the clearinghouse can fail.  More to the point, given the size of the position of a defaulting party, clearing only affects the allocation of losses, not their total amount.  Now, this allocation can be superior, but not necessarily so.  But I grind my teeth at the suggestion that clearing magically makes default risk disappear.  

This also has implications for systemic risk.  In a cleared market, the default risks are borne in the first instance by clearinghouse members, who are typically systemically important banks.  Clearing can actually concentrate and increase the counterparty risks that these systemically important banks bear.  This point is seldom made, but it is important.  Grant, Tett and van Duyn overlook it altogether.  

Most egregiously, they say this:

The proposals Mr Geithner, Ms Schapiro and others have unveiled try to tackle these problems in four ways. First, they demand all “standardised” derivatives are  centrally cleared to remove counterparty risk, even if they are not traded on an exchange.  [Emphasis added.]

No. No. No. NO!  Clearing DOES NOT REMOVE COUNTERPARTY RISK.  The three FT reporters should be sentenced to write that sentence over and over again on a blackboard, Bart Simpson-like, until they get their minds right.  Moreover, to atone for this, the FT should be required to devote an entire front page consisting entirely of “CLEARING DOES NOT REMOVE COUNTERPARTY RISK” in headline-sized type.  

Again.  Clearing redistributes the losses arising from counterparty default.  It does not remove it, or make it magically disappear.  What’s more, it does so in a way that can reduce efficiency, and increase systemic risks.  

Sheesh.  Grant et al state: “A public debate about derivatives is long overdue.”  I agree.  It would be nice if that debate would be based on a thorough, fact-based, understanding of the actual tradeoffs involved in clearing and exchange trading.  Instead, this article just recycles the same old bromides.  

The article does the service of quoting this gem by new SEC head Mary Shapiro (which I had wanted to call attention to when I saw it last week, but got distracted):

As Mary Schapiro, chair of the Securities and Exchange Commission, says: “OTC derivatives, particularly credit derivatives . . . contributed to the financial mess we are cleaning up today.”

Just how did they contribute?  Yes, like the Treasury letter, you can point to the OTC posterchild, AIG, but that would be incredibly dishonest (as it was when Treasury did it).  It is dishonest because the type of contracts AIG traded would never be cleared, and never traded on exchanges, and hence would be/have been unaffected by the Treasury proposal.  But although credit derivatives have been accused over and over again of contributing to the financial crisis, the type of products that would be affected by the Treasury proposal are conspicuous by their absence from any honest accounting of culpability for the crisis.  

This only goes to show that Mary Shapiro’s replacing of the execrable Chris Cox has not increased the intelligence or market knowledge at the SEC.  And that is a very scary thought.

I was quoted in today’s WSJ:

Companies could try to skirt the regulations by creating new contracts that are similar but not identical to clearable trades.

“People will see where the lines are…[and] devise products that fall outside the scope of this particular regulation and that particular regulation,” said Craig Pirrong, a finance professor at the University of Houston.

The Treasury Department says that clearinghouses need to ensure that “customized OTC derivatives are not used solely as a means to avoid” clearing.

Regarding the sentence following my quote.  As I noted in my post on the proposed Treasury regulations, the clearinghouses are not in a good position to monitor the use of non-cleared products, due to their lack of information, and perhaps more importantly, their conflict of interest in seeing more business come their way.  Although the WSJ article accurately characterizes the Treasury’s position, so much the worse for Treasury.  It suggests a serious failure to think things through.

If they decide to prevent the use of customization to circumvent the clearing requirement, as it almost certainly must if the clearing mandate is to survive, Treasury and Congress will require a regulator to enforce the circumvention ban.  This would require an incredibly intrusive regulator, evaluating the design of every contract, and the intent behind it.  I can state almost categorically that no regulator has or will have the information, expertise, or ESP required to do this.  Moreover, this will just throw us back into the days of pre-CFMA requirement that all “futures” be traded on exchanges.  Not a good thing.  This created regulatory uncertainty, legal ambiguity, and served to protect the interests of exchanges.  One can only imagine the Talmudic inquiries that would be involved in determining whether a particular derivative is, or should be cleared, or was designed to escape a clearing mandate.

