Streetwise Professor

The FT reports that major banks are reluctantly supporting the formation of a CDS clearinghouse, if only to stave off something worse–the Harkin proposal to force all trading of everything onto exchanges:

The world’s biggest investment banks are throwing their weight behind a proposal for mandatory central clearing of the $54,000bn over-the-counter credit derivatives market, according to a memo obtained by the Financial Times.

The initiative suggests that dealer banks are stepping up their campaign in Washington to head off proposals for a radical overhaul of the sector, including attempts to force the entire industry to move trading in contracts such as credit default swaps (CDS) on to an exchange. (Emphasis added.)

This suggests that the big banks are not sold on the idea of CDS clearing.   This doesn’t surprise me, given the problematic aspects of a CDS CCP that I’ve discussed in gruesome detail in numerous posts.   I’ve read that dealers bought Clearing Corp earlier this year with the thought that the time would be right for CDS clearing in 2011 or 2012, but that intense political pressure has accelerated that time schedule.

Harkin’s legislative grenade is of course not the only source of government pressure to create a clearinghouse; the NY Fed (under the leadership of Treasury Secretary nominee Timothy Geithner) has been leading the charge.   But there is no doubt that Harkin’s initiative has put the fear of God into the banks, and has overwhelmed any reservations that they have harbored.   Geithner, the Fed, the Treasury, could pressure the banks and make their lives uncomfortable; Harkin’s bill could put them out of the CDS market making business altogether.   Given this selection of poisons on offer, it’s pretty easy to understand why the banks have chosen the one they did.

This has historical precedents.   For instance, exchanges fought the first attempts to regulate futures in the 1920s.   The prospect of legislation that would have essentially put them out of business made them willing to accept unpalatable regulations that nonetheless permitted them to continue to operate.

This just illustrates that a bill needn’t be passed to have pernicious effects.   Very bad proposals can lead to the adoption of less bad, but still undesirable policies.   It would be somewhat comforting if the banks had their Come to Jesus moment because events and sober analysis had convinced them that clearing of CDSs was in their benefit, and would improve market efficiency.   Their shouts of Hallelulah under the threat of severe compulsion are hardly credible professions of their faith in the revealed truth of clearing.   Given that there are strong reasons to believe that CDS clearing is not a panacea, and may well impair market efficiency and increase systemic risk, their pragmatic protestations of belief make me even more skeptical that this is the right thing to do.

Yesterday the WSJ published a long article about Morgan Stanley’s near death experience in September.   Although the byline reads Susan Pulliam, Liz Rappaport, Aaron Lucchetti, Jenny Strasburg, and Tom McGinty, it reads like it was ghosted by Chris Cox because it raises the specter of evil speculators ganging up to destroy Morgan by buying credit protection against the bank, and short selling its stock:

Trading records reviewed by The Wall Street Journal now provide a partial answer. It turns out that some of the biggest names on Wall Street — Merrill Lynch & Co., Citigroup Inc., Deutsche Bank and UBS AG — were placing large bets against Morgan Stanley, the records indicate. They did so using complicated financial instruments called credit-default swaps, a form of insurance against losses on loans and bonds.

A close examination by the Journal of that trading also reveals that the swaps played a critical role in magnifying bearish sentiment about Morgan Stanley, in turn prompting traders to bet against the firm’s stock by selling it short. The interplay between swaps trading and short selling accelerated the firm’s downward spiral.

. . . .

Pressure also mounted on another front. There was a surge in “short sales” — bets against the price of Morgan Stanley’s stock — by large hedge funds including Third Point LLC. By day’s end, Morgan Stanley’s shares were down 24%, fanning fears among regulators that predatory investors were targeting investment banks.

. . . .

New York Attorney General Andrew Cuomo, the U.S. Attorney’s office in Manhattan and the Securities and Exchange Commission are looking into whether traders manipulated markets by intentionally disseminating false rumors in order to profit on their bets. The investigations also are examining whether traders bought swaps at high prices to spark fear about Morgan Stanley’s stability in order to profit on other trading positions, and whether trading involved bogus price quotes and sham trades, people familiar with the probes say.No evidence has emerged publicly that any firm trading in Morgan Stanley stock or credit-default swaps did anything wrong. Most of the firms say they purchased the credit-default swaps simply to protect themselves against potential losses on various types of business they were doing with Morgan Stanley. Some say their swap wagers were small, relative to all such trading that was done that day.

. . . .

But swaps were also a good way to speculate for traders who didn’t own the debt. Swap values rise on the fear of default. So traders who believed that fears about Morgan Stanley were likely to intensify could use swaps to try to turn a fast profit.

Note the use of the word “bet” (three times) in the first three quoted paragraphs.   The article also throws about terms like “financial Frankenstein” to describe credit default swaps.

I agree with Felix Salmon’s verdict:

In fact it tells a much simpler tale: Morgan Stanley’s counterparties were forced to buy CDS protection to hedge their exposure to the bank, and Morgan Stanley’s hedge-fund clients withdrew a lot of money, not in a bear-raid attempt to kill it off, but because prudence demanded that they do so, and also because they were understandably upset about John Mack’s role in getting the short-selling ban put in place. That ban devastated many hedge-fund relative-value and convertible-arbitrage strategies and caused a lot of anger in the hedge-fund community.

. . . .

So yes, it’s possible that those demonic short-sellers were responsible for the fall not only in Morgan Stanley’s share price, but also in Citi’s at the end of last week. But it’s also possible that it was just old-fashioned sellers, who weren’t selling short but were rather selling down their existing long positions. And it’s also possible that it wasn’t selling at all, but simply a lack of buyers willing to place bets on a fragile institution with a possible leadership vacuum. We simply don’t know — which is why it’s silly to assume that short-sellers were to blame.

That is, it was individually rational for the Merrills, Citigroups, Deutsche Banks, UBSs, etc., to hedge their counterparty risk.   This was especially true in the immediate aftermath of the Lehman collapse, which had demonstrated that (a) a big investment bank could collapse with stunning swiftness, and (b) there was no guarantee that the government would intervene to prevent the collapse.   Put differently, one can explain what went on without positing that malign speculators were making these trades with the specific intent of destroying the firm.

There is still an issue that deserves thought, but which is likely impossible to resolve.   That is whether this individually rational behavior was economically efficient–or collectively rational.

For instance, the activities of those hedging against (or betting on) a Morgan Stanley collapse could be consistent with an informational cascade.   The individual banks had information on Morgan Stanley’s creditworthiness, but were also drawing inferences from the actions of other potentially informed parties.   A given bank, observing others buying protection or short selling MS stock, would infer that these parties had received adverse information about Morgan’s creditworthiness.   Even if a given bank’s own information wasn’t that bearish, the inference drawn from the behavior of others could be sufficient to convince it that the firm was on the brink of failure, leading it to buy protection against an MS default.   And the next bank, seeing what that bank had just done, would likely make the same inference.   And the next bank, and the next one.   Such a “cascade” can become self-sustaining, leading everyone, regardless of their information, to join the wave of those “betting” against MS’s survival.

The literature on cascades demonstrates that these cascades can lead to the “wrong” outcome.   Specifically, if the first couple of traders act on signals that present an overly pessimistic view of Morgan’s condition, an unjustifiably bearish cascade can occur.   In such a cascade, even those with more optimistic signals will make bearish trades. Thus, the ultimate outcome of the cascade may not aggregate information accurately.   A healthy firm can be brought to its knees by a cascade.

So it is possible that Morgan Stanley’s agonies were the result of an inefficient informational cascade in which everybody was individually rational, but the result was inefficient and collectively irrational.

This raises the question: What can be done to stop such inefficient cascades?

The literature on cascades suggests that cascades are very fragile.   They can be stopped quickly by the release of accurate, credible information.   It is hard to imagine this occurring in the frenzied conditions of the market on those September days.   Who could have provided this credible, accurate information in real time?   Morgan Stanley itself was hardly a credible source of information.   Given the opaque nature of the firm’s balance sheet, moreover, it is hard to imagine that there was any credible source of information.

Perhaps some sort of circuit breaker–or, perhaps, “cascade breaker”–would have done the trick.   Stopping trading would have stemmed the cascade’s momentum.   This stoppage would have had to have been coordinated across several markets, including the CDS, stock, and options markets, in the US and abroad.   Moreover, how would the breaker be triggered?   Would it be some non-discretionary trigger based on observable market prices, e.g., a fall in a company’s stock price of X percent?   Or a discretionary action?   If discretionary, who would exercise it?   A government regulator?   There are obvious pitfalls with any of these alternatives.   (Look at the chaos in the Russian stock market in recent weeks, with myriad market closures.)

