Streetwise Professor

February 10, 2010

Fractured Clearing Fairy Tales

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 3:27 pm

One of the tales about derivatives clearing, told repeatedly by Timmy! Geithner and Gary Gensler is that the clearing fairy magically makes counterparty risk disappear.  The reality is that it doesn’t make it disappear: it just moves it around.  And not necessarily in a better way, as members of the CME clearinghouse clearly understand.

Many of these members are extremely leery of the CME’s plan to clear CDS.  This week, according to Bloomberg and DJ (not online, fortunately), big brokers Newedge and MF Global came out forcefully against the CME proposal precisely because they fear that clearing CDS will allocate the risk their way, and their customers’ way:

Newedge USA LLC, the largest U.S. futures broker, and MF  Global Holdings Ltd. are urging the U.S. to prohibit CME Group Inc. from using customer funds to back credit-default swap  trades alongside futures transactions in its clearinghouse.  The brokers said the lack of an underlying frequently traded contract for credit-default swaps, such as a future based on the swaps, made it too difficult to price the derivatives for risk-management purposes, according to a Feb. 4 joint letter the companies sent to the Commodity Futures Trading Commission.

“We do not believe it would be appropriate for the commission to now require futures customers to effectively cross guaranty CDS risk, however remote some may suggest the likelihood of a cleared CDS default to be,” the firms and CME Group members wrote in the letter. “MF Global and Newedge are not satisfied that the risks to futures customers’ funds and to our own guaranty deposits — risks we never signed up for — may adequately be assessed or contained.”

The Newedge/MF Global broadside gives the lie to other clearing fairy tales: namely, that contractual standardization is sufficient to make instruments appropriate for clearing, and that clearinghouses magically create transparency.  To the contrary, clearinghouses consume transparency/information: they need liquid markets with active price discovery to work effectively, and contractual standardization is not sufficient to ensure such liquidity.

Note their concern that risks may not be adequately assessed.  This requires information  about pricing and risk characteristics.  This information is hard to come by for many CDS, particularly single-name CDS.  Moreover, dealers may have better information than a clearinghouse.

In other words, clearing is not magic.  It doesn’t make risk disappear.  At best, it reallocates it.  Moreover, it can actually create problems, rather than mitigate them, when the clearer lacks the information to price the risks properly.  Newedge and MF Global, and before them Thomas Peterffy, the FIA, and Penson’s Chris Heymeyer, recognize that.  When will those who want to mandate clearing as broadly as possible figure it out?

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