Regulators–or clearinghouses serving as their agents–should not be in the position of intervening so intrusively in the contracting decisions of derivatives markets participants.  Such intrusion will raise transactions costs, and interfere with the efficient allocation of risk in the marketplace.  What’s more, there is no reason to believe that this interference will reduce systemic risk.  Indeed, it could well increase systemic risk.

News reports state that Geithner supports mandatory central clearing of OTC derivatives transactions.   His testimony is not quite so blunt, but could be interpreted that way:

Fourth, we should establish a comprehensive framework of oversight, protections and disclosure for the OTC derivatives market, moving the standardized parts of those markets to central clearinghouse, and encouraging further use of exchange-traded instruments.

I have argued against such a mandate here (“skinny” version), and here (“supersized” version).   Geithner is not specific about the organization of a clearinghouse, and in particular about the scope of products each would clear, but Darrell Duffie has argued that a specialized CDS clearinghouse would increase risk.   I’ve also laid out many of my arguments (that eventually showed up in the papers linked above) here on SWP–just type in “clearing” on the search bar if you’d like to find them.

Given the barrage of words I’ve already hurled at the subject, I’ll limit myself here to a bullet point list of the problematic issues:

• Risk pricing.   Dealers are likely to have better information about counterparty risks arising from the nature of the specific instruments, and especially from the balance sheet risks of counterparties.
• Netting is not necessarily a social benefit.   It redistributes wealth (in the event of a default) to clearinghouse members and from the other creditors of a defaulter, e.g., buyers of the defaulter’s commercial paper, its securities lending counterparties.   It is not immediately obvious that this allocation of counterparty risk is welfare improving.
• Clearing concentrates counterparty risk and redistributes it among the members.
• This concentration is especially problematic since derivatives counterparties have recourse to a dealer’s entire balance sheet in the event of a default.   In a CCP, recourse is limited to the capital of the CCP, plus any additional “good to the last drop” obligations of members to contribute additional capital in the event that the CCP funds are exhausted.   These funds appear small to the potential loss in the event of a major default.   As an example, CME clearinghouse can tap into $6 billion of capital if margins don’t cover a default loss.   (This includes CME stock deposited by clearinghouse members, valued at its current price too, which would likely fall in the event of a major default.)   The size of ICE Trust’s Guaranty Fund (the backstop monies that would be available in the event that margins don’t cover a defaulter’s obligations) is not publicly known (at least I have not been able to track down that number).   ICE has committed $10 million, with a commitment to raise it to $100 million.   I think members are obligated to kick in $20 million to the fund, but that could be scaled as position sizes increase.   I have not seen any indication that there will be “Maxwell House” (H/T Lucio) features in ICE Trust.   Anyways, we’re talking less than $1 billion here.
• CCPs have a more rigid, mechanical collateralization mechanism.   This could be a feature, but it could also be a major bug in times of systemic stress.   CCPs require posting of collateral in cash or close substitutes, sometimes intraday, and no later that the opening of business of the next day.   Dealers can be more flexible with collateralization, extending credit, or accepting a wider range of collateral.   Large market moves create large demands for cash in a CCP structure.   This can contribute to a liquidity crisis.   Note in October, 1987, many banks were unwilling to extend credit to fund margin calls.   Fed action alleviated a collapse of CME and CBT clearinghouses, but the margin induced demand for liquidity nearly led to a systemic collapse.   (Bernanke actually wrote a paper on this in the 1991 RFS).

I have seen no evidence that any of these points have been given serious vetting by the powers that be.

