Streetwise Professor

November 22, 2008

If It’s So Great . . .

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics — The Professor @ 5:03 pm

Those who have read SWP regularly will have deduced that I have a historical bent.   Although historians and economists (and other social scientists) tend to think and analyze problems in very different ways, I think that history is quite often a useful source of material on which to test theories and conjectures, and a source of inspiration and ideas useful in the generation of new theories and models.   It also frequently proves quite useful in debunking assertions about the necessity or sufficiency of a certain factor causing some outcome.

Today’s historical excursion examines a couple of episodes in the past relating to clearing.   Specifically, two occasions in which important exchanges, the London Metal Exchange and the Chicago Board of Trade, adopted central clearing under government pressure only after a long period of resistance.   In each case, the memberships and/or leaderships of these exchanges steadfastly refused to introduce clearing until forced to do so by regulators.   In each of these cases, the regulators’ rationales were tangential, at best, to the actual economic purpose and effects of a clearinghouse.   It seems that as various government entities are pushing a clearing solution for the CDS market that we are in the process of repeating history.

A central counterparty/clearinghouse was first adopted in the US in 1891 in Minneapolis.   From time to time in the following years, some members of the Chicago Board of Trade proposed that the exchange adopt the “Minneapolis Model.”   Each time, either the membership or the board of directors rejected these proposals.

All of the merits of central clearing were pretty well understood.   In particular, CBT members understood that clearing would reduce the amount of money that would be tied up in margins–although some considered this a bug, not a feature.

The standoff between the advocates and opponents of clearing continued literally for decades.   The impetus for the move that actually resulted in the creation of the Board of Trade Clearing Corporation originated in the passage of the Grain Futures Act of 1922.   This Act gave the Secretary of Agriculture considerable power over grain exchanges.   The Secretary could put an exchange out of business by revoking its designation as a contract market.

In 1925, William Jardine was Calvin Coolidge’s Agriculture Secretary.   He was convinced that large speculators were manipulating the grain markets, to the detriment of farmers, and wanted to do something to stop it.   In another foreshadowing of current events, Jardine was convinced that identifying who held large positions would facilitate deterrence.     He further thought that a clearinghouse would achieve this objective because it would require the registration of all positions in order to perform its work.

Of course, it would have been possible to register positions without creating a central counterparty.   Indeed, such a change to clearing procedures had been proposed, but not adopted, in 1911.

The directors of the CBT continued to balk at creating a clearinghouse, until two influential members of the exchange, L.F. Gates and J.C. Murray, who served on the exchange’s Grain Exchange Legislative Committee, wrote a letter warning of dire consequences if the exchange failed to act.   Gates and Murray said that failure to implement the clearinghouse plan could lead to a revocation of contract market status.   Stung into action by their warning, the directors approved the creation of a clearinghouse (and a Business Conduct Committee to police the exchange’s members.)

Jim Moser argues that Jardine’s pressure was not what caused the CBT to adopt the central counterparty.   He notes that the exchange could have satisfied Jardine’s demands for transparency by registering every trade, but not providing a central guarantee.   He concludes that the directors’ reluctance to adopt the CCP was based on privacy concerns that Jardine alleviated.   From this he infers that the directors’ objection to the clearinghouse was not the risk sharing aspect of its operation, but the possibility that its operation could result in disclosure of position information.

Perhaps.   But it seems that if there was a strong demand for risk sharing via a CCP, the exchange could have found away to address the privacy concerns.     Thus, another, and in my view more straightforward, interpretation of events is that there was not a uniform desire for a CCP, and there was strong opposition to the concept; and that Jardine’s threat to shut down the exchange compelled the directors to pacify him by adopting a method that he had endorsed–the Minneapolis Method.

That’s one of the problems with history–it seldom permits definitive answers as to cause and effect.   But regardless of the interpretation, the extreme reluctance of the Board to adopt a CCP suggests that the concept is not nearly as beneficial as its advocates suggest.   To be sure, there were legal and privacy objections, but (a) where there’s a will, there’s a way, and (b) it is often the case that explicit objections camouflage the true reasons for opposition.     And to me, the most straightforward interpretation of the facts is that the CBT adopted a central counterparty not because of its inherent economic benefits, but only as result of government pressure motivated by considerations completely unrelated to the costs and benefits of sharing default risks. The failure of the CBT to adopt a central counterparty voluntarily is consistent with the view that this method of allocating default risk has costs that exceed the benefits.

