Streetwise Professor

October 18, 2008

Distributive Effects, Collective Action, and the Incentives to Adopt Central Clearing

Filed under: Climate Change,Derivatives,Economics,Exchanges,Military,Politics,Uncategorized — The Professor @ 8:19 pm

In the midst of the credit crisis, it has become conventional wisdom that OTC derivatives, especially credit derivatives, should be centrally cleared. Like Dudley Dooright, the central counterparty (CCP) will come in and save the day. Given that this idea is supported by many people who had probably never heard of clearing until quite recently, there is room for doubt that these high expectations are grounded in a firm understanding of what clearing is and what it entails.

I will explore various aspects of OTC clearing in several posts, of which this is the first.

The motivation behind these posts is a simple question: If clearing is so obviously wonderful,why has it not been adopted before this?

I think there are two answers to this question, answers which are not mutually exclusive. The first is that clearing would be welfare enhancing, but as a result of some collective action problem it has not been implemented. The second is that there are costs and benefits to clearing, that these costs and benefits vary by product, and for some products, the costs exceed the benefits.

The public policy implications of the two alternatives are obviously quite different. The first provides a justification for robust government intervention: the second does not. I think that both factors have an element of truth. This implies that there is a basis for government involvement, but that considerable care should be exercised.

I have explored both questions in my academic work, and will draw upon that work in drafting these posts. I have recently done more work on the collective action issue, and will report the results of that analysis for the first time in the blog; I will write up the results of the analysis more formally in the coming weeks.

This post focuses on the collective action issue. If clearing is welfare enhancing, but it has not been adopted due to transactions costs/collective action problems, then arguably a case can be made for regulatory or legislative initiatives to encourage–or even force–its creation. Indeed, one can argue that the NY Fed’s frantic efforts in recent weeks to push market participants towards creation of a CCP reflects such a belief.

I first mooted the possibility that CCPs were not adopted due to some sort of collective action problem in a working paper in 1997. I also mentioned this idea in a more recent paper. The basic idea was that clearing could have distributive effects, most particularly, redistributing wealth from well capitalized firms to less well capitalized ones. This could occur if clearing leveled the competitive playing field by eroding the competitive advantage held by well-capitalized OTC dealers.

In my earlier work, this argument was made verbally. It is not an easy thing to formalize it, but I have made some progress in that direction. The model is a relatively simple one. There is a representative agent hedger, with CARA utility. The hedger has an endowment of a risky asset. There are two risk neutral dealer firms. These dealers are risk neutral, and have no endowment of the risky asset, but they have limited capital. Their capital is also risky. Therefore, if they enter into derivatives contracts, they may default as their losses on their derivatives positions may exceed their capital.

The two dealers have different starting capitals. There is a large dealer and a small one. The volatilities of the firms’ capitals can also differ. The dealer capitals are imperfectly correlated.

The dealers incur operational costs to execute derivatives transactions. For simplicity, these costs are quadratic in the quantity of contracts executed. Although the dealers have different capitals, I assume that they are equally operationally efficient. That is, their costs of execution are the same for a given number of transactions.

It is well known that a defaultable derivatives contract, such as a forward or swap, is effectively an option. In this model, the hedger that buys a forward contract from a dealer actually enters into contract with a payoff equal to the minimum of the payoff on a non-defaultable contract, and the counterparty-dealer’s capital.

Due to this optionality, the problem is inherently non-linear, and even assuming CARA utility, must be solved numerically. Therefore, since that nettle has already been grasped, there is no need to make the drunk-looking-for-his-wallet-under-the-lamppost assumption of normality in the distribution of the price of the risky asset, or the values of the dealers’ capitals. Normality facilitates the determination of closed form solutions in linear problems, but since this problem is non-linear that is of no help. I therefore utilize more realistic assumptions. I allow for heavy-tailed and skewed price distributions, by assuming that returns on the risky asset are characterized by a negatively skewed normal inverse Gaussian distribution. (This means that crashes are more likely that upward spikes in prices, as is the case for equity indices.) I assume that dealer capitals are characterized by fat-tailed Student-t distributions. Skewness and kurtosis are realistic features of real markets, and may provide an important reason to hedge and affect the likelihood of default. The world is not normal, and non-normality is especially important in this context.

I first solve for equilibrium in a bilateral OTC market. I assume that all parties are price takers. The resulting equilibrium is quite sensible. The hedger trades more with the firm with the greater capital, and sells at a higher price to the less-well capitalized firm. That is, since the deals are negotiated individually, and since the counterparties are heterogeneous, the terms of trade and quantities of trade differ. The hedger sells more at a lower price to the advantaged well-capitalized firm.

I next solve for equilibrium in a cleared market. In the cleared market, the two dealers form a CCP and share default risk. If one firm defaults, the other party covers the loss, up to the amount of its capital. The hedger suffers from a default only if the dealers’ collective losses on their trades is larger than the sum of their capitals.

The details of possible sharing arrangements under a CCP are complex, and potentially varied, so I simplify matters by assuming that the CCP allocates trades among the two so as to maximize joint profits. This would require some sort of pricing mechanism, or some other means of allocation, which is not modeled specifically. I do turn attention to the possible pricing issues later.

