Streetwise Professor

September 25, 2010

Clearing Up a (Minor) Disagreement

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:05 pm

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.

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  1. Under Fin Reg, the clearing houses have access to the Federal Reserve. Ug. That access may actually encourage them to take more risk-endangering the financial system not protecting it!

    I think the key is information. In OTC, and in corporate bond markets there is very poor information on price and volume. No one can tell if the market is heads or tails. Banks intentionally keep it this way. They profit off it.

    That is really the crux of the problem.

    You and I probably disagree on the existence of dark pools in the cash equity and option markets as well. I think a centralized marketplace is better for liquid cash equity and option markets. Would stop flash crash’s.

    Comment by Jeffrey Carter — September 26, 2010 @ 7:55 am

  2. @Jeff–CCP access to central banks is a damned if you do, damned if you don’t situation. If you don’t: you could have a liquidity problem a la 10/20/87 take down the CCP. If you do: you could have the moral hazard “what me worry?; Uncle Ben’s got my back” problem. Not a pretty choice.

    I imagine we do disagree re transparency and dark markets.

    Re OTC markets, opacity is exaggerated, IMO. At a Chicago Fed conference 3 weeks ago the Treasurer of FMC, who heads a major association of OTC derivatives end users, disputed vigorously that he lacked adequate information on prices of OTC derivatives. Moreover, esp. where there’s a close exchange traded substitute (e.g., vanilla IR swaps and Eurodollar futures), it is pretty straightforward to evaluate dealer bids.

    Also, even for some relatively vanilla products, trading volumes (or more accurately, deal volumes) aren’t conducive to continuous trading. Products that trade 50-100 times/day don’t make sense to trade in a continuous auction. A “search” market makes more sense.

    Re equity dark markets, you need to be careful here. Dark markets proper didn’t have anything to do with the Flash Crash. Dark markets are price taking, not price making markets. They work off of crossing (derivative pricing), internalization, etc. Big, uninformed traders (e.g., index funds) find them effective ways to reduce execution costs.

    The issue in equity markets is the fragmentation of price discovery resulting from RegNMS and the consequent creation of multiple execution venues (that are *not* dark pools, because they have both pre- and post-trade transparency). This can work fine when things are normal, but linkages break when things get stressed.

    Even there, it’s not an easy situation. Even if we were back in the old days where the NYSE had a monopoly on price discovery in its stocks (with other venues being primarily free riders off of prices discovered on NYSE), there are still linkages: between cash equities and index futures and index and individual stock options. Those linkages can be stressed too (again, look at 10/20/87). Indeed, it seems that a linkage between the index futures market and the cash equity markets was relevant to understanding the Flash Crash.

    The ProfessorComment by The Professor — September 26, 2010 @ 2:38 pm

  3. […] This post was mentioned on Twitter by John Avery, John Kiff. John Kiff said: Craig Pirrong: Clearing up a (minor) disagreement on how CCPs work today […]

    Pingback by Tweets that mention Streetwise Professor » Clearing Up a (Minor) Disagreement -- — September 26, 2010 @ 7:16 pm

  4. Biggest difference though is in 1987 the exchange was mutually held. Good to the last drop. In 2010, the exchange is a public company. Very different.

    With regard to dark markets we disagree. There is a mini flash crash in a stock every day now. Fragmentation of liquidity is bad. Price+volume equals information that the market needs for supply and demand. Currently under the SEC system, it’s not working. Payment for order flow, internalization, dark pools all add to that.

    In 2008 Lehman had massive positions in the S+P 500, and massive positions in interest rate futures. Transferred with nary a blip.

    Comment by Jeffrey Carter — September 28, 2010 @ 8:55 pm

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