The LME was another exchange that adopted central clearing only when its very existence was threatened by government action.   The LME had suffered a major crisis in 1985-1986 with the collapse of the International Tin Council’s price support program.   Tin prices collapsed, contracts were breached, and many LME members suffered huge losses, with some closing their doors.   Prior to the Tin Crisis, the LME had been strictly a principals’ market, with all dealings done on a bilateral basis just as is the case in OTC markets today.   The LME clearinghouse was merely a mechanism for netting payments and deliveries, similar to a bank clearinghouse.   It was not a CCP.   Indeed, the LME had consciously resisted creation of a CCP for years after this practice had become standard in both American and British commodity markets.

Remarkably, the LME’s resistence to the idea continued after the Tin Crisis.   Thus, even a major series of dealer defaults was not sufficient to convince the membership that a central counterparty was a superior method of sharing default risks.   The LME adopted a CCP only after the newly formed U.K. Securities and Investment Board (SIB) made it clear that it would deny the LME its license to operate unless it introduced an independent CCP.

Most of the benefits attributed to CCPs are private benefits that accrue to their members–lower collateral, more efficient sharing of default risk, prioritization of derivatives counterparties over other creditors.   If this was all there was to the story, derivatives markets participants should adopt a CCP without fail.   But, as these historical episodes demonstrate, they don’t.   Indeed, they demonstrate that the resistance to the idea can be so strong that only intense government pressure can overcome it.   Thus, there must be more to the story.   There must be some costs sufficiently large to overwhelm the private benefits commonly attributed to a CCP.   These costs, unfortunately, are seldom–if ever–the subject of serious analysis.   They should be.   A reasoned judgment about the efficiency of a CCP must be predicated on a judicious weighing of both costs and benefits. Presumably 1920s grain traders and 1980s metals traders whose livelihoods depended on the efficient operation of their markets made such a judicious appraisal, and decided that the costs outweighed the benefits.   That should give advocates of CCPs pause, and spark a more thoughtful consideration of their full effects.

Throughout the period of explosive growth in OTC derivatives, market participants have arrived at a similar judgment.   The concept of clearing is well known.   The subject has been mooted–and rejected (for the most part).   That judgment should not be overridden without excellent justification.

Heretofore, that justification has been totally lacking, but government pressure to adopt a CCP for credit derivatives, and perhaps eventually other derivatives, is unrelenting.   There are repeated invocations of   “systemic risk” and the bandying about of scary (and often mixed) metaphors–“weapons of mass destruction,” “time bombs,” etc.   But the concept of systemic risk is never precisely defined, nor do the advocates of clearing of OTC derivatives present any serious argument as to how a CCP would reduce that which is scary (but undefined.)

Typically, the argument stops at “a CCP would net which would reduce replacement costs in the event of a default, thereby lowering the costs that other dealers pay when one dealer defaults.”   That argument is incomplete, not generally true, and arguably false.   It fails to recognize that netting just redistributes default costs from derivatives counterparties to other creditors, some of whom may be systemically important; it does not consider that the formation of a CCP may increase the sizes of positions that traders hold, thereby increasing the potential for default losses; it ignores the effects of a change in risk allocation on asymmetric information and the incentives to monitor counterparty risk; it overlooks the fact that a CCP, by effectively guaranteeing customer positions, requires dealers that are members of a clearinghouse to bear the costs of a defaulter’s entire net position (including trades done with non-member customers), rather than merely their direct trades with the defaulting member.

If systemic risks are an increasing function of the default losses that dealers incur, it is a straightforward exercise to create examples in which such losses (and hence systemic risks) are higher, rather than lower, with a CCP.   This is true even if one ignores the effects of asymmetric information.   The monomoniacal focus on netting obscures the myriad effects of the mutualization of default risk, and leads to a wild overestimate of the efficacy of clearing in reducing systemic risks.

The government forcing grain traders or metals traders to adopt an inefficient method of allocating default risks is bad enough, but the social costs of these actions were likely bearable because these markets were small in the scheme of things.   Forcing the adoption of clearing in the massive OTC financial derivatives markets is another thing altogether.   Here the costs of a mistake could be huge.   The incomplete and faulty analysis that is being used to justify the creation of a CDS CCP greatly increases the odds that its adoption would in fact be such a mistake.