There’s an old joke that the Founding Fathers should have ended the Bill of Rights after the first five words of the First Amendment.   The lunacy surrounding derivatives regulation suggests that there is more than a little wisdom in that witticism.  

The House Ag Committee first mooted a proposal that would have limited the trading of credit default swaps to hedgers (only those long bonds could buy protection; only those short bonds could sell it).  That proposal met with snorts of derision and bellows of outrage from many quarters (including hereabouts, where I voiced both), so committee chair Peterson soon backtracked on that.  Then it was reported that the bill would permit the CFTC to summarily stop trading in CDS products.  As I was quoted in Bloomberg, that was an improvement, but it was still horrible.  So, channeling Maxwell Smart, Rep. Peterson said “Check that.  Would you believe that what I really meant was that CFTC could stop trading in CDS by those without positions in the underlying security only on companies that were subject to an SEC short sale ban.”  

Given that the SEC short sale ban was arguably one of the most idiotic public policy moves of recent memory (and the competition is very stiff in that category, sports fans), House Ag’s new position appears to be that the CFTC has the authority to imitate the moronic moves of a thoroughly discredited agency.  Great.

The bill’s future is extremely uncertain.  You might think that’s good news, but the reason for its tenuousness just gives rise to other concerns.  Barney Frank is moving to get control of the bill shifted to his committee.  Yes, the Barney Frank who should not be allowed within several galaxies of any responsibility for regulation of anything related to the financial system.  The Barney Frank who, if he had a scintilla of shame (I know, I know), would have retired to a hermitage in the aftermath of Freddie and Fannie.  One can only imagine the mischief and mayhem he can create given control over derivatives market regulation.

Congress shall pass no law.  Sounds good to me.  But it will.  And, as the old saying goes, no man’s life, liberty, or property are safe while the Legislature is in session.  That mordant remark was never truer than today.

I have always held Congress in low regard, but never so low as now.  Capitol Hill has become a veritable vortex of stupidity.  

Exhibit 1: The laughably mis-characterized “stimulus” bill, which will do nothing of the sort.  If a private business engaged in such blatant false advertising, the FTC would shut it down tomorrow.  This bill is nothing more than a Trojan Horse stuffed with every political boondoggle conceived over the last decade.

Exhibit 2: “A draft bill circulated in Congress that would change how over-the-counter derivatives are regulated might ban most trading in the $29 trillion credit-default swap market.”  The bill forces central clearing of CDSs.  As I’ve argued ad nauseum, this is a bad idea.  But that’s not the worst of it:

House of Representatives Agriculture Committee Chairman  Collin Peterson  of Minnesota unveiled an updated draft bill today that would prohibit credit-default swap trading unless investors owned the underlying bonds. The draft, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the$684 trillion  over-the-counter derivatives market to be processed by a clearinghouse.

This requirement that CDS traders “own the underlying bonds” would prevent the credit derivatives market from performing its vital risk transfer function.  Note to Congress, and to Rep. Peterson: Hedgers (who own the bonds) want to reduce their exposure to that risk.  They do so by buying protection FROM SOMEBODY THAT DOESN”T OWN THE BOND.  That is, the bond owner can’t hedge unless he can buy protection, almost always from somebody who doesn’t own the bond.  The CDS market effectively transfers risk from the current bondholder to a speculator.  This is a transaction between consenting adults that presumably makes both of them better off-or else they wouldn’t do the deal.   Put differently, if you want to permit bond holders to reduce their exposure to the risk of that bond’s default, you need to let somebody else increase that exposure.  

But this is apparently lost on Rep. Peterson, and the bill’s supporters.  They have apparently internalized the view that hedging is good but that speculation is bad.  But you can’t have hedging without speculation.  

This is especially true in the corporate debt market.  In commodities, you have natural long exposures (e.g., oil producers) and natural short exposures (e.g., airlines) who can hedge by trading with one another.  Speculators are necessary only to the extent that the hedging demands of the natural longs and natural shorts don’t match completely.  In corporate bonds, there is a lot of natural long exposure looking to hedge, but not a significant natural short exposure.  Hence, speculators–market participants willing to absorb exposure to default risk–are especially important.  

