Streetwise Professor

November 3, 2008

Clearing My Mind

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 3:09 pm

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.

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