This “cascade breaker” could provide an intellectually respectable justification for a restriction on short sales.   (Not that the opponents of short sales have made such a justification, preferring instead to portray short sellers as financial Snidely Whiplashes.)

But not so fast.   Although it seems that bank runs–and what happened to Morgan Stanley is analogous to a bank run–are inherently bad, and that stopping them would be good public policy, the banking literature does not support this conclusion.   As Diamond and Rajan and others have shown, bank runs can be a valuable disciplining advice.   Absent the threat of runs, financial institutions that supply liquidity can act opportunistically towards their creditors.   This opportunistic behavior can be costlier than a run.

Thus, there is no immediately obvious policy response to the events described in the WSJ article.   The cartoonish demonization of short sellers and credit protection buyers is certainly not a reasonable basis for intervention into the markets.   The details presented in the article do not prove that speculators intent on driving Morgan Stanley out of business were responsible for the short sales and the CDS purchases; individually rational hedging behavior could have produced the same behavior.   Individual rationality does not imply efficiency because of the possibility of inefficient information cascades, but even then, the optimal policy response is not obvious.     Unless policy makers can reliably distinguish between inefficient and efficient runs/cascades, intervening to prevent all cascades through the imposition of a circuit breaker can eliminate a valuable disciplining mechanism that reduces the costs of contracting.

In the end, I imagine that one’s priors about the likelihood of inefficient cascades determines one’s policy recommendation.   Since information cascades are the result of myriad individual decisions, and the optimality of these decisions depends on private information unobservable to any investigator, it is impossible to determine ex post (let alone in real time) whether a particular run/cascade was efficient or inefficient.   Thus, there is inevitably a paucity of evidence that people can use to revise their priors.   Moreover, any policy action is likely to have large, and virtually impossible to quantify, costs.   (How does one quantify the costs arising from less efficient contracting when the elimination of disciplining runs rules out the “best” contracts?)   Thus, cascade breakers, or any policy response, are little more than shots in the dark, based on quasi-religious views about the efficiency of markets.

I know that’s not a very palatable diagnosis, but there it is.   We are ignorant, and the ignorance cannot be remedied.

Those who have read SWP regularly will have deduced that I have a historical bent.   Although historians and economists (and other social scientists) tend to think and analyze problems in very different ways, I think that history is quite often a useful source of material on which to test theories and conjectures, and a source of inspiration and ideas useful in the generation of new theories and models.   It also frequently proves quite useful in debunking assertions about the necessity or sufficiency of a certain factor causing some outcome.

Today’s historical excursion examines a couple of episodes in the past relating to clearing.   Specifically, two occasions in which important exchanges, the London Metal Exchange and the Chicago Board of Trade, adopted central clearing under government pressure only after a long period of resistance.   In each case, the memberships and/or leaderships of these exchanges steadfastly refused to introduce clearing until forced to do so by regulators.   In each of these cases, the regulators’ rationales were tangential, at best, to the actual economic purpose and effects of a clearinghouse.   It seems that as various government entities are pushing a clearing solution for the CDS market that we are in the process of repeating history.

A central counterparty/clearinghouse was first adopted in the US in 1891 in Minneapolis.   From time to time in the following years, some members of the Chicago Board of Trade proposed that the exchange adopt the “Minneapolis Model.”   Each time, either the membership or the board of directors rejected these proposals.

All of the merits of central clearing were pretty well understood.   In particular, CBT members understood that clearing would reduce the amount of money that would be tied up in margins–although some considered this a bug, not a feature.

The standoff between the advocates and opponents of clearing continued literally for decades.   The impetus for the move that actually resulted in the creation of the Board of Trade Clearing Corporation originated in the passage of the Grain Futures Act of 1922.   This Act gave the Secretary of Agriculture considerable power over grain exchanges.   The Secretary could put an exchange out of business by revoking its designation as a contract market.

In 1925, William Jardine was Calvin Coolidge’s Agriculture Secretary.   He was convinced that large speculators were manipulating the grain markets, to the detriment of farmers, and wanted to do something to stop it.   In another foreshadowing of current events, Jardine was convinced that identifying who held large positions would facilitate deterrence.     He further thought that a clearinghouse would achieve this objective because it would require the registration of all positions in order to perform its work.

Of course, it would have been possible to register positions without creating a central counterparty.   Indeed, such a change to clearing procedures had been proposed, but not adopted, in 1911.

The directors of the CBT continued to balk at creating a clearinghouse, until two influential members of the exchange, L.F. Gates and J.C. Murray, who served on the exchange’s Grain Exchange Legislative Committee, wrote a letter warning of dire consequences if the exchange failed to act.   Gates and Murray said that failure to implement the clearinghouse plan could lead to a revocation of contract market status.   Stung into action by their warning, the directors approved the creation of a clearinghouse (and a Business Conduct Committee to police the exchange’s members.)

Jim Moser argues that Jardine’s pressure was not what caused the CBT to adopt the central counterparty.   He notes that the exchange could have satisfied Jardine’s demands for transparency by registering every trade, but not providing a central guarantee.   He concludes that the directors’ reluctance to adopt the CCP was based on privacy concerns that Jardine alleviated.   From this he infers that the directors’ objection to the clearinghouse was not the risk sharing aspect of its operation, but the possibility that its operation could result in disclosure of position information.

Perhaps.   But it seems that if there was a strong demand for risk sharing via a CCP, the exchange could have found away to address the privacy concerns.     Thus, another, and in my view more straightforward, interpretation of events is that there was not a uniform desire for a CCP, and there was strong opposition to the concept; and that Jardine’s threat to shut down the exchange compelled the directors to pacify him by adopting a method that he had endorsed–the Minneapolis Method.

That’s one of the problems with history–it seldom permits definitive answers as to cause and effect.   But regardless of the interpretation, the extreme reluctance of the Board to adopt a CCP suggests that the concept is not nearly as beneficial as its advocates suggest.   To be sure, there were legal and privacy objections, but (a) where there’s a will, there’s a way, and (b) it is often the case that explicit objections camouflage the true reasons for opposition.     And to me, the most straightforward interpretation of the facts is that the CBT adopted a central counterparty not because of its inherent economic benefits, but only as result of government pressure motivated by considerations completely unrelated to the costs and benefits of sharing default risks. The failure of the CBT to adopt a central counterparty voluntarily is consistent with the view that this method of allocating default risk has costs that exceed the benefits.

The LME was another exchange that adopted central clearing only when its very existence was threatened by government action.   The LME had suffered a major crisis in 1985-1986 with the collapse of the International Tin Council’s price support program.   Tin prices collapsed, contracts were breached, and many LME members suffered huge losses, with some closing their doors.   Prior to the Tin Crisis, the LME had been strictly a principals’ market, with all dealings done on a bilateral basis just as is the case in OTC markets today.   The LME clearinghouse was merely a mechanism for netting payments and deliveries, similar to a bank clearinghouse.   It was not a CCP.   Indeed, the LME had consciously resisted creation of a CCP for years after this practice had become standard in both American and British commodity markets.

Remarkably, the LME’s resistence to the idea continued after the Tin Crisis.   Thus, even a major series of dealer defaults was not sufficient to convince the membership that a central counterparty was a superior method of sharing default risks.   The LME adopted a CCP only after the newly formed U.K. Securities and Investment Board (SIB) made it clear that it would deny the LME its license to operate unless it introduced an independent CCP.

Most of the benefits attributed to CCPs are private benefits that accrue to their members–lower collateral, more efficient sharing of default risk, prioritization of derivatives counterparties over other creditors.   If this was all there was to the story, derivatives markets participants should adopt a CCP without fail.   But, as these historical episodes demonstrate, they don’t.   Indeed, they demonstrate that the resistance to the idea can be so strong that only intense government pressure can overcome it.   Thus, there must be more to the story.   There must be some costs sufficiently large to overwhelm the private benefits commonly attributed to a CCP.   These costs, unfortunately, are seldom–if ever–the subject of serious analysis.   They should be.   A reasoned judgment about the efficiency of a CCP must be predicated on a judicious weighing of both costs and benefits. Presumably 1920s grain traders and 1980s metals traders whose livelihoods depended on the efficient operation of their markets made such a judicious appraisal, and decided that the costs outweighed the benefits.   That should give advocates of CCPs pause, and spark a more thoughtful consideration of their full effects.

Throughout the period of explosive growth in OTC derivatives, market participants have arrived at a similar judgment.   The concept of clearing is well known.   The subject has been mooted–and rejected (for the most part).   That judgment should not be overridden without excellent justification.

