Streetwise Professor

March 25, 2010

Glad to Have the Company

Filed under: Derivatives,Economics,Exchanges,Financial crisis — The Professor @ 8:29 pm

Economics of Contempt makes a point that I’ve advanced for well over ten years now (including fairly recently in a guest piece at FTAlphaville.) Namely, that clearing depends on price transparency and liquidity to work; it does not create these things.  Clearinghouses consume price transparency and liquidity–they don’t create them.

Moreover, trying to clear things for which price information is lacking due to a lack of trading can create systemic risks, rather than reduce them.  CCPs can’t price risks adequately for illiquid products.  Moreover, they have a very difficult time of managing the risks of any defaulted positions in illiquid products.  This means that taking on exposure to these products puts the CCP at risk, which, in turn, creates the potential for a clearinghouse failure, an eventuality that EoC “would rather not see . . . in [his] lifetime.”  Having stared it in the face (in 1987), I concur wholeheartedly.

EoC echoes another frequent SWP argument, namely the chronic misinterpretation of the AIG debacle.  He notes that contrary to what is commonly stated, AIG’s positions WERE collateralized, and indeed, it was the collateralization mechanism that was the proximate cause of the firm’s demise.  Those who flog the clearing solution really, really, really need to spell out how having AIG pay variation margin to a CCP, instead of Goldman and Deutsche Bank and French banks, would have made any substantial difference whatsoever.  (See the post “It’s a Wonderful Life: AIG Edition” for my statement of this argument.)  Indeed, it could have made things worse.

It should also be emphasized that collateralization is often the positive feedback mechanism that creates systemic events; big collateral/margin calls in the aftermath of big market moves lead to liquidation of positions, which moves prices more, which weakens the financial position of those affected by the initial price moves more, etc. Geithner and Gensler and others suggest that more, and more rigid, collateralization (via a clearinghouse) unambiguously reduces systemic risk.  Not so.  It is more plausible to say that collateral can mitigate some moral hazards, and can be a way of pricing some risks, and can be a way of mitigating one-off, non-systematic defaults.  But it can also be the doomsday machine that accelerates the spread of financial distress.

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