Streetwise Professor

September 15, 2013

If You Have Lemons, Make Lemonade: Or, We’ll Always Have Paris (if Not Pittsburgh)

Back in Houston after time in Geneva, and a quick day trip to Paris for a conference.  The conference was sponsored by the ECB, Banque de France, and the Bank of England.  It was an examination of the progress in OTC derivatives regulation since the G20 declaration in Pittsburgh in September, 2009.

For the most part, the audience was central bankers, and the theme was “Yay! Look what we’ve accomplished!”  And of course, I had to rain on that parade.  My paper was titled “Bill of Goods: CCPs and Systemic Risk”, and the themes were (a) most of the arguments about how clearing would reduce systemic risk (e.g., the effects of netting) are wrong, and (b) clearing and collateral mandates created new sources of systemic risk.  Meaning that the G20 sold us a bill of goods in Pittsburgh.

So call me Mr. Popular.

A good part of the rest of the program on Wednesday was the Craig show.  The next panel was chaired by someone from the ECB, who gave a rather injured defense of the Pittsburgh agenda: I wasn’t mentioned by name, but it was pretty clear that she was attempting-ineffectually, IMO-to rebut me.  Several of the panelists said “as someone said in the previous panel”-and then referred to something that I had said.

Then a representative from the BIS presented, to much fanfare, the results of the Macroeconomic Assessment that I criticized heavily before I left for Europe.  After presenting the results, he discussed criticisms and caveats, and spent most of the time attempting-even more ineffectually, IMO-to rebut the arguments I raised in my post.

Very flattering.  Thanks.

The next panel was another group of academics.  The authors of two of the three papers, Bruno Biais and Hector Perez-Saiz (from the Bank of Canada), stated that their papers were motivated/inspired by my earlier research (which Biais called “seminal”).

Even more flattering.

My panel generated some interesting discussion and questions.  Many related to Dale Rosenthal’s paper about the potential inefficiencies that can occur when defaulted positions are replaced (or hedged).

As I’ve written for 3-plus years, the one main benefit of CCPs is that a centralized mechanism (e.g., an auction) for replacing/hedging defaulted positions is likely to be more efficient than an uncoordinated scramble in a bilateral OTC market.  The question is whether this function can be unbundled from the other functions performed by CCPs, which may not reduce systemic risk, and may in fact increase it.

Indeed, since there will be massive quantities of non-cleared derivatives, many of them of the more complex variety, the clearing mandates will not eliminate the replacement/hedging problem.  Even if the cleared derivatives are handled in an orderly auction process, these massive quantities of non-cleared derivatives will not.  These positions will have to be dealt with, and there is a serious risk that the process of replacing them will be very chaotic and destabilizing.

I confess to amazement that in all of the post-Pittsburgh regulatory efforts, this issue has escaped attention.  The focus on clearing, margins, SEFs, etc., has apparently taken up all the oxygen.  This is truly unfortunate, because a centralized auction mechanism to replace or hedge defaulted positions is likely to be far more effective and efficient than a non-centralized mechanism.  Put the other way, the decentralized mechanism is likely to be chaotic and destabilizing and excessively volatile.

Again, the clearing mandate does not solve this problem because many derivatives, especially the most exotic and illiquid (and hence problematic) ones will be outside CCPs, and CCP auction processes.

Which got me thinking (during a conversation with Dale Rosenthal during a break) of how this issue could be addressed.  What popped into my head? The swap dealer designation.

For the most part this designation is all pain, no gain.  How could we make lemonade out of this lemon?  Well, the thought that comes to mind is that designated swap dealers could be required to participate in the auction/hedging of a positions defaulted on by another swap dealer (or dealers).

I am somewhat reluctant to advance this proposal, because I am usually skeptical about mandating anything.  But there is arguably a public good (in the technical sense of the term) element to the process of  replacing/hedging defaulted positions: as the Rosenthal paper suggests, there are potentially many coordination and strategic behavior problems when this process is decentralized.  Consequently, it is worth some further thought.  (The clearing and collateral and capital obligations of swap dealer designation do not have as compelling a public good justification.)