Heretofore, that justification has been totally lacking, but government pressure to adopt a CCP for credit derivatives, and perhaps eventually other derivatives, is unrelenting.   There are repeated invocations of   “systemic risk” and the bandying about of scary (and often mixed) metaphors–“weapons of mass destruction,” “time bombs,” etc.   But the concept of systemic risk is never precisely defined, nor do the advocates of clearing of OTC derivatives present any serious argument as to how a CCP would reduce that which is scary (but undefined.)

Typically, the argument stops at “a CCP would net which would reduce replacement costs in the event of a default, thereby lowering the costs that other dealers pay when one dealer defaults.”   That argument is incomplete, not generally true, and arguably false.   It fails to recognize that netting just redistributes default costs from derivatives counterparties to other creditors, some of whom may be systemically important; it does not consider that the formation of a CCP may increase the sizes of positions that traders hold, thereby increasing the potential for default losses; it ignores the effects of a change in risk allocation on asymmetric information and the incentives to monitor counterparty risk; it overlooks the fact that a CCP, by effectively guaranteeing customer positions, requires dealers that are members of a clearinghouse to bear the costs of a defaulter’s entire net position (including trades done with non-member customers), rather than merely their direct trades with the defaulting member.

If systemic risks are an increasing function of the default losses that dealers incur, it is a straightforward exercise to create examples in which such losses (and hence systemic risks) are higher, rather than lower, with a CCP.   This is true even if one ignores the effects of asymmetric information.   The monomoniacal focus on netting obscures the myriad effects of the mutualization of default risk, and leads to a wild overestimate of the efficacy of clearing in reducing systemic risks.

The government forcing grain traders or metals traders to adopt an inefficient method of allocating default risks is bad enough, but the social costs of these actions were likely bearable because these markets were small in the scheme of things.   Forcing the adoption of clearing in the massive OTC financial derivatives markets is another thing altogether.   Here the costs of a mistake could be huge.   The incomplete and faulty analysis that is being used to justify the creation of a CDS CCP greatly increases the odds that its adoption would in fact be such a mistake.

The seeming compulsion to “do something” in the face of a burgeoning credit crisis threatens to hasten the implementation of an ill-considered plan with major systemic consequences.   Let’s hope that that compulsion is replaced by contemplation and measured action before it is too late.

My post yesterday on Senator Harkin’s derivatives bill was based on the WSJ report. Michael Giberson at Knowledge Problem kindly provides a link to Harkin’s full statement (and even more kindly links to SWP.) And wouldn’t you know, as I suspected, Harkin indeed quoted the Sage of Omaha’s “Weapons of Financial Mass Destruction” yadda yadda, and adds some hyperventilating of his very own:

My bill will end the unregulated ‘casino capitalism’ that has turned the swaps industry into a ticking timebomb. And it will bring these transactions out into the sunlight where they can be monitored and appropriately regulated.

“Casino capitalism.” “Ticking timebomb.” “Bring these transactions out into the sunlight.” How trite: that scores very low on the originality scale, senator. Like a zero.

How about a serious comparative analysis of the costs and benefits of alternative trading mechanisms for different instruments? How about at least a moment of silence to ponder the questions: “Why have these markets evolved in this fashion, with a diversity of trading methods for a variety of different products?” and “What makes me so much smarter than the market?” and “What specific market failure (externality, collective action problem, etc.) is at work here, and how does forcing everything onto an exchange fix it?” and “Gee, we tried this before, and it created all sorts of problems, so why should we expect it to work any better now?” How about a recognition that market participants with very high powered incentives in fact spend a great deal of effort and money to monitor counterparty risks?

The issues here are very, very, very complicated. There are myriad moving pieces. I certainly disclaim any divine insights as to what the best way to organize derivatives markets. But I can make a plausible case based on a comparative analysis grounded in an understanding of basic economic considerations that there are very good reasons for trading some things on exchanges subject to centralized clearing, and to trade other things on bilateral OTC markets without clearing. A debate over the appropriate regulatory framework should focus on these kinds of considerations. Maybe such a debate will lead me–and others–to conclude that there are remediable problems in the way that markets are organized, and to identify the most efficient fixes. One thing for sure, however, is that cheap, lazy, hackneyed, grandstanding, and fact-free bloviations about “casinos” and “timebombs” are hardly the basis for re-engineering markets involving billions and perhaps trillions of dollars.

I truly admire Natasha de Teran’s reporting on derivatives markets. Her work is head and shoulders above everybody else’s. If you are interested in these markets you should read her in efinancialnews (registration required).

Yesterday Natasha gave some very nice coverage to my work on clearing. She does a very good job at condensing the avalanche of words I’ve written on the subject on SWP into a concise, accurate, and readable summary. Moreover, she adds a couple of very illuminating stories that provide excellent real world (and near real time) illustrations of some of the pitfalls I’ve been writing about.

Thanks again, N. Hopefully this will increase the visibility of some of the concerns I’ve raised as the CDS clearing express train roars down the tracks. (Matt Leising of Bloomberg tells me that there is an MOU in place to give the Federal Reserve primary regulatory authority over a CDS clearinghouse, and that President Bush will announce this at as part of a plan to be announced at a gathering of world leaders to discuss the financial crisis later in the week.) Rushing ahead without giving adequate considerations to these issues could lay the groundwork for greater problems in the future.

* Apologies to the Rocky and Bullwinkle Show. And Natasha de Teran has nothing in common with Natasha Fatale. Especially the accent;-)

Given the difficulties that some folks have had getting access to the article, here it is:

OTC clearing as a cure-all could be OTT
Natasha de Terán
10 Nov 2008

The promotion of clearing as a cure-all, tax on and apology for the over-the-counter derivatives industry is a neat one – but history demonstrates it may not act effectively as any of those things, and specialists worry it could do far worse.Regulators, when caught on the back foot, habitually rush to put out directives and convince lawmakers to rubber-stamp them at the double. Frequently such measures are ill-thought-out, delivering little more than a short-term injection of credibility and a longer-term expansion of their authority.

The participants, in this case the banks, will counter that their markets are self-correcting and that alternatives of their own devising will better assuage any regulatory concerns. Often their principal concerns are to protect their vested interests and preserve the status quo.

And when, between these poles, merchandisers – in this case the exchanges – spring up claiming to have devised tools to resolve this conundrum and boasting that their particular version is superior to those of their rivals, it is the profit motive that is generally their paramount concern.

As a result, and although all of the above groups’ claims about OTC clearing have some weight, they should be seasoned with healthy doses of scepticism. For when an experienced academic, with acknowledged expertise and no skin in the game, weighs in with serious concerns about the proposed rules, the participants’ interpretation of them and the suitability of the apparatus on offer, it is time to sit up and pay attention.

Craig Pirrong, a finance professor and director of the energy institute at the University of Houston, has spent his career studying derivatives markets, exchanges and clearing houses. Recently he has been giving a lot of thought to the issue of over-the-counter derivatives clearing – and he is far from convinced that rushing to clear OTC business is going to help anything. Worse, he worries that it could cause serious problems.

At the risk of being too simplistic, his principal concerns could be boiled down to one issue: that of information asymmetries.

First, he worries that clearing members could have better information about the price of OTC risks than a central counterparty that clears them. When the CCP’s insurance of OTC risk is underpriced, they will avail themselves of it, and when it is overpriced they will not.

This will result not only in an incomplete insurance of OTC risk, but – in the extreme – it will make the risk-sharing device altogether inefficient.

Second he worries that clearing members might have better information about the balance sheet risks of other OTC players and be able to react more quickly to any real or perceived deterioration in their balance sheet strength than CCPs.

This is because the broad spread of members’ business activity with each other should afford them greater insight into their relative balance sheet strengths than a CCP would have. Also, CCPs do not typically charge for balance sheet risks. Instead, they determine criteria for membership based on capital levels, and then set thresholds for collateral postings based on the risks of the instruments the members hold in the CCP. That means that any two given members with the same portfolio, but potentially vastly different balance sheets, will post the same amount of collateral.

On the rare occasions when CCPs do attempt to address this balance sheet issue, they cannot use the soft and hard information mix that OTC counterparts rely on. Instead they must use transparent rule-based mechanisms, typically requiring members with lower credit ratings to post more initial margin than those with higher ratings. If this crisis has shown anything, it is that those ratings are nothing better than rudimentary laggard indicators of balance sheet risks.

Given the above, it is worth considering two things: where exchanges get their information from to price risks and what a counterparty active in both cleared and uncleared OTC markets might do about the perceived deterioration of another’s balance sheet strength.

First, pricing information. Clearing houses manage price risks by looking to liquid, transparent datapoints. In futures and options markets, they can do this easily by looking to the prices on listed markets. In the case of interest rate swap risk, such as that managed by LCH.Clearnet’s SwapClear, the pricing is based on a large number of liquid, observable prices that can be derived from multiple data points.