Some reporting I’ve seen about the bill talks about how its supporters denigrate “naked shorting” via the CDS market.  Sheesh, just when I’m glad to see Christopher Cox’s taillights fade to black, here are legislators parroting his moronic moralizing about perfectly legitimate–and essential–actions.  

Peterson is (as I recall) a former insurance commissioner in Minnesota.  Perhaps he would understand this analogy: his bill makes as much sense as one that would allow only firms that own high rise buildings to insure high rise buildings.  

This measure is exactly NOT what is needed in the market right now.  If anything, our shaky banking system needs better, more robust mechanisms to manage credit risks.  It definitely does not need the decapitation of the existing mechanism for managing these risks, as imperfect as that mechanism may be.  

I actually wonder why the bill even bothers to mandate creation of a clearinghouse.  The provision I’ve just discussed means that there won’t be any trades to clear.  So what’s the point of creating a clearinghouse?  

Who knows whether this absurd provision will actually become law.  Of course it will be distressing–and very costly to the market and to the economy–if it does.  But even if it doesn’t, it is bad enough that such a clearly idiotic proposal, predicated in a complete and willful misunderstanding of the role of derivatives markets, has made it this far.  It is a testament to a truly frightening combination of ignorance and arrogance that is rife in Congress.    So convinced of their own rectitude, and their own ability to control complex markets, they meddle ceaselessly in what they do not understand.  They are modern day sorcerer’s apprentices, who wreak havoc in the vain belief that they are doing good.  

I say again: I hope Bismarck was right when he said there is a special providence for fools, drunkards, small children, and the United States of America, for we have fools and drunkards (on power) governing America, and imposing crushing burdens on small children–and the children of today’s small children.

The WSJ published an editorial expressing deep skepticism of regulators’ rush to force the creation of a CDS clearinghouse. The editorial’s argument incorporates many elements I’ve raised repeatedly on SWP (and since I know several folks at the Journal read SWP, perhaps the blog contributed to their thinking.) Most importantly, the piece emphasizes the potential for balance sheet risk and moral hazard inherent in the central clearing structure:

[T]he Fed-imposed architecture should still cause taxpayer concern. That’s because it takes the widely dispersed risk in the CDS marketplace and attempts to centralize it in one institution. If not structured correctly, it may reward the participating firms with the weakest balance sheets. For this reason, some of the dealers who have resisted a central counterparty because it threatens their profits may now embrace it as a way to socialize their risks.

. . . .

Here’s how the New York Fed’s central counterparty would change the market: Right now, CDS trades are conducted over-the-counter as private contracts between two parties. They are reported to the Trade Information Warehouse, so the market has some transparency, but nobody is on the hook besides the two parties to the agreement. This provides an incentive for each party to make an informed judgment on whether the counterparty can be relied upon to pay debts. The buyer of credit protection — who is paying annual premiums for the right to be compensated if a company defaults on its bonds — has every reason to study the balance sheet of the seller of a CDS contract. [The superior ability and incentive of bilateral counterparties to evaluate creditworthiness is the essence of my argument about the virtues of bilateral markets.]

. . . .

[T]his system also introduces new risks, because all participants become liable for the potential failure of the weakest members. How does one appropriately judge the credit risk of a participant? ICE Trust and the Fed haven’t released details. Sources tell us that participants will need to have a net worth of at least $1 billion, and, more ominously, that the Fed wants a high rating from a major credit-ratings agency as a crucial test of financial health.

$1 billion net worth? That’s a real screamer. Just what was Lehman’s net worth before it went bust? AIG’s? So . . . $1 billion is supposed to provide some sort of comfort? And, given that balance sheets are notoriously opaque (especially now, when it is impossible to determine market values for large swaths of the assets of big banks and investment banks who would be members of the clearinghouse) relying merely on balance sheet information to assess creditworthiness is extremely dangerous. Extremely. Just because there’s $1 billion on the books doesn’t mean you can take that billion to the bank.

