Streetwise Professor

July 14, 2009

Cognitive Dissonance Alert

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 8:17 pm

Administration officials, most notably Geithner and Gensler, Congressional leaders, and European regulators have touted central counterparties/clearinghouses as a way of dramatically reducing systemic risk.  They have portrayed the CCP as nearly free of the risk of default.  

Apparently the Federal Reserve takes a different view.  (H/T Matt Leising, who made me aware of the issue and reports on it in today’s Bloomberg.)  Evidently responding to the glowing praises of clearinghouses emanating from Geithner et al, on behalf of the members of ICE Trust the law firm of Cleary, Gottlieb, Steen and Hamilton wrote the Fed a letter requesting that

a zero percent risk weight  under the risk-based measure of the Board’s Capital Adequacy Guidelines for state  member banks and bank holding companies (“Risk-Based Capital Rules”) be  assigned to (1) the counterparty credit risk charge on credit default swap (“CDS”)  transactions with ICE Trust, and (2) funds placed with ICE Trust as part of ICE  Trust’s guarantee fund (“GF Contributions”) or as additional margin (“Margin”).” That is, the Cleary lawyer asked the Fed to consider the ICE Trust clearinghouse to be effectively free of default risk, thereby eliminating the necessity of any bank or securities firm with an exposure to the clearinghouse to hold any capital against that exposure.

The Fed demurred, however:

Based on all the facts of record, including the information provided in your  request and other supervisory information, the Board believes that it would be  appropriate to allow current participants in ICE Trust (and their top-tier bank  holding companies) to apply a 20 percent risk weight under the Risk-Based Capital  Rules to claims on ICE Trust, including counterparty credit risk of the CDS  exposures cleared through ICE Trust and claims in the form of Margin and  GF Contributions, for the first-quarter reporting period of 2009 and for subsequent  reporting periods. A 20 percent risk weight for such claims on ICE Trust is  appropriate because the risks ICE Trust poses to counterparties are not materially  different than those posed by other U.S. depository institutions, as well as by banks  in countries that are members of the Organisation for Economic Co-operation and  Development (“OECD banks”). Claims on OECD banks are also risk weighted at  20 percent.

That is, from the Fed’s perspective, ICE Trust is just another bank. Note the key sentence: “the risks ICE Trust poses to counterparties are not materially different than those posed by other U.S. depository institutions.” Thus, an OTC counterparty must hold as much capital against a CDS position cleared through ICE as a CDS deal done with Goldman Sachs–or even BofA or Citi. So much for the magical powers of a clearinghouse to make counterparty risk disappear.

Interestingly, the Fed letter notes that the capital weight required for derivatives traded on exchanges like the the CME that adjust margins daily is zero.  

This decision is very difficult to square with the official boosterism of clearing emanating from the administration, the Hill, and the EC.  It has always seemed to me that the Fed was much more diffident about the efficacy of clearing than Treasury, and this letter makes that difference in enthusiasm quite plain.

There is another interesting angle to this.  In his recent testimony Geithner made it plain that he intended to impose more onerous capital requirements on OTC deals that were not cleared than cleared deals.  The Fed letter essentially puts cleared and non-cleared deals on a level playing field.  So does this mean that other changes are in store, such as raising the capital requirement to above 20 percent on bank-to-bank OTC derivative exposures?  If so, will other inter-bank exposure capital weights be changed, or will there be a differential between OTC derivative risk weights and other inter-bank exposure weights?  Or will the Fed decision be modified subsequently?   Whatever changes are to come, this appears to represent a major disconnect between the Fed–which announced its decision on 5 June–and Treasury, which as recently as last week stated its intention to treat cleared and non-cleared exposures differently.  

Moreover, the Fed’s action gives the lie to Treasury and Congressional and EC boosterism of clearing.  It is a salutary reminder that clearing does not make counterparty risk go away.  Perhaps the Fed’s equation of the risk of ICE Trust and Citi, for instance, is wrong.  But by making it quite plain that the counterparty risk of ICE Trust is north of zero, its decision will hopefully lead to a more productive and informative discussion of the real risks of clearing vs. bilateral dealing.   It’s about time.

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