But when CCPs start clearing OTC credit derivatives risks, they will have much more limited data: they will have to base their assumptions on a smaller number of less liquid, less transparent variables and derive their pricing from just a few sources. In stressed scenarios they might not be able to mark to market at all. Instead they will be marking to model.

Second, what might a clearing house member do in the event they suspect that the balance sheet of other OTC counterpart and clearing house members is being unduly stretched? They could cease trading with that counterpart, they could require that the counterpart post surplus collateral to cover this risk, or they might continue trading with the counterpart but require all the OTC trades be novated to the CCP.

In doing so, they would be parking the unsavoury risk at the clearing house and buying “cheap” insurance from it.

Unlikely? Consider this. In the last few days before the Lehman Brothers collapse, two different behaviours were evidenced in the cleared OTC marketplace.

In the repurchase agreement market, a large dealer refused to take Lehman’s name even though the trade was going to be novated to LCH.Clearnet’s repoclear facility. The trader’s decision was predicated on the belief that Lehman’s counterparty risk was too bad to take.

Not only did he therefore not want to carry it himself, but also he didn’t believe that he should oblige others to share it with him.

In the swap market, another dealer is meanwhile alleged to have attempted to offload to LCH.Clearnet’s Swapclear facility a legacy portfolio of interest rate swap trades that he had on with Lehman. At that time LCH.Clearnet would have been more than aware of Lehman’s risks and would have been able to make an informed decision about whether the assumption of new risks reduced or added to the sum of Lehman’s risks.

In the event, the swap issue proved immaterial since the swap portfolio was not novated to the CCP, but this second incident clearly demonstrates the difficulties that might arise from information assymetries and the potential for abuse of risk-sharing mechanisms. Worse is this: if the actions of the swap trader were known to the repo trader, the latter’s incentive to behave prudently and shun the profit motive in favour of the co-operative’s greater good would have been eliminated.

Thus it is easy to see how the use of a CCP could encourage a wholesale adoption of this worst practice kind of behaviour – taken to the extreme, why would OTC market counterparts ever need to bother who they deal with if someone else is managing it and others insuring it?

Pirrong is a great advocate of clearing and he is also a supporter of derivatives, but his concerns about mixing the two into a ready-made soup are considerable. More OTC clearing could include the potential for excessive and irresponsible risk taking, the mispricing of risk and the exploitative use of information asymmetries.

Natasha tells me that the editor did some fine surgery with a chainsaw (my characterization), lopping off the last 400 words, hence the rather abrupt ending. But you all should get the drift.

I know there are very few new things under the sun . . . but although I’ve read a great deal about clearing, I don’t think that I’ve seen anyone point this out: The main benefit commonly attributed to a central counterparty (CCP)–netting–effectively gives derivatives counterparties a priority in bankruptcy that they would not otherwise possess. As a result of the effective change in priority, the initiation of clearing transfers wealth from CCP members’ other creditors to their derivatives counterparties (who include CCP members.) That is, in dollar terms, formation of a CCP is not a positive sum game (although it can be from the perspective of the CCP members), but a zero sum game. CCP members win at the expense of the other creditors of their members.

This has important implications. Advocates of centralized clearing argue that netting reduces systemic risk by reducing the cost of replacing defaulted derivatives positions. In a bilateral market, counterparties must replace all of the defaulter’s out-of-the money positions; with a CCP, they replace only the net positions. Since replacement is costly (as the counterparties lose in-the-money positions and replace them with new ones of zero value), netting reduces the losses counterparties incur, thereby reducing the likelihood that the counterparties will in turn default; that is, netting reduces the susceptibility of the market to a “daisy chain” of defaults.

Or does it? What about the other creditors? Netting eliminates an asset: the dealer’s in-the-money derivatives positions that are net against some or all of its losing positions. Without netting, both derivatives counterparties and other creditors would have a claim on this asset. With netting, the asset disappears, meaning that the other creditors cannot use it to satisfy their claims against the bankrupt dealer. Thus, netting favors derivatives counterparties at the expense of other creditors.

This means that holding the dealer’s position constant, netting engineers a transfer of default loss, not a reduction of total default loss. It only does so when one considers only derivatives counterparties, and ignores the defaulter’s other creditors.

This has implications for systemic risks. Perhaps netting reduces the possibility that a dealer’s default will cause derivatives counterparties to default, but it increases the likelihood that its other creditors will face financial distress, and perhaps bankruptcy. The defaulter’s other lenders may include banks, hedge funds, money market funds, commercial paper investors, and so on. These lenders may also be systemically important, in the sense that their financial distress can have ripple effects, or trigger a cascade of subsequent defaults.

It is therefore by no means obvious that the ultimate effect of the formation of a CCP is a reduction in systemic risk exposure. Netting redistributes the wealth effect of a default. Unless derivatives counterparties are uniquely systemically important, netting can actually worsen systemic risks.

These points can best be illustrated by an example. Large dealers typically buy and sell the same contract in large quantities. For instance, a dealer may buy 1000 contracts and sell 500 of the same contract to different counterparties. This dealer has a net exposure of 500 long contracts.

In a bilateral market, the offsetting 500 contracts are not eliminated by netting. This has several implications. First, a firm with offsetting positions often has to post collateral on the both the purchased and sold contracts, even though some of those contracts offset (thereby resulting in no market risk exposure.) Since collateral is costly (because it requires the dealer to hold liquid instruments with lower yields than alternative investments), the firm incurs a cost on the offsetting positions that could be avoided if these positions were netted out. Therefore, given the positions held by market participants, the formation of a CCP that nets positions economizes on collateral.

Second, as shown by Jackson and Manning (2006), the lack of netting increases the costs of replacing defaulted positions. Consider a dealer in a bilateral market who is long 1000 and short 500 contracts. Assume that the dealer defaults when the long positions are a liability to him, and the corresponding 1000 short contracts are an asset to his counterparties, and his 500 short positions are an asset to the dealer. The counterparties must replace the contracts at the prevailing market price (at which the short positions they enter have zero values, and hence are neither asset nor liability.) This is an economic loss to the victims of the default, which is reduced by whatever they realize from their claim on the assets of the defaulter, which will be less than what they are owed. It is important to recognize that these replacement costs are incurred on the entire gross position of 1000 contracts.

In contrast, in a cleared market, replacement costs are incurred only on the 500 net positions. Thus, clearing and netting reduces the losses that the defaulter’s counterparties incur to replace the defaulted positions because fewer positions (and sometimes no positions) must be replaced.

It should be noted that this “benefit” from netting is in fact a transfer, rather than a true cost savings. In the absence of netting, the non-offset in the money positions (in the example, the dealer’s 500 short contracts) are an asset to the defaulting firm. This asset can be used to pay the defaulter’s creditors, including derivatives counterparties and others. Netting reduces assets and liabilities by an equal amount; netting reduces the claims against the defaulter’s assets, but reduces the assets by an identical amount. Thus, the total loss suffered by creditors does not change, although the allocation of the loss is likely to change.

In the context of the example, without netting shorts holding 1000 contracts must share with all the other creditors the defaulter’s remaining assets, including the defaulter’s 500 short positions. With netting, in contrast, shorts holding only 500 contracts must share with all the other creditors the defaulter’s remaining assets, which do not include the 500 netted short positions. Thus, in effect, netting gives derivatives counterparties a priority claim to one of the defaulter’s assets–his winning derivatives positions–assets that they would have to share with other creditors absent netting.

An extension of the example illustrates these points. Assume that in a default, the 1000 contracts cost the counterparties $1 billion to replace, and hence the defaulter’s 500 short contracts are worth $500 million to the defaulter in the absence of netting. The defaulter has other assets of $700 million, and other liabilities of $1 billion. In a bilateral setting, the defaulter has assets of $1.2 billion, and liabilities of $2 billion. If the defaulter’s assets are split pro rata among the derivatives counterparties and the other creditors, the victims of the default receive $600 million, and hence lose $400 million. Other creditors also receive $600 million and lose $400 million.

With netting, the derivatives counterparties have a claim of $500 million ($1million on each of the 500 contracts that do not net out), and the defaulter’s assets are $700 million because netting reduces both assets and liabilities by $500 million. Pro rata division of the defaulter’s assets results in a payment of $233.3 million to the derivatives counterparties, meaning they lose $266.7 million. The other creditors receive only $466.7 million and lose $533.3 million. Thus, although netting makes the derivatives counterparties better off, it makes the other creditors worse off by the exact same amount.

Thus, netting effectively transfers wealth in a default from a defaulter’s other creditors to its derivatives counterparties. In the example, netting redistributes $133.3 million from other creditors to the derivatives counterparties. Reductions in replacement costs therefore do not reduce social costs, unless some frictions, related perhaps to systemic risks, imply that giving one set of claimants priority enhances wealth. I discuss this issue further below.