The editorial’s main original contribution is to highlight the FRBNY’s anointing of the big three rating agencies (S&P, Moody’s, & Fitch) to provide validation of the creditworthiness of clearinghouse participants. (It isn’t clear whether this means that CCP members have to achieve a certain credit rating, or the customers they clear for.)

As the Journal says, these guys are always the last to know. All too often they serve the same function as the crime scene unit guy who draws the chalk line around the corpse on the sidewalk. Or, to put it differently, they’re coroners rather than diagnostic physicians. When it comes to evaluating counterparty risk, however, autopsies aren’t all that useful.

Moreover, the rating agencies have no real skin in the game. Sure, they might take a reputational hit if they miss the impending implosion of a credit, but that hardly compares to suffering a major loss when a counterparty defaults. And hell, if the FRBNY is forcing the rating agencies on the ICE clearinghouse even in the aftermath of their abject failure over the past couple of years, even the reputational penalty doesn’t seem that great. If anything, it seems that incompetence is being rewarded, rather than punished. A party to an OTC trade has a much stronger incentive–and almost certainly, better information–to evaluate counterparty risk than the three ratings stooges.

The editorial also raises the excellent point that it is almost inevitable that the Fed would inevitably bail out the clearinghouse if it failed. Indeed, that implication inheres in the Fed’s rationale for the clearinghouse, namely, to reduce systemic risk. The Fed and other regulators argue that OTC market participants are so interconnected that a major failure poses a risk of contagion. But, wait a minute–a central counterparty connects these very same market participants, so it could also be the source of contagion, rather than a force preventing it. It is by no means clear that a central counterparty structure is less susceptible to contagion. Indeed, for reasons I’ve set out in a (tediously long) academic paper, it could actually be more susceptible. That, plus the inevitable too big to fail aspect, means that a CCP could create additional moral hazard. Great.

It is somewhat encouraging to see that a major publication has not imbibed the CDS clearinghouse Kool-Aid. It is also encouraging that the WSJ recognizes that a clearinghouse just slices and dices and redistributes default losses, rather than eliminate them (“all participants become liable for the potential failure of the weakest members”). Too much sloppy reporting, editorializing, and politicking traffics the lie that a CCP somehow makes this risk disappear, through some mysterious financial alchemy. Wrong again. Clearing is a risk sharing mechanism, not a risk eliminating mechanism. Big difference.

Hopefully, now that some of the hyperventilating over credit derivatives has abated a bit, cooler heads will prevail, and will examine the real (rather than imagined) costs and benefits of clearing before forcing a flawed solution on the market. Perhaps the WSJ editorial is the harbinger of such a welcome development. Here’s hoping.

In a moment of clear thinking (pun intended), Britain’s antitrust authority, the Office of Fair Trading, has decided not to pursue further analysis of exchange ownership of clearinghouses:

The OFT has decided not to undertake any work in the market for derivatives clearing, after inviting views earlier this year.

The OFT called for submissions on the broader issue of competition in this market in May after it concluded that ICE Clear Europe’s regulatory provisions did not have a significantly adverse effect on competition.

In reaching its decision, the OFT considered both the submissions it received from interested parties, and recent developments in the market. It concluded that, whilst some potential concerns about the competition effects of vertical integration between derivatives exchanges and clearing the transactions on them were raised, no specific action is required at present because:

• Regulatory initiatives from both the US and EU suggest that now would not be an appropriate time for the OFT to take further action other than to monitor developments closely.
• The industry is characterised by rapidly changing market developments and product and technological innovation which further indicate action at this time is not appropriate.
• Consumers in derivatives trading in the majority are large, globally active companies which have demonstrated that they are able to react to market developments.

