Streetwise Professor

March 9, 2011

Clearing Mandates, Credit, Capital Structure, and Systemic Risk

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 1:31 pm

John Parsons and Antonio Mello have a series of posts taking aim at the notion that requiring end users to post collateral on derivatives trades will impose a large burden on them that will cause them to reduce real investment.  Their basic point is that OTC derivatives trades often embed an unsecured credit line, and that firms that are forced to post collateral can fund it with an explicit borrowing transaction and/or credit line. This ability to substitute one form of credit for another should dampen the impact of clearing and collateral mandates on corporate end users.

I agree with the essential point.  It was one of the reasons why I long ago opined that requiring AIG to post collateral (initial margin/independent amount) likely would not have materially caused them to reduce their positions in CDS because they would have been able to borrow–and would have wanted to borrow–to fund that collateral.  Less debt in one portion of the balance sheet would have made it possible to borrow more in other ways.  I discussed that point more generally in my Cato Policy Analysis piece.

I further agree with Parsons’ and Mello’s conclusion that this means that looking at the total collateral that end users will be required to post is a misleading measure of the financial burden that collateral, clearing, and capital requirements will impose on end users.

That analysis is as fine as it goes, but it’s worthwhile to push it further–much further.  In particular, to push it to examine the effects on systemic risk, which Parsons-Mello also (rightly) identify as the key driver of the ultimate impact for good or ill of clearing mandates.

There are a couple of cases.  In the first case, firms have access to perfect substitutes for the unsecured credit embedded in many OTC derivatives trades.  In the second, there are not perfect substitutes.  (It seems to me that M-P believe there are pretty close substitutes–feel free to correct me if I’m wrong, guys).

In the first case, clearing mandates and required collateralization will have no appreciable effects.  Firms will just substitute an economically identical form of financing/credit for the proscribed bundled credit.  New labels will be slapped on old bottles.

But that means that the systemic effects of the mandates will be minimal–and perhaps non-existent.  That’s because the mandates will not affect the quantity, character, and crucially, fragility of the capital structures of either end users or financial intermediaries.  The same banks will end up extending the same amount of credit of the same risk characteristics to the same counterparties. It will just go by a different name.

In the second case, where there are not perfect substitutes, things are much more complicated.  Firms will adjust on many margins.  They will substitute different kinds of financial claims (debt and equity) for the proscribed financing embedded in derivatives: the systemic effects of this are very difficult to know.  Firms will engage in less risk management, most likely: again, the systemic effects, and efficiency effects more broadly considered, are hard to predict.  And yes, firms will likely reduce the scale of investment as limited pledgeable capital will be diverted from supporting real investments into liquid assets to support derivatives positions.

It is interesting to note that corporate end users–manufacturers, airlines, energy companies, and the like–have been the most outspoken critics of clearing mandates and margin requirements, while financial firms have been relatively mute on the subject.  This is particularly interesting given that to address end user concerns, CFTC Chairman Gensler has emphasized that financial firms are the main targets of the mandates and margins.

To me, this makes sense in light of the foregoing analysis.  Banks and other financial institutions likely can substitute other forms of unsecured credit for credit bundled in derivatives trades more readily than can end users.  Banks engage in massive amounts of unsecured credit transactions (e.g., interbank funding) with other banks with which they trade derivatives and extend and receive embedded credit.  (Many interbank trades are not collateralized.)  A mandate that says “thou shall not extend unsecured credit via derivatives trades” is unlikely to be hugely burdensome on the banks, because they will just increase other unsecured  financing to substitute for the decreased credit embedded in derivatives trades.  It is plausible that end users have fewer such options.

Why might end users have poorer substitutes?  Here are some conjectures.

For one, the mandates may reduce the set of firms from which end users may obtain credit.  Consider a firm that is looking to hedge natural gas prices.  It can do a swap with Goldman, sure, but it it can also do a trade–and get credit from–BP, or Cargill, or myriad other firms.  With the mandate, the firm won’t be able to get credit from those counterparties.  It may still trade with them, but it would have to finance the necessary collateral either out of its own resources or by borrowing from a bank.

This creates many potential difficulties.  For instance, due to concentration limits and other factors, any given creditor may incur increasing marginal costs to extend financing to a given borrower.  This means that it is often more efficient to get a given total amount of credit from multiple sources, rather than just one.  Reducing the number of potential suppliers of credit can therefore raise the costs of credit.

Moreover, narrowing the sources of potential credit may expose end users to greater opportunism.  It is well understood that banks obtain information about the firms that they finance which gives them an advantage over other potential sources of credit.  They can exploit this information advantage opportunistically.  Firms seeking credit can limit their vulnerability to such holdups by dealing with multiple creditors.  Margin and clearing mandates that force end users to get credit to support derivatives positions through banks may therefore increase their vulnerability to holdup–thereby inflating the cost of trading derivatives.

I also wonder whether the credit embedded in derivatives trades is likely to represent a more robust commitment to extend finance in the future than other forms of unsecured lending.  This is more conjectural, but I find it a plausible conjecture.  If the suppliers of other forms of credit can more readily renege on commitments to supply liquidity to support a derivatives position, the liquidity and funding risks are greater in a clearing/margin mandate world.

These are just thoughts off the top as to how bundled and unbundled credit can differ.  I suspect that there must be some difference, at least for end users, based on revealed preference grounds.  This essentially turns the Parsons-Mello point on its head.  If the form of credit associated with a derivatives position is a matter of indifference, why do we see a decided preference among many users for non-collateralized trades that bundle credit from the counterparty?  Why are end users so vociferous in their opposition (granting that some of their vociferous arguments don’t really hold water)?