In sum, netting by a CCP benefits its members by (a) reducing collateral, and (b) reducing replacement costs. The important part of that last sentence is “its members.” It is important for two reasons. First, this is a private benefit that these firms will presumably take into consideration when evaluating the net benefits to them of cooperating to create a CCP. Second, since one of the benefits to a CCP’s members is actually a transfer from other creditors, dealers may have an excessive incentive to form a clearinghouse. This makes the absence of a CCP all the more peculiar–and supports the possibility that other costs, such as those arising from asymmetric information, exceed the private benefits of netting received by CCP members.

Netting can also affect systemic risk by affecting the scale of dealer trading activities. To the extent that that the introduction of a CCP reduces the costs dealers incur at the margin to engage in derivatives trades, dealers will trade more. By accumulating bigger positions, they can pose a greater systemic risk.

Netting can affect marginal cost in at least two ways.

First, netting reduces costly collateral. Lower collateral costs induce greater trading activity. (In the 1920s, opponents of central clearing at the CBT argued that bilateral trading encouraged “conservatism”–i.e., less trading–because it imposed higher collateral costs which restrained trading activity.)

Second, reductions in replacement costs could have a similar effect. Here the analysis is more complicated, however. Holding the terms of the dealers’ other liabilities constant, a reduction in replacement costs due to netting encourages dealers to trade more. However, the dealer’s creditors will certainly respond to the implicit reduction in their seniority resulting from clearing by adjusting the terms on which they supply capital to the dealers. Increasing the scale of trading activity increases the default costs other creditors incur. If creditors price capital appropriately, and charge the firm an additional dollar for each additional dollar of default cost they absorb as a result of an expansion in dealers’ trading activity, the dealers will internalize the cost of the transfer, and reductions in replacement costs will not distort their incentives to trade. Given the complexity of dealer balance sheets and the difficulty in evaluating total derivatives exposure, however, it is possible that other creditors will not fully recognize the implications of an expansion of a dealer’s trading activity, and underprice capital as a result. This would encourage the dealer to expand trading activity excessively, as the costs of this expansion are borne by other creditors.

To the extent that lower collateral requirements and replacement costs encourage dealers to trade more, reductions in dealer default exposures that result from clearing will be smaller than one would estimate holding positions constant. Larger positions increase default losses, offsetting in part or in whole the effect of clearing on default losses per trade.

In sum, it is clear that the distributive effects of clearing have not been widely appreciated–if they have been recognized at all. Netting via clearing effectively gives derivatives counterparties a priority claim on some of a dealer’s assets–the portion of a dealer’s positions that are offset by other positions. In a bilateral market, all creditors, not just derivatives counterparties, would have a claim on that asset. This redistributes the burden of a default from derivatives counterparties to a defaulter’s other creditors. Netting is therefore effectively a zero sum game, not a positive sum game. Moreover, the losers may not be members of the clearinghouse, which could distort the incentives to create a CCP. Furthermore, the systemic effects of this redistribution are ambiguous. Imposing additional losses on other creditors could put them into financial distress, even while it eases financial distress from derivatives counterparties. Financial distress by these creditors could also pose a systemic risk.

Thus, the debate over the formation of a CCP should be framed very differently than it has been heretofore. The appropriate question is: Should derivatives counterparties receive a priority claim on a defaulter’s assets? That is, should derivatives counterparties receive priority over a defaulter’s other creditors? The answers to these questions are not immediately obvious.

A couple of thoughts regarding clearing, both important and overlooked, methinks.   They’ve been on my mind for awhile, and I have a moment to get them off.

First, the issue of systematic risk.   The chairman of The Clearing Corp, Goldman’s Michael Dawley has stated that a central counterparty for CDS contracts would reduce systemic risk.   The article in which Dawley is quoted does not go into detail as to how a CCP would reduce systemic risk.   Presumably, by regularizing procedures and centralizing information, it would mitigate operational risks that could metastasize into systemic ones.

But let me interject a note of skepticism.   Systemic risk presumably arises because of an externality.   Private contracting decisions can lead to outcomes that jeopardize the financial and payments systems.   Damage to the payments system, for instance, can impose immense costs on individuals not parties to the original contracts that were the source of the contagion.   It is the existence of this externality that means that private contracting decisions, notably, decisions regarding the amount of risk to incur, may be suboptimal.

Such costs are external to the parties to CDS contracts in a bilateral OTC market, and are almost certainly external to a CCP, especially one owned and governed by large dealers.   That is, creating a clearinghouse does not internalize the externality that is the source of systemic risk.   Indeed, if a CCP prices risks badly (due to asymmetric information, for instance), it might actually exacerbate systemic risks.

I therefore conclude that the formation of a CCP is not sufficient to reduce substantially systemic risk, and that expectations or representations that it will (beyond the effect of reducing operational risks) are overly optimistic.

Second, consideration of the balance sheet risks in OTC markets led me to think about balance sheet risks for exchange clearinghouses.   The brokerage/FCM industry has evolved dramatically over the past decades, and now clearinghouse membership is dominated by the big banks, whereas at one time the clearing business was less concentrated, and less dominated by huge integrated financial institutions.

As I’ve written in posts about OTC clearing, these huge, integrated financial institutions have opaque balance sheets that carry a great deal of risk that is difficult for third parties to evaluate.   As clearing members, they expose exchange clearinghouses to their balance sheet risks.   Moreover, exchange clearinghouses don’t attempt to evaluate this risk (almost certainly because they lack the information to do so), and certainly don’t price it.

Thus, the evolution of the clearing business has arguably increased exchange clearinghouses’ vulnerability to balance sheet risks.   Given the potentially disastrous implications of a clearinghouse failure (and it’s not outside of the realm of possibility–both CME and CBT clearinghouses came within an ace of failure on 10/20/87), this is something that deserves some attention, but which has not heretofore.

In an earlier post I surmised that behomoth hedge fund Citadel was playing balance-of-power politics, working with the banks and against the CME by supporting the upstart ELX futures exchange, and working with the CME and against the banks in a CDS clearing venture.   In each case, Citadel was allied against the incumbent, dominant player (CME in futures, and the banks in the CDS market).

It appears that Citadel has decided this is not a viable strategy, and that it can’t play both sides against the middle.   According to a Bloomberg story by Matt Leising (not yet online), Citadel has resigned its ELX board seat.   Though it will still retain an ownership stake, it will no longer promote the ELX venture.

Presumably the deciding factors were (a) Citadel’s assessment of the likely success of the two ventures, and (b) its estimate of the profit potential of each.   One inference is that Citadel decided that the CME clearing venture is likely to succeed, and potentially in a big way, and that ELX is a much more iffy proposition.

There is definitely a case to be made for both propositions.   Although I’ve identified some hurdles that CME must overcome to make the CDS clearing venture go, most of the reporting I’ve read suggests that the exchange has the inside track.

Overall, I think this is another signal that the banks’ dominance in derivatives has been eclipsed.   Not only are their stock prices low, but their political stock is low as well.   Citadel is a savvy player, and its choice is a lot more credible statement about the current landscape than anything that I, or any other observer, can put forward; they are putting their money on the table.

My most recent clearing post explored the possibility that the formation of a clearinghouse for OTC derivatives is efficient, but that distributive considerations and collective action problems have heretofore prevented its formation. In this post, I consider the possibility that the costs of formation of an OTC clearinghouse (for CDSs, for instance) exceed the benefits.

A central counterparty (CCP) is a default risk sharing mechanism. In a typical CCP setup, a group of intermediaries who trade on their own account and as agents for customers share default risk among themselves. If a customer defaults, the intermediary through whom that customer clears bears the loss. The risk sharing mechanism kicks in only if the one of the CCP member firms defaults.

Two factors drive the default risk that the CCP members share. The first is the riskiness of the instruments that are cleared. The second is the riskiness of the balance sheets of the member firms. A default occurs only if (a) a member firm incurs a loss on its position(s), and (b) this loss exceeds the value of the other assets (net of liabilities) that the firm can draw upon (e.g., sell) to cover this loss. Thus, the members of a CCP take on an option-like exposure, where the option is a complex one with a payoff that depends on multiple factors, namely, the prices of the instruments cleared and the values of the other assets and liabilities in each member’s portfolio.

Recent events (though not in the context of a CCP) indicate that both sources of risk are important in determining the likelihood of default. Lehman and Bear Stearns defaulted on their derivative obligations not because of losses incurred on these derivatives, but because of losses incurred on other investments (primarily mortgage securities). In contrast, AIG collapsed because the huge losses on derivative positions overwhelmed the capital on its otherwise healthy balance sheet.