Whilst it has decided not to prioritise work in this area at present, the OFT will continue to monitor market developments closely.

In the second item, contrary to a SWP prediction, ELX has chosen the Options Clearing Corporation to clear its futures business.   Since there was a large overlap between the ELX founders, and the group of firms that invested in the Clearing Corporation Formerly Known as BOTCC, I had predicted that ELX would choose the ClearingCorp.   My conjecture is that the purchase of the CCorp by ICE scuppered those plans.   Getting clearing services from a potential competitor, ICE, was probably not that appealing a prospect.   The whole CDS clearing issue was not on anybody’s radar screen when ELX was first mooted, and the banks invested in CCorp.   The CDS clearing thing took on a life of its own, and the ICE initiative made sense, and pushed the ELX to the back burner.

There are two competing models in CDS clearing.   The CME model is to clear these products through its existing clearing structure, effectively “co-mingling” futures risks and CDS risks.   The alternative model, embraced by ICE and Eurex, will clear CDS and futures products seperately.

As I’ve mentioned on a few occasions, there is considerable tension among CME clearing members over the co-mingling idea.   This article from DJ News Wires details the competing claims and complaints over the various models:

CME argues that “co-mingling” futures and CDS contracts in its clearinghouse will avoid an additional capital call on banks and dealers.

The strategy has generated warnings from some of CME’s largest partners in the futures industry, who are concerned they will be exposed to CDS risk.

Patrice Blanc, chief executive of Paris-based Newedge, said co-mingling futures and CDS clearing is “dangerous,” and that it could “create huge systemic risk” for market participants.

Clearing CDS contracts is “a much more complex issue than it’s been made out to be,” Blanc said in a recent interview with Dow Jones Newswires.

Thomas Peterffy, CEO of electronic brokerage firm and CME clearing member Interactive Brokers, has also come out against mixing futures and CDS risk on CME’s platform.

Co-mingling of futures and CDS risk could threaten the integrity of a clearinghouse, says Roger Liddell, CEO of London-based clearinghouse LCH.Clearnet.

He also cautioned that clearing CDS trades may be more complicated than many believe.

“There is a risk in assuming that everyone can clear everything,” Liddell said at the Futures Industry Association’s 2008 Expo in Chicago last week.

I concur with the various cautions voiced by Liddell, Blanc, and Peterffy.   They are, in effect, in agreement with my assessment that CDS clearing presents acute balance sheet and product risks that are inherently more costly to share through a clearinghouse, due to asymmetric information problems.

Now, “co-mingling” is synonym for “diversification.”   In a world of complete information, the CME’s Kim Taylor would be exactly right:

Kim Taylor, president of the CME clearinghouse, has acknowledged the concerns. She argues that combining the risk of futures and CDS contracts in one clearinghouse provides diversification, lower overall risk and cutting trading costs.

Taylor, speaking on a panel at the FIA event, noted that risk management for the clearinghouse as a whole has become more efficient when CME has brought new product lines into its clearinghouse, notably the energy and metals contracts from the New York Mercantile Exchange.

In a world of complete information, with no information asymmetry, there are economies of scope in clearing.   Through the diversification effect, the riskiness of a combined CDS and futures portfolio would be lower than the sum of the risk of the stand alone CDS portfolio and the risk of the stand alone futures portfolio.   Moreover, clearing across products economizes on margins.   Again, due to the diversification effect, with a combined portfolio one can achieve the same default loss profile for a smaller margin than one can with seperate portfolios.

So, co-mingling sounds like a no brainer.   So why aren’t savvy market participants buying this?   I think the answer is pretty clear.   They understand that this is not a situation of complete information.   Due to information problems, moral hazard and adverse selection problems make it costly to clear CDS trades.   CME clearing members are quite right to be very leery of importing the product and balance sheet risks associated with credit default swaps into a futures clearing system that has worked very well.

