Streetwise Professor

Since the financial crisis began, and people began casting about for “solutions,” I’ve argued that central clearing is not a panacea; not the silver bullet; not the cure.  Over here, that’s the decided minority view, and the Treasury and the Fed and Congress and the SEC and the CFTC are all gung ho for clearing, and forcing its widespread use.

In Europe, however, they are having some second thoughts on the subject, as this article by Aline Vanduyn and Jeremy Grant in the FT makes plain:

In the months that followed the near-implosion of financial markets, regulators scrambled to figure out how to rein in the vast over-the-counter (OTC) derivatives markets that were seen as central to the crisis.

But, as numerous high-level meetings this week by central bankers and regulators show, the hunt for solutions has thrown up a fresh dilemma: new risks posed by clearing houses.

Clearing houses have been touted as the perfect shock absorbers for risks [sadly true, especially in the US] associated with the $600,000bn, privately-traded or OTC derivatives markets, since they guarantee that trades are completed even when a party to a trade – such as a derivatives dealer – defaults.

. . . .

‘Clear more, and faster’ is what we are being told to do,” says an executive at a derivatives dealer. Indeed, dealers who met regulators in New York yesterday are expected to sign up to just that. However, it is rapidly dawning [I wouldn’t call it rapid; “finally dawning” is more like it] on regulators that, while forcing more OTC derivatives into clearing houses removes systemic risks from one area of the financial system, it may at the same time be concentrating new risks in clearing houses themselves. [Eureka! They’ve finally figured out that clearing just reallocates risks, rather than making them disappear.]

Minds are being focused in recognition that many of the OTC products that look set to be cleared have never been handled by clearing houses before. [And I wonder why that is?  Better late to asking that question than never.]

. . . .

That concern is mirrored in Europe. Alexander Justham, director of markets at the UK’s Financial Service Authority, says: “We should be under no illusions that clearing houses are highly systemic, therefore what goes into them and the risk standards that apply must be extremely high.”

. . . .

They call for clearers to forge links with each other to facilitate cross-border clearing and give traders a choice over where to send their deals for clearing, rather than being tied to one monopoly clearer.

Yet regulators are now concerned that the creation of these links – a process called “interoperability” – could be the source of another systemic crisis. The worry is that the weakest in the chain could bring others down if it were involved in a default and was insufficiently capitalised to meet margin calls. [In other words, clearing doesn’t eliminate linkages, it just reconfigures the system of linkages.]

. . . .

Yet there are many other questions that need answering even before new rules are set. The complexities are so great that a new regulatory group has been created to tackle them. [Complexity?  Who knew?]

. . . .

Damian Carolan, a partner at Allen & Overy, warns: “There is a real risk that the focus on ensuring that CCPs are sufficiently robust to withstand these historically unseen risks is lagging behind the work to push derivatives through those clearing houses. The two have got to go hand in hand.” [Listen to the man.  First do no harm.  Too much clearing can be as systemically risky–or more so–than not enough.]

All true.  And there’s so much more.  I’m compiling a list of ways central clearing can actually increase systemic risk–the concentration and interlinkage issues mentioned in the article being only two.   Hopefully this will be the subject of a blog post in the coming week, travel and teaching schedule permitting.

But it is at least a relief that somebody, the Europeans in this instance, have disabused themselves of the notion that CCPs are “perfect shock absorbers.”  It is also a relief that some people finally recognize that the concentration of risk in a single entity that uses a single method to evaluate and price risk means that mistakes in this methodology are inherently systemic in nature.  (Think “rating agencies.”)

Fools rush in where angels fear to tread.  Grand constructivist schemes to re-engineer a vast, complex system like the OTC derivatives markets create a huge systemic risk–the risk that the scheme is ill-advised, or implemented badly.  If it doesn’t work, the resulting crisis in response to a shock could be devastating.

In the US especially, the attitude is a Red Queen-esque “Sentence first, verdict afterwards.” Or, “ready, fire, aim.”  It would be far better (as Vernon Smith might say) to understand the ecology of the OTC derivatives markets before attempting to reshape them; to view them from a biological perspective, rather than engineering one.  To understand how this complex order has emerged, before attempting to engineer a new one.

I’m reading a book titled The New Institutional Economics: A Guidebook, by my friends Eric Brousseau and Jean-Michel Glachant.  One thing that comes clear in the book, and in reading the NIE literature generally, is that it is very hard to reform complex systems and institutions.  Embeddedness, interconnections, path dependence, beliefs, and informational demands, to name just a few, affect institutional performance, and are very difficult to understand, let alone take into account when making wholesale changes.  The potential for adverse unintended consequences is huge.  I think that if you are an NIE scholar, you are predisposed towards humility and skepticism about the potential for root-and-branch restructuring of complex economic and social systems.  Hopefully the FT article and the views it reports are harbingers of a growing humility about the advisability of a grandiose restructuring of the OTC markets.

I’m sure that kudzu sounded like a good idea to somebody at one time.  (H/T SW Mom.)  The idea of bringing in the cats, then dogs, and then elephants all sounded good to the apocryphal Indian villagers infested by mice.  The problem in each case was that “solutions” to one problem were based on reductionist analyses that focused on that problem in isolation, didn’t take into account the ecological complexities, and ended up creating worse problems than the one they were intended to fix.

We are on the verge of making that error in financial market regulation.  But only on the verge.  The FT article gives some hope that we aren’t about to bring in the elephants just yet.