But these are the kinds of questions that have to be addressed to understand fully how clearing and collateral mandates are going to work.  And these are the kinds of questions that the advocates of the mandates haven’t even acknowledged, let alone answered.

There’s another issue here that deserves special attention.  Clearing and margin mandates must be met by the posting of high quality, liquid collateral such as cash and Treasury securities.  Where is the increased supply of these instruments going to come from?  (Manmohan Singh at IMF has written about this issue.)

Here I think that the Holmstrom-Tirole distinction between “inside” and “outside” liquidity is important.  They distinguish between liquidity supplied within the corporate sector (“inside liquidity”) and liquidity supplied by households, or through the government (via taxing the household sector) (“outside liquidity”).  My thoughts here are very preliminary–this is really thinking out loud–but I sense that the effects of clearing mandates on inside and outside liquidity is actually the crucial issue, and one that deserves probing analysis by knowledgeable people.

One plausible conjecture is that much of the liquidity that currently supports derivatives trading is inside liquidity, and that mandates, by requiring posting of collateral in the form of cash and high quality securities, will increase the demand for outside liquidity.  Some of this may be supplied by the corporate sector as they adjust investment policies to favor more liquid assets.  But a good portion will have to come from the household sector or the government sector.

This is unsettling.  It is unsettling in part because it means that the efficiency of derivatives markets will be intertwined even more closely with fiscal and monetary policies that affect the supply and demand for outside liquidity.  It is also unsettling because as Gary Gorton, Bengt Holmstrom, and Jean Tirole (and others) have argued, one impetus for securitization–including subprime securitization–was the need for high quality collateral, i.e., it was a response to demand for liquidity from the corporate/financial sectors. To the extent that clearing and margin mandates make the corporate and financial sectors more dependent on outside liquidity, it would tend to drive a similar dynamic.

Moreover, when systemic risk is considered, correlated/aggregate/macro shocks are the most difficult to address through the design of liquidity supply mechanisms.  If we are worried about the financial system’s vulnerability to aggregate shocks–more generally, shocks that can’t be diversified away within the corporate sector–we have to think seriously about legislative and regulatory changes that may affect the reliance of the corporate/financial sector on outside liquidity.

In sum, I think it is worthwhile to think long and hard about some of the indirect effects of clearing mandates–especially their effects on capital structure and the demand for liquidity, particularly specific forms of liquidity.

To try to close the circle here, Mello and Parsons analyze a crucial issue: the effects of clearing mandates on capital structure.  In a Modigliani-Miller world, this wouldn’t matter, and that might be their point.  But if capital structure is relevant, legislatively mandated changes in the way companies finance themselves and the way credit is extended and used will have real effects.  What’s more, some of these effects may be systemic.  After all, research on systemic risk focuses on the ways that imperfections in financial markets can lead maximizing firms to choose capital structures that lead to inefficient, and often destabilizing, responses to economy-wide shocks.   Therefore, to understand the systemic effects of major policy changes like mandatory clearing and collateralization of derivatives trades, we need to understand how these policies will affect financial contracting generally.  I don’t think we understand even remotely what those effects will be.  I am far from convinced that those effects will be salutary, or even benign.  But that’s the kind of thing academics and policy makers should be focusing on.

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  1. […] starve Dodd-Frank.  This mandated clearing aspect is not well thought out and will lead to big problems down the […]

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  2. The fact that OTC derivatives trades contain an embed of an unsecured credit line is not a new concept to players in the derivatives market. Whether a firm chooses to extend credit to a derivatives counterparty or to post collateral with a central clearing house should be immaterial as long as the firm extending the credit line recognizes the asset/ liability pursuant to FAS 157. Posted collateral would be disclosed on the balance sheet of a derivatives counterparty just as bilateral credit would be. The difference between the two would be the liquidity of posted collateral, but if a counterparty doesn’t value the liquidity, why should a government imposed mandate create the added cost of financing the collateral position held by the clearing house?

    The meltdown in the financial sector wasn’t caused as much by the concentration of counterparty risk amongst a few financial firms (Lehman, AIG, etc). It was the failure of the counterparties to disclse the risk of the underlying positions that caused the problem. Lehman had a hole in its balance sheet on the order of $150B. AIG horribly mispriced CDS risk. Concentrating the same bad risks into a clearinghouse and then having the government back up the clearinghouse wouldn’t cause market risk to disappear. What would reduce the risk would be better disclosure and more eyeballs on the balance sheets of derivatives counterparties. Forcing derivatives into a clearinghouse will result in the same problems as backing up bank deposits with FDIC insurance. Counterparties will simply ignore the risk and look to the government to make them whole if any losses occur. Bilateral credit diffuses the credit risk amongst counterparties and makes shareholders liable for losses. Whether the government backs up AIG or a central clearinghouse is immaterial as long as government can’t recognize excessive risks that the taxpayers are going to be on the hook for. Before we champion derivatives clearing as the solution to the problem, why don’t we look at who is going to oversee the clearinghouse. Until the regulators are made more robust, where we direct market risk won’t reduce any risk whatsoever.

    Comment by Charles — March 10, 2011 @ 8:35 am

  3. This post is right on the money prof. It should also be noted that the scope of mark to market collateral at most OTC CCPs will be cash in the currency of the contract only. Thus increasing further the funding and liquidity risks on those end users who do not enjoy direct access to the discount window.

    Comment by Greenwich Tiger — March 10, 2011 @ 8:41 am

  4. […] (University of Houston), a specialist in the organization of exchanges and commodity markets, reviews our position in his blog Streetwise […]

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