To operate effectively, any risk sharing mechanism must price risks appropriately. Mispricing of risks provides perverse incentives. If the default risk posed by a particular member of a CCP is underpriced, that member will trade excessively, thereby imposing excessively large risks of loss on the other members.

It should be noted that in practice CCPs typically do not charge different members different fees to reflect differential risks. That is, there is no “experience rating” of clearing fees. Instead, CCPs price risk indirectly by choosing collateral (margin) levels and capital requirements. Since the CCP is effectively a risk sharing mechanism, where the risks are not priced directly and “premiums” do not flow from one member to another, a CCP ideally sets collateral and capital levels so that the expected default cost is the same across all members. By doing so, there are no wealth transfers across members. Failure to do so leads to a transfer of wealth from one set of members to another.

Even though CCPs do not price default risk through insurance premia, as a convenient shorthand I will refer to the pricing of default risk by the CCP, with the understanding that this pricing is indirect through the setting of collateral.

Information asymmetries challenge any risk pricing/insurance mechanism. If the insured (i.e., a clearing member) has better information about his risks than the insurer (i.e., the CCP), he will trade too much and hold positions that are too big when his information indicates that the insurance is underpriced, and trade too little and hold positions that are too small when his information indicates that the insurance is overpriced. Asymmetric information problems usually result in incomplete insurance of risks. In the extreme, information asymmetries and the associated adverse selection and moral hazard problems can make risk sharing inefficient altogether.

In the context of a CCP, asymmetric information about the instruments traded and the balance sheets of the dealer firms that trade them–and who would be the members of a CCP–impedes the sharing of default risk. The severity of these information problems can vary by instrument, and by the nature of the firms that intermediate the trading of these instruments. An examination of CDSs in particular, and more exotic derivatives in general, strongly suggests that asymmetric information about both risks is likely to be acute. This tends to reduce the net benefit of introducing a CCP for these products, and may make this net “benefit” negative, especially when the costs of establishing and operating a CCP are considered.

First consider the issues relating to the risks of a particular type of instrument. To price risk, a CCP uses information on (a) the risk-return characteristics of this instrument, and (b) the current price/value of the instrument. Given the current value of the instrument, and holding the (true economic) capital of a member firm constant, the likelihood of default depends on the probability distribution of returns on the instrument and the size of the position. Therefore, margin setting/risk pricing depends on information regarding the price behavior of the instrument. Moreover, information about the current price of the instrument is important. A CCP uses an estimate of market price to adjust collateral. Using an incorrect price leads to an incorrect estimate of the gain or loss on a position, and therefore to an incorrect determination of the risk exposure, and relatedly, the collateral level.

For homogeneous, linear, traditional instruments traded in liquid, transparent markets, a CCP is likely to have information on these variables that is nearly as good as, and perhaps better than, that in possession of its members. For an actively traded instrument (e.g., S&P 500 futures), transactions are numerous and observed, so positions can be marked to current value with no difficulty. Moreover, extensive historical data is readily available to calibrate risk models, and “rocket science” modeling is not necessary to estimate these risks. Thus, for such instruments, centralized clearing is unlikely to face severe adverse selection problems, and risks can be priced correctly. One would expect to observe central clearing for such instruments–and one does.

Things are quite different for exotic instruments. These instruments are traded less frequently, and so current market price information is harder to come by. Indeed, at times, there may be no transactions, so it is necessary to “mark-to-model” rather than “mark-to-market.” Moreover, sophisticated modeling is necessary to quantify and understand the risks of these instruments.

This pricing complexity is likely to be an important issue for credit derivatives, especially on individual names. The products are relatively new. Often they are not traded in high volumes in liquid transparent markets. Marking to market is not a trivial exercise as a result. Moreover, understanding the risks of these things is difficult. This is particularly true for portfolios of these instruments, due to the potential for default dependence between different instruments (i.e., the unconditional risk of default of a single instrument is not sufficient to determine the risk posed by a CCP member with positions in multiple instruments; you need to know about the correlations across instruments, and these dependencies are especially tricky to model and calibrate with credit products).

Big dealer firms specialize in developing models designed to quantify and characterize these risks. Moreover, these dealers expend resources to develop the data to calibrate and test these models. They have strong incentives to develop good models, as with better models they can manage their own risks better, and perhaps generate higher trading profits. Therefore, it is highly, highly likely that for a product like CDSs, dealer firms that engage in proprietary trading of these instruments will have better models and better information than a CCP.

To reiterate something I’ve said in previous posts, this is not to say that these models are great in some absolute sense. The key issue in risk sharing is asymmetry, which depends on the relative quality of information. If a CCP member has a better model than the CCP, there is an information asymmetry problem, even if the former’s model is, well, pretty bad. As I’ve said before, the one eyed man is king in the land of the blind.

(For an illustration at the problems associated with third party’s attempts to evaluate the risks of heterogeneous, complicated, non-linear derivatives, consider the rating agencies’ disastrous experience with CDOs, and monoline insurers.)

Thus, in my view, it is almost certainly the case that for exotic derivatives, and for CDSs in particular, dealer firms that make markets in these products have much better information about their values and risks than would a CCP. This creates the potential for adverse selection, which reduces the benefit of default risk sharing through a CCP.

It should also be noted that big dealer firms that (a) are the primary intermediaries in exotic derivatives and CDS products, and (b) would be the members of any OTC derivatives clearinghouse, are very complex financial firms with relatively opaque balance sheets. They are in the business of providing information intensive intermediation, through their loans, investments, and trading. As a result of this information intensity, it is challenging for third parties to appraise their balance sheets, and quantify the risks associated with those balance sheets. It is certainly the case that the intermediaries (banks and investment banks and in some cases insurance companies) have better information than third parties about the value of the assets and liabilities on their balance sheets, and the risks of those assets and liabilities–including the correlations between those asset and liability values and the values of derivatives positions on its books.

This means that if a CCP’s members are complex dealer firms engaged in information intensive intermediation, the potential for asymmetric information about balance sheet values is acute.

Put these two things together, and it is evident that the formation of a CCP to clear exotic products, including credit derivatives, and which has big financial institutions with complex balance sheets who supply information intensive intermediation, faces far more daunting challenges than a CCP clearing “vanilla” products and which has simpler firms has members. The pricing of risk is almost certainly far more difficult, and more importantly, the potential for information asymmetries is far greater. Thus, adverse selection problems would almost certainly be far more acute if the big dealer firms formed a CCP to share default risks for credit derivatives and other exotic products.

This suggests caution is in order in moving towards a CCP structure in CDS products in particular. Myriad regulators, market participants, commentators, and legislators have seized on central clearing as the panacea for these products. There has been little–if any–recognition in the public debate of the special challenges that these kinds of products and the institutions that trade them would impose on a central clearing mechanism. Thus, it is quite possible that a CCP has not been adopted for these products is not due to the selfishness of dealers who fear that clearing would increase competition for them, but instead reflects a sober appraisal of the greater costs of sharing default risks for these products.

A couple of other points are worth noting. First, traditional CCPs typically do not vary risk pricing (i.e., collateral levels) to reflect the balance sheet risks specific to each member firm. CCPs typically set collateral levels based on the risks of the instruments held in each member’s portfolio of cleared products, and two members with the same portfolio would post the same collateral even if their balance sheet risks are quite different. CCPs do impose some constraints on balance sheets, but normally through capital requirements that are simply a function of collateral levels. For instance, the CME clearinghouse sets minimum member capital equal to a multiple of the member’s margin level. Importantly, it does not vary capital requirements or collateral levels based on assessments of the balance sheet risks of member firms. Thus, in most CCPs balance sheet risks are not priced.

This may not be a big problem when CCP members are relatively simple–and relatively homogeneous–firms with relatively simple and transparent balance sheets. Many futures commission merchants and securities firms that are clearing members fit this characterization. Some are subsidiaries of complex, broad-based intermediaries, but from the perspective of the clearinghouse, the relative simple balance sheets of the actual member firms are what matters.

If big banks and investment banks continue to dominate intermediation of CDS and exotic derivatives, the members of any clearinghouse for these products will inevitably be firms with complex, opaque balance sheets, for which asymmetric information is likely to be quite acute. Simply adopting futures and options CCP practices will not be adequate for this business. Moreover, I have serious concerns that the difficulties in assessing and pricing balance sheet risk will seriously impair the effectiveness of a CCP for credit derivatives.

The second point is that it is incorrect to say that default risks are not shared among dealers in a bilateral OTC structure. Dealers trade with dealers. I daresay that big dealer firms had the biggest exposures to Lehman, Bear, and AIG. Inter-dealer trade means that default risks are shared among the dealers who would be the members of a clearinghouse even in a formally bilateral market.

