Streetwise Professor

March 5, 2011

Do You Believe In Magic?

Filed under: Clearing,Derivatives,Economics,Exchanges,Financial crisis,Politics,Regulation — The Professor @ 8:23 am

Gary has a magic box, called a “clearinghouse.”  You put counterparty risk in the box, and it disappears!:

One of the central goals of Dodd-Frank is to redirect much of the OTC derivatives market through exchanges, electronic trading platforms and central clearinghouses that stand behind dealings in derivative contracts.

“What that means to the American public is it’s less likely that the taxpayers stand behind that transaction,” [Gary Gensler] said.

“Instead the clearinghouse stands behind it, and I think that’s what Congress recognized. Moving as much of this into clearinghouses lowers interconnectedness, but also says a clearinghouse stands there, not the taxpayer.”

Uhm, but what stands behind the clearinghouse?  Where does that risk go?  Well, financial institutions—including many major banks—actually stand behind clearinghouses.   Meaning that if counterparty losses are big enough, the banks bear a big chunk of the loss (so things are still interconnected).  Or, if the banks limit the amount of loss they are willing to bear, the clearinghouse can fail.  Who wears the loss in that event?

Gensler might argue that collateralization in clearinghouses makes it highly unlikely the banks will bear any loss, and even less likely that the clearinghouse will fail.  Let’s say that collateralization is indeed extremely robust, so that the risk of clearinghouse failure is vanishingly small.  Does that mean that everything is great?

Well no, really. The risk still hasn’t disappeared.  Given the positions that firms take*, collateralization (and netting, another commonly touted benefit of clearing) affects the distribution of losses arising from the bankruptcy of a derivatives trading firm, not the total amount of the losses.  If collateralization is so robust that derivatives counterparties always get paid, that means that the entire loss arising from a bankruptcy falls on the firm’s other creditors.  So the magician may point to the magic derivatives clearinghouse box and say: “See!  No losses!  They disappeared!”  But they are somewhere, behind the curtain, borne by somebody else; collateralization changes the priority of claims, not their magnitude.**  Most likely, the loss is shifted to unsecured creditors—who may include banks backed by taxpayers, or owners of money market mutual funds who may run if it looks like their funds will break the buck, which can also lead to a Federal bailout (like what happened in September, 2008).

There’s also the issue of where the collateral comes from.  Some of it may come in the form of loans extended by banks that used to extend credit via derivatives trades; like in a real-world magic trick, the credit didn’t disappear, it was just shifted somewhere else.  Some collateral may come from firms foregoing higher yielding, but less liquid investments: this is a real cost as too many resources are tied up in liquid assets and too little invested in more productive projects.

There are other things going on behind the curtain.  Rather than enter into expensive collateral derivatives trades, firms may decide to hedge less, forcing their claimants (including lenders, employees, suppliers, and shareholders) to bear more risk.  Again, the risk doesn’t disappear–it leaves through a trapdoor and winds up someplace else.

And collateral can have perverse effects in a crisis.  The pressure of collateral calls can force firms to liquidate positions, exacerbating price moves.  Or firms may engage in fire sales of other assets to meet the calls, causing price shocks to spill over from the derivatives market to other markets.  How’s that for an interconnection?

Gary also has a magic transparency trick, a visibility cloak if you will.  Exactly the opposite of Harry Potter’s invisibility cloak, it makes the invisible visible:

“I also think transparency helps,” he said, looking back to the widespread uncertainty during the crisis of the value of assets on the books of giants such as American International Group.

“The law now says they have to be valued daily and valuations have to be shared between the counter-parties and if they run a clearinghouse, the clearinghouse has to share it with the public.”

Indeed, this cloak is so magical it can make visible things that don’t even exist.   For, in situations like AIG, the problem was that the values of the assets were uncertain because there were no trades: these things weren’t marked to market, they were marked to a guess—or to a self-serving price that was hard to challenge because there were no real prices to compare it to.   Many of the contracts that Gensler would like to see cleared trade little, if at all—and no trades, no prices.  It is a magical cloak indeed that can make prices and valuations visible when there are no trades to produce actual prices.

Magical thinking about clearing, counterparty risk, and transparency is extremely dangerous.  It creates very real risks.  Those who believe that things like clearing and transparency are magical solutions, and who do not grapple with the complex realities and difficult trade-offs are all too likely to impose rules and regulations that make things worse, not better.  Sad to say, I think that’s happening in spades, both here in the US and in Europe–and that’s not a card trick.  The consequences are pretty sobering to contemplate.

