Streetwise Professor

November 25, 2008

If It’s So Great, Continued

Filed under: Derivatives,Economics,Exchanges,Politics — The Professor @ 9:12 pm

The FT reports that major banks are reluctantly supporting the formation of a CDS clearinghouse, if only to stave off something worse–the Harkin proposal to force all trading of everything onto exchanges:

The world’s biggest investment banks are throwing their weight behind a proposal for mandatory central clearing of the $54,000bn over-the-counter credit derivatives market, according to a memo obtained by the Financial Times.

The initiative suggests that dealer banks are stepping up their campaign in Washington to head off proposals for a radical overhaul of the sector, including attempts to force the entire industry to move trading in contracts such as credit default swaps (CDS) on to an exchange. (Emphasis added.)

This suggests that the big banks are not sold on the idea of CDS clearing.   This doesn’t surprise me, given the problematic aspects of a CDS CCP that I’ve discussed in gruesome detail in numerous posts.   I’ve read that dealers bought Clearing Corp earlier this year with the thought that the time would be right for CDS clearing in 2011 or 2012, but that intense political pressure has accelerated that time schedule.

Harkin’s legislative grenade is of course not the only source of government pressure to create a clearinghouse; the NY Fed (under the leadership of Treasury Secretary nominee Timothy Geithner) has been leading the charge.   But there is no doubt that Harkin’s initiative has put the fear of God into the banks, and has overwhelmed any reservations that they have harbored.   Geithner, the Fed, the Treasury, could pressure the banks and make their lives uncomfortable; Harkin’s bill could put them out of the CDS market making business altogether.   Given this selection of poisons on offer, it’s pretty easy to understand why the banks have chosen the one they did.

This has historical precedents.   For instance, exchanges fought the first attempts to regulate futures in the 1920s.   The prospect of legislation that would have essentially put them out of business made them willing to accept unpalatable regulations that nonetheless permitted them to continue to operate.

This just illustrates that a bill needn’t be passed to have pernicious effects.   Very bad proposals can lead to the adoption of less bad, but still undesirable policies.   It would be somewhat comforting if the banks had their Come to Jesus moment because events and sober analysis had convinced them that clearing of CDSs was in their benefit, and would improve market efficiency.   Their shouts of Hallelulah under the threat of severe compulsion are hardly credible professions of their faith in the revealed truth of clearing.   Given that there are strong reasons to believe that CDS clearing is not a panacea, and may well impair market efficiency and increase systemic risk, their pragmatic protestations of belief make me even more skeptical that this is the right thing to do.

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