This has an important implication. Specifically, the choice between a “bilateral” and “centrally cleared” market structure is a choice between different ways of sharing default risks among dealers (and between dealers and customers); it is NOT a choice between interdealer sharing and no interdealer sharing.

Thus, it is imperative to analyze the comparative costs and benefits of these alternative sharing mechanisms. This is a multi-faceted problem, but I will focus on one issue, one that I think is of primary importance.

In a CCP structure, the CCP is responsible for evaluating the balance sheet and product specific risks of each member firm. That is, there is a centralized risk evaluation and risk pricing mechanism. In contrast, in a “bilateral” market, each dealer firm makes individualized assessments of the product specific and balance sheet risks posed by each counterparty. Moreover, since dealers trade with one another, each dealer assesses and monitors the counterparty risks of each of the other dealers.

Centralized monitoring has one clear benefit–there is no duplicative monitoring. Each dealer is evaluated once. In contrast, in a bilateral market, each dealer assesses and monitors every other dealer, meaning that for N dealers there are 2 to the power N monitoring costs incurred.

However, decentralized monitoring likely has a substantial benefit when complex financial institutions trading complex products are involved. These firms interact with one another in many markets, and have various sources of hard and soft information about the balance sheet risks of its counterparties. This information is almost certainly superior to what a clearinghouse is likely to collect. Moreover, since due to the complexity of the balance sheets of the big dealer firms, any individual firm’s assessment of the balance sheet risks of another is likely quite noisy. Multiple signals should be more precise than a single one. Therefore, monitoring by multiple counterparties generates information that is likely to be collectively far more precise than the information collected by any one. If this information can be aggregated in some way, multiple counterparty risk assessments in a bilateral market can be far more efficient than a single risk assessment by a CCP. (The mechanism for aggregation is a complicated subject in itself. Dealers will make inferences from the actions of others. If dealer A cuts back on trading with B, or decides not to trade with B altogether, dealers C, D, etc., will make inferences about A’s information regarding B’s performance risk. One issue that deserves study is whether this aggregation method encourages information cascades that can lead to inefficient outcomes.)

Furthermore, dealers in bilateral markets can–and do–charge counterparty-specific prices for balance sheet risk. Specifically, they require different counterparties to post different amounts of collateral, where variations in collateral levels across counterparties reflect both product-specific risks and the particular balance sheet risks of each counterparty.

(Member-specific collateral levels in a CCP setting would also put tremendous stress on the governance of a clearinghouse. Each member would have an incentive to influence the CCP to impose higher collateral requirements on competitors. Heterogeneity puts stress on collective/cooperative bodies such as clearinghouses. Even though institutional mechanisms such as the non-profit form can mitigate heterogeneity-driven rent seeking in such organizations, it cannot eliminate it, and these rent seeking costs are typically greater when members are heterogeneous.)

This analysis raises the question of whether it is efficient to bundle the trading of these instruments with the supply of information intensive intermediation. Big banks and investment banks with opaque balance sheets (due to the information intensity of their various financing and trading activities) pose greater balance sheet risks than would simple, “vanilla” intermediaries that specialize in trading these derivatives and eschew other activities.

But we don’t see such simple, vanilla, boutique intermediaries. I think that for a variety of reasons this makes sense, as there are likely scope economies between trading things like CDSs and offering other forms of financial intermediation. After all, banks specialize in evaluating credit risk, and the resources and skills used to do this in lending and underwriting can be put to use in valuing and assessing the risk of derivatives, and most particularly, credit derivatives. Moreover, there are scope economies in modeling and risk evaluation. Thus, I think a strong case can be made that bundling of intermediation of complex derivatives (and especially credit derivatives) with the supply of other information intensive financial intermediation activities is efficient.

In sum, before charging ahead with a CCP for credit derivatives and other exotic products, it is worthwhile to step back and ask why this hasn’t happened before now. Sure, it may reflect inefficient strategic behavior by dealers and collective action problems. But it may be the result of high costs of centralized risk sharing for complex products traded by firms who supply information intensive intermediation, and therefore have somewhat inscrutable balance sheets and balance sheet risks.

I have serious reservations about the efficiency of a CDS clearinghouse consisting of big banks/investment banks. Balance sheet risks are a big deal when such firms are involved, and traditional CCPs have not priced these risks (or have priced them in a very, very crude way.) Moreover, the risks of the instruments themselves will be difficult for a CCP to quantify. Indeed, sometimes it will be difficult for the CCP just to determine the market value of these instruments. (Which is why firms like Markit are included in CDS CCP proposals.) Given the instruments, and the firms trading them that would be in a clearinghouse, risk pricing will be extremely difficult, and beset by asymmetric information problems. To me, it is by no means clear that centralized assessment, pricing and sharing of position and balance sheet risks is more efficient than decentralized, “bilateral” assessment, pricing and sharing of these risks.

This argument may seem somewhat Panglossian–to some it may appear that I am suggesting that we live in the best possible world, and intervention to change performance risk sharing mechanisms is therefore unwarranted. I would disagree with that characterization. Suffice it to say that starting from the basics of risk sharing economics, and analyzing the specifics of credit derivatives and other exotic products, a strong argument can be made that a bilateral OTC market structure is efficient relative to alternative structures, including a CCP-based system. To put things in legal terms, I should think that the burden of proof should lie on those who implicitly or explicitly assert that the existing market structure is inefficient compared to a realistic alternative.

And I will close by noting that some practitioners with skin in the game share reservations similar to those I have expressed here. This Bloomberg article by Matt Leising quotes “electronic trading pioneer” Thomas Peterffy’s objections to the CME’s proposal to clear CDS products. Long time Chicago broker Chris Hehmeyer (CEO of FCM Penson GHCO) is also “balking at” this initiative. Peterffy “doubts that the exchange will be able to determine CDS pricing because they trade infrequently.” Although neither Peterffy nor Hehmeyer (or David Rutter, also quoted in the article) mention the very different balance sheet risk posed by big CDS dealers, I wouldn’t be surprised if that’s a concern as well. Though they aren’t quoted as saying so, these gentlemen have to realize that when the big dealers clear CDS products, the other members of the clearinghouse–firms like theirs–not only bear the risks associated with the CDSs, but also the risks associated with subprime, or CDOs, or whatever happens to be floating the banks’ boats at the moment. This cannot be a comforting thought.

So, before we rush in to create a CDS clearinghouse, it behooves us to examine carefully the risks of doing so. Not all instruments and not all intermediaries are created equal. Some are well-suited for the sharing of default risk through a central clearing mechanism. Others are more problematic. Credit derivatives are among the most problematic of all. Creating a central counterparty without a full assessment of the unique challenges that these products pose is itself a risk–a risk of a train wreck somewhere down the line when the mispricing of default insurance encourages excessive risk taking, and a member (or members) of the clearinghouse defaults. Conditional on the probability of default, a central counterparty is probably the efficient way to bear risk. But if the CCP prices risk wrong, it could increase the probability of default and actually create more problems than it solves.

Do I know this will happen for certain? No, I don’t. But I do think there is considerable basis to conclude that it is a serious possibility. So before venturing down the CDS CCP road, it would be advisable to (a) give this issue serious attention, and (b) design the CCP to mitigate these problems.

In the midst of the credit crisis, it has become conventional wisdom that OTC derivatives, especially credit derivatives, should be centrally cleared. Like Dudley Dooright, the central counterparty (CCP) will come in and save the day. Given that this idea is supported by many people who had probably never heard of clearing until quite recently, there is room for doubt that these high expectations are grounded in a firm understanding of what clearing is and what it entails.

I will explore various aspects of OTC clearing in several posts, of which this is the first.

The motivation behind these posts is a simple question: If clearing is so obviously wonderful,why has it not been adopted before this?

I think there are two answers to this question, answers which are not mutually exclusive. The first is that clearing would be welfare enhancing, but as a result of some collective action problem it has not been implemented. The second is that there are costs and benefits to clearing, that these costs and benefits vary by product, and for some products, the costs exceed the benefits.

The public policy implications of the two alternatives are obviously quite different. The first provides a justification for robust government intervention: the second does not. I think that both factors have an element of truth. This implies that there is a basis for government involvement, but that considerable care should be exercised.

I have explored both questions in my academic work, and will draw upon that work in drafting these posts. I have recently done more work on the collective action issue, and will report the results of that analysis for the first time in the blog; I will write up the results of the analysis more formally in the coming weeks.

This post focuses on the collective action issue. If clearing is welfare enhancing, but it has not been adopted due to transactions costs/collective action problems, then arguably a case can be made for regulatory or legislative initiatives to encourage–or even force–its creation. Indeed, one can argue that the NY Fed’s frantic efforts in recent weeks to push market participants towards creation of a CCP reflects such a belief.