The seeming compulsion to “do something” in the face of a burgeoning credit crisis threatens to hasten the implementation of an ill-considered plan with major systemic consequences.   Let’s hope that that compulsion is replaced by contemplation and measured action before it is too late.

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  1. I enjoyed your history of the development of clearinghouses in North America. It was interesting to understand the background behind the evolution and motivation of the CCP concept. But, in my view, clearinghouses and the concept of a central counterparty guarantor is “so great”.

    I’ve been involved in agricultural commodity trading since late 1971, just prior to the infamous Great Grain Robbery of 1972. I’ve been a student of futures exchanges and clearinghouses since that time. I have always believed them to be the purest form of supply and demand, the sum total of the collective will of price discovery. Some of this has been clouded by the recent influx of hedge funds as that has tended to misrepresent real supply and demand but in the end, as we are seeing by the downward price adjustment in the past months, the true influence of supply and demand will prevail.

    More to your point, in respect to clearinghouses, my view is the concept is excellent but the delivery can be flawed. Member owned exchanges/clearinghouses are little more than country club arrangements between the powerful traders in a marketplace designed to exclude weaker participants from entering their oligopoly. They make the price of entry so high it is impossible for a smaller dealer to establish a presence in the market. As a result the smaller guy appears to be a “risky” counterparty and this tends to drive business to the apparently more powerful and secure entity, albeit at a wider margin – but a safer deal.

    But when the clearinghouse is self funded and all members are equal this creates a more level playing field and an opportunity for greater participation and market options. Granted all participants must play the game by the same rules I.E. posted margins, standardized contracts, pre-approved credit and a set of rules and procedures. This still gives the stronger participant an edge but it does give new players an opportunity to play in the game (within their means) and it does mean the individual participant can depend on having of an advocate in the event of a dispute. It also means larger companies must honor margin calls and policies and procedures just like everyone else. If companies do increase the size of their positions as a result of greater securitization of contracts that’s fine – as long as they continue to post margins as required.

    I don’t believe in the concept of sharing default risk and I doubt most market participants are in favor of that concept in the current market. But I do believe in the merits of individual credit worthiness and the techniques of initial and maintenance margining. In the world of instantaneous position monitoring and high speed bank transfers there is no reason every counterparty can’t be monitored for open position exposure on a live basis on all cleared transactions. However one of the biggest challenges is mark to market valuations. This can be difficult in thinly traded OTC markets but the effort is worth it and the cost justified in order to prevent market failures from happening as opposed to trying to clean up the mess after the event.

    I agree with your assumption that if market participants oppose a clearinghouse they must have a reason. But in my view the reason is the fear that they will give up more than they will gain. I don’t think you will find and exchange or clearinghouse operator today who opposes clearing. The revenues from clearing account for a large portion of their bottom lines. In fact ICE has just announced intentions to clear Credit Default Swaps:

    NEW YORK, Oct 10, 2008 /PRNewswire-FirstCall via COMTEX News Network/ — A group of leading credit derivative market participants today announced they have joined forces to support a joint global clearing solution for Credit Default Swaps (CDS). Signatories to the letter of intent include The Clearing Corporation, Markit Group, Risk Metrics, and IntercontinentalExchange, Inc. (NYSE: ICE) through its subsidiaries, including ICE US Trust, a New York limited Trust Company (ICE Trust), Creditex and T-Zero. ICE Trust will operate as a New York limited Trust Company and function as global clearinghouse and central counterparty for CDS transactions. ICE Trust plans to become a member of the Federal Reserve System. The letter signals the intention of the signatories to use their best efforts to work together in establishing a clearinghouse that will accomplish the objectives established by the Federal Reserve Bank of New York.

    While I’m sure this is not news to you it makes the point that existing exchanges and clearinghouses see value in expansion.

    But back to opposition.

    If a strong market participant feels that the presence of a clearinghouse will erode their market strength it should come as no surprise that they will oppose any change to the status quo. But these are the very guys that the smaller participant needs protection from (Enron, et al). Put another way, the riskier the marketplace appears to be the more likely it is for business to gravitate to the larger, more secure players. Larger entities prefer to see this condition of systemic risk prevail as it leaves them in the position of power. The less information available to the masses the better it is for those who understand and control it.