* The amount of margin will affect the sizes of positions and the structure of positions that firms take.  Netting will also affect positions, because (a) netting can actually economize on collateral, and (b) the amount of collateral savings can depend on how extensive cross-margining and portfolio margining are.  It is difficult to know what the net effect of clearing mandates will be on the trades that firms make, and the composition of the firms that make them.  I mention one possible effect below–some hedgers may exit the market, or hedge less.  Indeed, the potential effects are so extensive it is difficult even to list them.  Making it costlier to shift risks via derivatives transactions affects not just risk management decisions, but capital structure decisions (hedging really being just a capital structure choice), investment decisions (the amount and composition of investment), management compensation decisions, and on and on.  All I want to emphasize in the main discussion is that one major effect of collateralization is to affect claim priority, given the total aggregate size of claims against a bankrupt firm.  It secures some claims–which reduces the priority of other claims.

**Same caveat.

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  1. Naive question, I should have asked this long before…
    Won’t clearing house participants have an incentive to monitor exposures of other members and close out trades before they blow up?
    Thus clearing house parties have incentives to limit who participates…I am sure this is what you have argued before. This type of thinking will enforce homogeneity among participants – in other words they will be the same old you know whos – big “well” capitalized banks. And I guess folks like Griffin will raise hue and cry at being left out.
    But if govt. issues a fiat the every Tom n Jerry has to be accommodated then lot of well capitalized banks will withdraw and stop offering derivative products, which might be overall less beneficial.

    But then one might come up with some sort of position limit or something resembling a credit card limit…Depending on perceived credit quality the clearing house can set limits. This might lead to the stronger players forcing out the weaker ones quickly through adverse limit setting.

    My brain is too tired to think further…and I can begin to see why ur are so interested in these things…it is indeed quite a conundrum.

    Comment by Surya — March 5, 2011 @ 10:46 pm

  2. […] Pirrong — aka author of the Streetwise Professor blog — holds up for ridicule Gary Gensler, Chairman of the US Commodities Futures Trading Commission. Pirrong cites […]

    Pingback by The ‘Conservation of Total Risk’ and the Social Payoff to OTC Regulatory Reform « Betting the Business — March 6, 2011 @ 5:09 am

  3. @Surya–Interesting thought, but things can actually cut the other way. In bilateral trades, you are at risk to your counterparty, and hence have an incentive to monitor; monitoring is a private good. In a CCP, monitoring essentially becomes a public good; if you monitor, the benefits are captured by other members of the CCP. There is a moral hazard here. In essence, the members delegate monitoring to the CCP, and have little incentive to monitor their counterparties themselves.

    This can be beneficial, as duplicative monitoring is avoided. But how do you incentivize the CCP to monitor properly? Typically agents with multiple principals are subject to low power incentives. Also, CCPs typically do not, and I argue reasonably cannot, effectively discriminate among members even if they pose different risks. Everybody is charged the same margin.

    Note too that major CCPs did nothing to Lehman until it was on the verge of failure. Indeed, I would argue that they were laggards–other counterparties were running from Lehman well before the CCPs did. Who was monitoring more closely? I would say Lehman’s other counterparties. (Same thing with Bear, Merrill, etc.)

    Thanks for sparking that thought–I’ll follow up on the leader-laggard point.

    Your brain is tired for good reason. Mine is too when thinking about these issues. You pick up on one of my themes: how do you distinguish between prudent measures to limit exposure to risky firms from opportunistic efforts to disable competitors? It ain’t easy.

    What drives me nuts about this is that there are too few people like you who are trying to see the real complexity, and who actually appreciate it. Instead we get magic stories.

    Thanks, as always, for a good comment.

    The ProfessorComment by The Professor — March 6, 2011 @ 11:22 am

  4. […] Parsons of MIT takes issue with my post arguing that CFTC Chairman engages in magical thinking on clearing.  John claims that my criticism is based on a (non-existent) “conservation of risk” […]

    Pingback by Streetwise Professor » I Agree That Oversimplification Will Not Do: That’s What I’ve Been Saying All Along — March 6, 2011 @ 9:33 pm

  5. I would add to the Professor’s response to Surja that a move to mandated central clearing means that small to mid sized players, that cannot access CCP services, will be forced to accept indirect access. This introduces concentration risk and in some cases against lower rated direct clearers.

    Comment by Pinot — March 7, 2011 @ 12:03 am

  6. […] notably in my posts on AIG.  Specifically, clearing does not make risks go away.  (No, Gary, there is no magic box.)  It just shifts risk around.  It has to go somewhere.*  Collateralization, by moving […]

    Pingback by Streetwise Professor » Is There an Echo in Here? — June 4, 2011 @ 1:32 am

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