I first mooted the possibility that CCPs were not adopted due to some sort of collective action problem in a working paper in 1997. I also mentioned this idea in a more recent paper. The basic idea was that clearing could have distributive effects, most particularly, redistributing wealth from well capitalized firms to less well capitalized ones. This could occur if clearing leveled the competitive playing field by eroding the competitive advantage held by well-capitalized OTC dealers.

In my earlier work, this argument was made verbally. It is not an easy thing to formalize it, but I have made some progress in that direction. The model is a relatively simple one. There is a representative agent hedger, with CARA utility. The hedger has an endowment of a risky asset. There are two risk neutral dealer firms. These dealers are risk neutral, and have no endowment of the risky asset, but they have limited capital. Their capital is also risky. Therefore, if they enter into derivatives contracts, they may default as their losses on their derivatives positions may exceed their capital.

The two dealers have different starting capitals. There is a large dealer and a small one. The volatilities of the firms’ capitals can also differ. The dealer capitals are imperfectly correlated.

The dealers incur operational costs to execute derivatives transactions. For simplicity, these costs are quadratic in the quantity of contracts executed. Although the dealers have different capitals, I assume that they are equally operationally efficient. That is, their costs of execution are the same for a given number of transactions.

It is well known that a defaultable derivatives contract, such as a forward or swap, is effectively an option. In this model, the hedger that buys a forward contract from a dealer actually enters into contract with a payoff equal to the minimum of the payoff on a non-defaultable contract, and the counterparty-dealer’s capital.

Due to this optionality, the problem is inherently non-linear, and even assuming CARA utility, must be solved numerically. Therefore, since that nettle has already been grasped, there is no need to make the drunk-looking-for-his-wallet-under-the-lamppost assumption of normality in the distribution of the price of the risky asset, or the values of the dealers’ capitals. Normality facilitates the determination of closed form solutions in linear problems, but since this problem is non-linear that is of no help. I therefore utilize more realistic assumptions. I allow for heavy-tailed and skewed price distributions, by assuming that returns on the risky asset are characterized by a negatively skewed normal inverse Gaussian distribution. (This means that crashes are more likely that upward spikes in prices, as is the case for equity indices.) I assume that dealer capitals are characterized by fat-tailed Student-t distributions. Skewness and kurtosis are realistic features of real markets, and may provide an important reason to hedge and affect the likelihood of default. The world is not normal, and non-normality is especially important in this context.

I first solve for equilibrium in a bilateral OTC market. I assume that all parties are price takers. The resulting equilibrium is quite sensible. The hedger trades more with the firm with the greater capital, and sells at a higher price to the less-well capitalized firm. That is, since the deals are negotiated individually, and since the counterparties are heterogeneous, the terms of trade and quantities of trade differ. The hedger sells more at a lower price to the advantaged well-capitalized firm.

I next solve for equilibrium in a cleared market. In the cleared market, the two dealers form a CCP and share default risk. If one firm defaults, the other party covers the loss, up to the amount of its capital. The hedger suffers from a default only if the dealers’ collective losses on their trades is larger than the sum of their capitals.

The details of possible sharing arrangements under a CCP are complex, and potentially varied, so I simplify matters by assuming that the CCP allocates trades among the two so as to maximize joint profits. This would require some sort of pricing mechanism, or some other means of allocation, which is not modeled specifically. I do turn attention to the possible pricing issues later.

Due to the equal operational efficiency of the two firms, the efficient outcome is for the output of the two dealers to be equal. In the clearing equilibrium, (a) the hedger trades more, (b) the output of the small capital dealer goes up, and (c) the output of the large capital dealer goes down. Moreover, the price at which the large dealer buys goes up slightly, and the price at which the small dealer sells goes down. The hedger’s expected utility rises, and joint profits of the dealers are higher because (a) total output is higher, and (b) total costs go down due to a more efficient allocation of output across the dealers. There is also a more efficient allocation of risk, and the incidence of default falls, even though the scale of trading rises, because of the diversification of the dealers’ capital risks.

In brief, the formal model, solved numerically, generates results along the lines of what I laid out informally in the earlier working papers.

The implications are quite striking, and important. Implementation of a first-best risk sharing mechanism improves welfare (obviously) but redistributes wealth from the large dealer to the small dealer. The small dealer’s smaller capital makes him a less desirable trading party for the hedger, even though from a social perspective diversification and operational costs make it efficient for the hedger to split his trades between the two dealers. That is, from a welfare perspective, pooling of the dealers’ capitals is efficient as it facilitates efficient allocation of output across dealers. (This raises the question of why don’t the dealers just merge? Well, merger of all the dealers into one would effectively create a clearinghouse. Moreover, there may be sources of diseconomies of scale and scope not captured in the simple, formal model that mean that sharing of risk via a clearinghouse is a more effective way of pooling capital for default mitigation purposes than a formal merger.)

Since the joint profits of the dealers are higher under clearing, the small dealer’s profits rise more than the large dealer’s profits fall. In the absence of transactions costs, the dealers would execute a Coasean bargain that would make both better off, and one would expect the CCP to form.

However, it is well known (see particularly Libecap’s work–some done with Steve Wiggins–on the creation of property rights in natural resources), that distributive effects can interfere with the creation of efficient property rights. The common pool problem in oil (which I discussed in earlier SWP posts) is a classic example of this. Even though unitization of oil fields–the efficient allocation of output across potential producers–maximizes joint profits, it has proved devilishly complicated in practice for competing drillers to consummate this wealth-enhancing bargain, due to the tussle over rents.

Moreover, due to the complexities in bargaining, and the potential costs of enforcing any arrangement among the firms, the dealers may arrive at a pricing or trade allocation structure that limits the distributive impact of the formation of a CCP. In the stark model, however, any such deals reduce welfare. Thus, even if a CCP is formed, it may not achieve the efficient outcome. Alternatively, the feasible bargaining outcomes may not include the efficient outcome. If there are fixed costs to implementing the CCP, it may not form.

In particular, as I have shown in my work on exchanges (JSTOR access privileges required), coalitions of heterogeneous firms create the potential for redistributive rent seeking. As a result, organizational form and governance structures for coalitions of heterogeneous firms are usually crafted to mitigate the potential for such redistribution. The resulting structures and pricing mechanisms may not be first best.

It should also be noted that even though CCPs are typically formed as coalitions of dealers, some of the benefits flow to (in the model) hedgers. That is, CCPs are usually coalitions of sell-side firms, but the benefits of CCPs spillover to buy side firms. Again, since the CCP is first best (in the model), there is a potential grand bargain that makes the buy side and the sell side firms better off. This only expands the bargaining complications, however.

Thus, one explanation for the failure to adopt a CCP in OTC derivatives is that even though it is efficient, collective action and bargaining problems have impeded, and in some cases precluded, its creation. Distributive effects can preclude the adoption of efficient organizations and institutions. The model shows that the adoption of clearing can have pronounced distributive effects. Therefore, the failure to adopt clearing may reflect the effects of distributive effects and rent seeking behavior that impede collective action.

In this situation, government action (and essentially, government can serve as a mechanism to reduce the costs of collective action) can improve welfare to the extent that it reduces transactions/coordination costs.

In essence, government is just another mechanism through which parties can act and bargain to achieve a given outcome. Government possesses coercive powers. Moreover, especially in democratic/republican polities, a broad array of interests can influence/bargain through the government. This can be important, and sometimes result in enhanced efficiency–though it can reduce efficiency at other times. In the present instance, for example, buy side firms that would benefit from the formation of a CCP can exert influence on various government entities (the Fed, Treasury, the legislature), and beseech the government to employ its coercive powers to advance the interests of these firms. It may be cheaper for these firms to bargain through the government, than directly with the sell side firms.

This analysis reflects the strongest case for government intervention to, ahem, encourage the formation of a CCP for credit derivatives, and other products traded OTC. But one must be careful. Clearing is a risk sharing arrangement, and it is well known that risk sharing arrangements are often plagued by adverse selection and moral hazard costs. These costs can vary depending on the type of risk being insured. These costs reduce the amount of risk sharing, and in some cases, can make it better not to share risks at all. Thus, the failure to form a CCP that shares default risks for some products may also be due to the fact that moral hazard and adverse selection costs are so large as to make risk sharing inefficient. I will consider that possibility in the next post, and argue that this possibility is particularly pertinent for products like credit derivatives. Thus, the benefits of the formation of a CCP for these types of products may be substantially smaller, and the case for government intervention weaker, than the collective action problem-focused analysis of this post suggests.