Due to the equal operational efficiency of the two firms, the efficient outcome is for the output of the two dealers to be equal. In the clearing equilibrium, (a) the hedger trades more, (b) the output of the small capital dealer goes up, and (c) the output of the large capital dealer goes down. Moreover, the price at which the large dealer buys goes up slightly, and the price at which the small dealer sells goes down. The hedger’s expected utility rises, and joint profits of the dealers are higher because (a) total output is higher, and (b) total costs go down due to a more efficient allocation of output across the dealers. There is also a more efficient allocation of risk, and the incidence of default falls, even though the scale of trading rises, because of the diversification of the dealers’ capital risks.

In brief, the formal model, solved numerically, generates results along the lines of what I laid out informally in the earlier working papers.

The implications are quite striking, and important. Implementation of a first-best risk sharing mechanism improves welfare (obviously) but redistributes wealth from the large dealer to the small dealer. The small dealer’s smaller capital makes him a less desirable trading party for the hedger, even though from a social perspective diversification and operational costs make it efficient for the hedger to split his trades between the two dealers. That is, from a welfare perspective, pooling of the dealers’ capitals is efficient as it facilitates efficient allocation of output across dealers. (This raises the question of why don’t the dealers just merge? Well, merger of all the dealers into one would effectively create a clearinghouse. Moreover, there may be sources of diseconomies of scale and scope not captured in the simple, formal model that mean that sharing of risk via a clearinghouse is a more effective way of pooling capital for default mitigation purposes than a formal merger.)

Since the joint profits of the dealers are higher under clearing, the small dealer’s profits rise more than the large dealer’s profits fall. In the absence of transactions costs, the dealers would execute a Coasean bargain that would make both better off, and one would expect the CCP to form.

However, it is well known (see particularly Libecap’s work–some done with Steve Wiggins–on the creation of property rights in natural resources), that distributive effects can interfere with the creation of efficient property rights. The common pool problem in oil (which I discussed in earlier SWP posts) is a classic example of this. Even though unitization of oil fields–the efficient allocation of output across potential producers–maximizes joint profits, it has proved devilishly complicated in practice for competing drillers to consummate this wealth-enhancing bargain, due to the tussle over rents.

Moreover, due to the complexities in bargaining, and the potential costs of enforcing any arrangement among the firms, the dealers may arrive at a pricing or trade allocation structure that limits the distributive impact of the formation of a CCP. In the stark model, however, any such deals reduce welfare. Thus, even if a CCP is formed, it may not achieve the efficient outcome. Alternatively, the feasible bargaining outcomes may not include the efficient outcome. If there are fixed costs to implementing the CCP, it may not form.

In particular, as I have shown in my work on exchanges (JSTOR access privileges required), coalitions of heterogeneous firms create the potential for redistributive rent seeking. As a result, organizational form and governance structures for coalitions of heterogeneous firms are usually crafted to mitigate the potential for such redistribution. The resulting structures and pricing mechanisms may not be first best.

It should also be noted that even though CCPs are typically formed as coalitions of dealers, some of the benefits flow to (in the model) hedgers. That is, CCPs are usually coalitions of sell-side firms, but the benefits of CCPs spillover to buy side firms. Again, since the CCP is first best (in the model), there is a potential grand bargain that makes the buy side and the sell side firms better off. This only expands the bargaining complications, however.

Thus, one explanation for the failure to adopt a CCP in OTC derivatives is that even though it is efficient, collective action and bargaining problems have impeded, and in some cases precluded, its creation. Distributive effects can preclude the adoption of efficient organizations and institutions. The model shows that the adoption of clearing can have pronounced distributive effects. Therefore, the failure to adopt clearing may reflect the effects of distributive effects and rent seeking behavior that impede collective action.

In this situation, government action (and essentially, government can serve as a mechanism to reduce the costs of collective action) can improve welfare to the extent that it reduces transactions/coordination costs.

In essence, government is just another mechanism through which parties can act and bargain to achieve a given outcome. Government possesses coercive powers. Moreover, especially in democratic/republican polities, a broad array of interests can influence/bargain through the government. This can be important, and sometimes result in enhanced efficiency–though it can reduce efficiency at other times. In the present instance, for example, buy side firms that would benefit from the formation of a CCP can exert influence on various government entities (the Fed, Treasury, the legislature), and beseech the government to employ its coercive powers to advance the interests of these firms. It may be cheaper for these firms to bargain through the government, than directly with the sell side firms.

This analysis reflects the strongest case for government intervention to, ahem, encourage the formation of a CCP for credit derivatives, and other products traded OTC. But one must be careful. Clearing is a risk sharing arrangement, and it is well known that risk sharing arrangements are often plagued by adverse selection and moral hazard costs. These costs can vary depending on the type of risk being insured. These costs reduce the amount of risk sharing, and in some cases, can make it better not to share risks at all. Thus, the failure to form a CCP that shares default risks for some products may also be due to the fact that moral hazard and adverse selection costs are so large as to make risk sharing inefficient. I will consider that possibility in the next post, and argue that this possibility is particularly pertinent for products like credit derivatives. Thus, the benefits of the formation of a CCP for these types of products may be substantially smaller, and the case for government intervention weaker, than the collective action problem-focused analysis of this post suggests.

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  1. Streetwise Professor ยป Distributive Effects, Collective Action, and the Incentives to Adopt Central Clearing

    Comment by GS test demo — April 1, 2013 @ 12:40 am

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