Streetwise Professor

Jeff Carter at Points and Figures wrote a nice post on my Cato clearing piece, for which I am appreciative. He is pretty much in agreement with me that mandates are a bad idea.  He is concerned with the command-and-control mindset inherent in Frank-n-Dodd, and supports the development of voluntary “Coasean” approaches.  Hear, hear.

Jeff does take issue with my characterization of the way that CCPs work today:

That meant that if you blew up, and caused major losses you could not afford, the rest of the clearinghouse members would have to pony up cash to cover the loss. If the loss were big enough to blow through all the cash that all the members had, the clearing house would go bankrupt. There hasn’t been a bankrupt clearing operation in the modern day, since 1900, history of trading that I know of.

Exchange clearinghouses are no longer mutually held, and have not been since the last major exchange went public in 2003. Instead, the clearing house takes out an insurance policy to cover potential problems. It also has lines of credit with several different bankers. This simple fact doesn’t change our agreement that government mandated clearing is a poor solution, but it does change the calculus of analysis a little.

I take issue with his taking issue.  Yes, exchanges are demutualized, but counterparty risk is still mutualized.  Take the CME, for instance.  This CME document, in the sections labeled “Default by a Clearing Member” and “Summary of Resources Backing Clearing” beginning on p. 11 demonstrates that the losses of default are borne by other clearing members.  First the CME dips into the guarantee fund–which the clearing members fund.  Then the CME can assess the clearing members.  (The CME also commits up to $100 million of its own capital.)  The assessments are limited to 275 percent of each CM’s original contribution.  The total from the CME contribution, the guarantee fund, and the assessment comes to about $7.5 billion.  The costs of default by a clearing member are thus shared among–mutualized by–other clearing members.

Jeff mentions insurance, but there is no third party insurance that pays in the event of a default at the major exchanges.  (There is no mention of insurance in the CME document.)

Jeff also mentions credit lines, and indeed CCPs have lines with major banks.  In the aftermath of Black Monday, 1987, exchange CCPs realized that they needed a more reliable source of liquidity.  On Black Monday, major banks (the clearing banks) balked at funding big CM margin calls; this is where Fed pressure and liquidity injection was important.  To avoid this problem going forward, the CCPs obtained lines of credit that they could call on to obtain liquidity, just as Jeff says.

It is important to note that these credit lines are just that.  If a CCP draws on the line, it–or more accurately, its members–still owes the bank the money.  The lending bank incurs a loss attributable to a CM default only if the CCP itself becomes insolvent.  That is, the credit line is a source of liquidity: it is not in the first instance a means of sharing the default risk with the bank.  Only if the CCP becomes insolvent do the lending banks suffer any default losses.

The CME document linked above makes that clear.  It calls the credit lines a “Temporary Liquidity Facility.”  It’s a source of liquidity to be used in extremis: it’s not a form of insurance.

There’s an irony, here, of course, and one that gives the lie to many of the claims in support of clearing.  Clearing mandate advocates, notably Gensler, talk about clearing reducing financial interconnectedness, and reducing the potential for contagion.  But clearing in times of stress demands ready access to liquidity.  This inevitably requires a connection between the clearing and banking systems.  It can’t be avoided.  If a clearinghouse runs into a big problem, and draws the credit line, it is possible that the CCP will not be able to pay it back.  In the event, the CCP problem would become a banking problem, and the lending banks would bear some of the default loss.  (Of course, to the extent that banks are clearing members, they will bear default losses too.)

The credit lines also expose the CCPs to bank credit.  If the bank extending the line is itself in financial difficulty, which may well be the case during the kind of crisis that would necessitate the CCP to call on its line, the clearinghouse may not actually obtain the needed liquidity.  So the contagion can work both ways.  From the CCP to the bank, or the bank to the CCP.

Again, the point is that clearing changes the topology of the network of connections among financial institutions: it doesn’t eliminate these interconnections.  One way or another, derivatives default losses are ultimately borne by major financial institutions, clearing or no.  No two ways about it.