The details will be challenging. In particular, since not all swap dealers will trade all of the types of instruments in a defaulted portfolio, it is not immediately obvious how to determine, in advance, each designated dealer’s auction obligations: that is, it’s not obvious how to specify which auctions each dealer must participate in.  For instance, it makes little sense to require BP or Cargill to participate in auctions for interest rate swaptions.  So who has to participate in what auctions?  Given the plethora of categories (interest rates, credit, equity, FX, commodities) and currencies, there is likely to be a plethora of auctions, and thus it will be difficult to say who is obligated to participate in what auctions.

However it is specified, this obligation will arguably make the swap dealer designation more onerous, and firms will attempt to structure their businesses to avoid falling afoul of it.  But the biggest dealers will not be able to avoid it.  What’s more, if I am correct that a centralized mechanism for handling defaulted positions is a public good, the creation of such a mechanism will actually redound to the benefit of all market participants, including the swap dealers.  After all, they are likely to have the biggest positions to hedge and replace in the event of a major default, and would benefit from a reduction in the risk of this process, and an improvement in the efficiency of the pricing mechanism in the aftermath of a major default.

This is something that at least deserves some consideration.  And, of course, regulators appear to have ignored it altogether in their focus on clearing and margins.  Which is another reason why I am not a G20 cheerleader, 4 years after Pittsburgh.

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  1. Craig —

    Wow! I’m glad someone else sees the key value in CCPs that I do — coordination — since global netting (across swapco subsidiaries), margining, collateral, and daily marking-to-market were all things we did at LTCM and that didn’t do a whit of good at stopping a crisis. The discussion of having dealers coordinate auctions was an interesting counterproposal and made me think if coordination is the only benefit of CCPs. (I suspect the ease of novation/true position exit may be the other benefit.)

    Thanks for the mention; I’m glad I got smart people (like yourself) thinking more about markets.

    P.S. It is a bit troubling that for some central bankers, the milestone event of the crisis was the Pittsburgh G20 and not Lehman’s collapse.

    Comment by Dale Rosenthal — September 16, 2013 @ 6:55 pm

  2. @Thanks, Dale. I’ve been making the coordination point off and on. I wrote about it first in April, 2010. I also discussed it in this policy piece I wrote for Cato. I think it’s an issue of first order importance that has been shockingly overlooked by regulators. Glad that you are banging the drum on it. Maybe somebody who can do something will pick up the beat.

    The ProfessorComment by The Professor — September 16, 2013 @ 9:15 pm

  3. To quote (out of context) Yeats re the central bankers: ” Once again you have disgraced yourselves completely”

    While coordination is a benefit, and your suggestion that the mandate be made is critical: any market that stops when dealers can simply not answer the phone is always going to have a crisis at some point. Not that such a thing will prevent a crisis, but that it makes the results quickly visible, and quantifiable (in part, at least).

    This later feature may be one of the things that makes the CB’s nervous. In any crisis management exercise there is always the issue of managing information: having data and numbers exposed runs counter to the bureaucratic imperative to control the message.

    The greatest danger of the CCP’s as implemented is the apparent (but not real) safety of these dealing in these instruments, particularly without a mandated auction process. In a world of complex derivatives, the CCP’s allows one to change a ( it is to be hoped ) matched book based on credit judgments about the counterparties into one that is “hedged” with basis risk in a market that may prove no more liquid than any other, but looks great! In other words the CCP’s themselves may promote riskier positions in complex derivatives since they can be hedged (with basis risk) in a “safe” as to credit market.

    I would be very interested in hearing about your thoughts on the effects of CCP’s on risk behavior, and if you think my concerns are justified.

    Comment by sotos — September 17, 2013 @ 10:04 am

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