Streetwise Professor

John 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” principle.  I respectfully disagree.  I am criticizing the arguments that Gensler has in fact advanced, whereas John is generously attributing to him arguments as to how changing rules (including clearing rules) can reduce risk that I have not seen Gensler make.

In contrast, I have written extensively that clearing affects both the allocation of risk for given economic decisions, and the amount of risk through its effects on myriad decision margins; I do so explicitly in “Do You Believe in Magic?”  From the very beginning of my writing on clearing mandates, dating back to late-2008 when the issue became a salient one, I have made that point repeatedly.  Indeed, my analysis of AIG–Exhibit A-to-Z in many pro-clearing mandate arguments–has emphasized this point.  See here, here,  and here, and my piece in the Journal of Applied Corporate Finance; I also raised it in an exchange with Jeffrey Gordon of Columbia Law School in my presentation on clearing that you can view here.  This working paper, written in the fall of 2008, details a variety of ways in which clearing (via its effects on margining, netting, monitoring, and risk sharing) affects both the amount of risk exposures and the allocation of these exposures.  I could go on and cite additional papers and presentations: suffice it to say, most of what I have written about clearing focuses on how clearing affects incentives and information, as compared to bilateral mechanisms, and how these changes affect the amount of risk in the system and the way that risk is allocated.  That’s far more than a start, I think it’s fair to say.

John states that the effects of clearing on the amount of risk in the system is “the very heart of the original argument behind clearing which Gensler is making.”  I’d like to see exactly what argument John is referring to.  I’ve read a lot of what Gensler has said and written in the last three years, and I haven’t even seen that issue even at the peripheries of his arguments.  Typically Gensler argues that shifting the risk to the clearinghouse eliminates interconnections and eliminates counterparty risk because the CCP stands behind trades, or because CCPs will require collateral that make sure that firms will have the resources to pay for their derivatives losses.  That’s it.  Nothing related to how clearing will affect incentives or information in a way that reduces the amount of risk in the system.

Consequently, I think the magic box metaphor is a very apt characterization of what he has been pushing since 2008.  Or, since it’s Sunday, it’s fair to say that he is promising a miracle that is sort of the inverse of the loaves and fishes: rather than taking meager fare and feeding multitudes, he is claiming that clearing will take risk from multitudes and make it meager.  There is certainly nothing as nuanced in what Gensler has said publicly as what John is attributing to him.

John closes by saying:

Let’s have a good discussion about which rules of the game produce the lowest total social risk and the greatest social payoff from the operation of the OTC derivatives market. It’s a tough problem to tackle. Oversimplification will not do.

Welcome to the party!  Seriously.  Compare that to what I wrote at the end of the piece in Regulation, “The Clearinghouse Cure,” published in 2008 (linked above):

The nature of this analysis is inherently qualitative. It is difficult for anyone, be they academics, market participants, or regulators, to determine definitively whether a clearinghouse would improve the  efficiency of the CDS market. I certainly do not claim to possess such definitive knowledge. It is troubling, however, that basic considerations relating to the economics of risk sharing and information have been almost completely absent in the public discourse over CDS clearinghouses. It is also troubling that the  potential pitfalls have not been fully aired. Nor has there been an extensive comparative analysis of alternative risk-sharing mechanisms. Therefore, at the very least, this article aims to raise the quality of the debate by identifying crucial issues that have been largely ignored until now, and to challenge a consensus that threatens to engineer a fundamental transformation of the financial markets without proper regard for fundamental economic issues. Moreover, the considerations identified herein should be kept in mind when designing a CDS clearinghouse to ensure that information problems do not make this prescription worse than the disease it is intended to cure.

I’ve been calling for a good serious discussion around these issues for arguably longer than anyone, and have written extensively about many of the “hard problems.”  There is indeed an oversimplification problem in this debate–and that’s precisely why I’ve been so hard on Gensler (and Geithner): because they’ve been the ones oversimplifying repeatedly and consistently, and as a result, we run the very serious danger of adopting arrangements that do not generate the greatest social payoff.  If I seem combative making that point (Combative? Moi? Nobody’s ever accused me of that before!) it’s primarily a response to the repeated oversimplification by the advocates of clearing mandates.

I know I can have a constructive discussion with John Parsons, even though it is highly likely that we would disagree on crucial issues.  But it would be a real discussion about real issues, and based on my extensive reading on the entire regulatory and legislative discussion leading up to Dodd-Frank and clearing mandates, that’s precisely what’s been missing in the 202 area code.