I quote from the Book of Duh:

Top executives from four major financial exchanges told federal lawmakers Monday they believe the clearing of certain kinds of credit derivatives should be mandated by law.

. . . .”Clearing should be mandated for most [credit-default swap] instruments,” said Johnathan Short, vice president and general counsel for Atlanta-based ICE.

Terry Duffy of the CME chimed in (this is from Bloomberg–no link yet): “We do believe there should be a mandate for clearing of credit-default swaps.”

Eurex also joined the party, although they were a little more restrained in their remarks, with the exchange’s Thomas Book (whom I participated with in a panel at the SFOA in September) asking only for:

As a consequence, Congress should take into account whether the regulatory enhancements that it is considering will reinforce and be supportive of the migration of (credit-default swap) transactions from the current bilateral structure to regulated and transparent (central counterparties)

Well of course the exchanges want Congress to force clearing onto exchanges because, as Thomas so mellifluously put it:

It should be noted that although the benefits of clearing are significant for the integrity of financial markets, it cannot be assumed that centralized clearing will be automatically and broadly accepted by current (over-the- counter) market participants.

That is, the banks are unlikely to do it voluntarily, so it’s necessary to force them to clear. And if they’re forced to clear, guess who’s just licking their chops to do that business?: ICE, CME, Eurex.   Surely a coincidence.

Which begs the question, often asked here: If it such a great idea, why don’t the banks do it on their own initiative?

[Crickets chirping.]

I’ve beaten this horse so many times that I’m sure PETA is already filing a complaint with local law enforcement, so I’ll try to keep it brief and make my getaway.

One should pay considerable deference to the survivorship principle.   Although path dependence can complicate matters, the survival of a particular institutional arrangement in the face of viable alternatives suggests that it offers efficiency advantages over these alternatives. I have laid out a case as to the likely sources of such an efficiency advantage of bilateral arrangements over central clearing: lower costs associated with asymmetric information.

Only if one can identify some sort of market failure (e.g., a coordination problem) or externality is a mandated change in default risk sharing arrangements justified.   Although there has been a lot of serious talk about “systemic risk” and “financial stability,” there has been no real identification of a concrete externality, or a demonstration that mandated clearing would fix it.     Apropos yesterday’s analysis of the Allen-Gale book, the discussion of clearing has been carried out without reference to any credible theoretical or logical framework.

So, my challenge to the advocates of clearing: What externality that justifies the impostion of clearing?   If the individual firms who would belong to a clearinghouse don’t internalize the externality, why would a clearinghouse?   Why, despite the fact that the concept of clearing is very well known and tested, have wide swaths of the OTC market deliberately eschewed it?   What are the likely equilibrium responses to the imposition of clearing?   How exactly will clearing reduce systemic risk?

The political economy of this is very interesting.   The congressional committee (House Ag) with jurisdiction over the futures markets and the exchanges is pushing legislation to mandate clearing.   (Chairman Peterson has indicated that he hopes to have a bill in January.)   This suggests that this is being driven by politics and the concentrated economic interests of the exchanges, rather than a serious deliberation over the pros and cons.   (Well, “Duh” again.)

I will close with an entertaining quote from a Chicago trader and CME clearinghouse member who understands very well the risks (notably the balance sheet risks) that CDS clearing could pose:

Howard Simons, one of the Chicago traders who always loathed the New York CDS dealers, speaks for many of his comrades in rejecting the trading of CDS on the futures exchanges. “The clearing members of the CME [Chicago Mercantile Exchange] think trading this stuff is the stupidest idea in the world. I didn’t work my whole life so some investment bank can take all our capital. Do I look like Hank Paulson?”

One of the most succinct descriptions of balance sheet risk ever uttered.   Couldn’t have put it better myself.

I am quoted extensively in this Reuters article on CDS clearing.   No surprises here: I’m just blowing another raspberry at proposals that the government force clearing, or the trading of all derivatives on exchanges.