    Take a look at the situation unfolding in Iowa with Verasun Energy. They have declared Chapter 11 Bankruptcy and now refuse to honor their high priced forward bi-lateral grain contracts from producers. Had these contracts been cleared and margined this situation would have been discovered long ago and losses would have been mitigated. As it stands the direct and indirect losses triggered by this event will cost millions of dollars. Ask anyone on the losing end of this situation about the cost/benefit of a clearinghouse. It’s like insurance – it seems expensive until you need it. The work I am currently doing on a clearinghouse implementation shows benefits clearly exceed costs when all measures are considered. This is more so for some participants than others but a case can be made for net benefits for all CCP users.

    My comments relate to the North American grain industry and not to the conditions surrounding anything in relation to CDS or the financial market in which I have very little knowledge or understanding. It may well be that a clearinghouse is not the solution for that market but, in my view, it has a practical application for both physical and futures markets in the commodity sector.

    Comment by Russ Crawford — November 23, 2008 @ 1:26 am

  2. Russ-

    Thanks for your thoughtful, extensive, and well-written comment. I am sympathetic to the view that the refusal to create a clearinghouse is sometimes due to the self-interested, anti-competitive motivations of large, well-financed players. I blogged about this possibility specifically here. The very fact that clearing may (as you suggest) level the playing field is reason for some who benefit from the current imbalance to oppose it.

    That said, I also believe that there are economic costs clearing, and that these disadvantages pertain especially to (a) complex products, (b) traded by complex, opaque intermediaries with large balance sheet risks. (Don’t know if you’ve read my posts pursuing this line of thought–type “clearing” in the search box and several recent posts examining the issue in excruciating detail will appear. I focus on issues relating the CDS market in particular. I will have a piece on CDS clearing in the Winter issue of Regulation Magazine. That is available online at Follow the link to publications. I have a piece on another aspect of clearing which may be of interest to you–whether exchanges should own the CH–in the current Regulation.)

    Given the huge potential for havoc (arising from perverse incentives, mispricing of default risk, adverse selection, moral hazard) that could result from an ill-conceived adoption of a clearinghouse, absent very strong evidence that the reason for adoption of a CH is the self-interested and opportunistic opposition of those who benefit from current arrangements, I am extremely dubious of government efforts to force adoption of a CCP. Part of the rationale for recounting the history was to show that previous government efforts to force the adoption of clearing were motivated by completely tangential issues and were predicated on a sketchy (at best) understanding of the economic consequences of clearing. When you are talking about immense OTC financial derivatives markets, ill-considered adoption of a CCP could have devastating consequences. Hence my caution.

    I do not oppose clearing categorically. I agree that it has benefits, and in some circumstances those benefits exceed the costs. But in other circumstances, the reverse is true. I am highly skeptical that the government can tell which is which.

    Would appreciate hearing more from you, and your thoughts on some of my other clearing related posts.

    BTW, how did you find SWP, and how long have you been reading?


    Craig Pirrong

    The ProfessorComment by The Professor — November 23, 2008 @ 2:06 pm

  3. Thanks for your response Craig. I took the opportunity to go through many of your writings on clearing and now have a much better perspective on facts and circumstances motivating your position.

    I found your blog only recently by way of a nightly Google search for key words – in this case “agriculture” and “grain”. Interestingly comments on clearinghouses are very pertinent to work in which I am currently involved. Many of your comments and observations are not related to me such as CDS but discussions relating to OTC clearing, systemic risk and mark to market challenges are very interesting.

    For my part my involvement is related to agricultural commodities in Canada. I can’t say more than that in such a public forum but would be very happy to discuss some of the details of my work and our experiences with you via e-mail if you are interested. (You have my address). I would be very appreciative of your perspective on some of our challenges related to clearing.

    In any event I will continue to monitor your site and learn from your postings.

    Comment by Russ Crawford — November 24, 2008 @ 3:29 pm

  4. Thanks, Russ–

    BTW, I was a consultant to the WCE in the mid-90s. I was involved in diagnosing problems with the canola contract (arising from the squeeze of the August contract in 94, if I recall the year correctly.) I also provided some input on the subsequent redesign of the canola contract to a shipping receipt-based mechanism.

    I’ll chat you up be email, perhaps after the holiday. Interested to hearing what you’re working on. I am getting back into some ag related issues here, looking at convergence issues in wheat, corn and beans.

    Thanks again, and regards,


    The ProfessorComment by The Professor — November 24, 2008 @ 6:42 pm

  5. I look forward to an e-mail chat.

    Will Hill speaks very highly of you.


    Comment by Russ Crawford — November 25, 2008 @ 2:25 am

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