Streetwise Professor

August 4, 2009

In the Shallow End

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics — The Professor @ 11:18 am

The SEC letter granting ICE Trust the exemptions necessary to clear CDS transactions provides a perfect illustration of the extraordinary shallowness that characterizes policy analysis of the subject of clearing:

The Commission believes that using well-regulated CCPs to clear transactions in CDS would help promote efficiency and reduce risk in the CDS market and among its participants. These benefits could be particularly significant in times of market stress, as CCPs would mitigate the potential for a market participant’s failure to destabilize other market participants, and reduce the effects of misinformation and rumors. CCP-maintained records of CDS transactions would also aid the Commission’s efforts to prevent and detect fraud and other abusive market practices.

A well-regulated CCP also would address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of the counterparties to a CDS. In the absence of a CCP, participants in the OTC CDS market must carefully manage their counterparty risks because the default by a counterparty can render worthless, and payment delay can reduce the usefulness of, the credit protection that has been bought by a CDS purchaser. CDS participants currently attempt to manage counterparty risk by carefully selecting and monitoring their counterparties, entering into legal agreements that permit them to net gains and losses across contracts with a defaulting counterparty, and often requiring counterparty exposures to be collateralized.11 A CCP could allow participants to avoid these risks specific to individual counterparties because a CCP “novates” bilateral trades by entering into separate contractual arrangements with both counterparties – becoming buyer to one and seller to the other.12 Through novation, it is the CCP that assumes counterparty risks. For this reason, a CCP for CDS would contribute generally to the goal of market stability.

As part of its risk management, a CCP may subject novated contracts to initial and variation margin requirements and establish a clearing fund. The CCP also may implement a loss-sharing arrangement among its participants to respond to a participant insolvency or default.

Stop right there.   So, in a bilateral market firms

“carefully manage their counterparty risks because the default by a counterparty can render worthless, and payment delay can reduce the usefulness of, the credit protection that has been bought by a CDS purchaser. CDS participants currently attempt to manage counterparty risk by carefully selecting and monitoring their counterparties, entering into legal agreements that permit them to net gains and losses across contracts with a defaulting counterparty, and often requiring counterparty exposures to be collateralized”

but once things are cleared, it’s apparently: “No worries!   The CCP takes care of everything!”   These sentences represent one of the greatest logical leaps–that is to say, non sequiturs–that I have read in a long time: “Through novation, it is the CCP that assumes counterparty risks. For this reason, a CCP for CDS would contribute generally to the goal of market stability.”

Uhm, yes, the CCP assumes counterparty risks.   But they don’t disappear.   Given the size of trading positions, the total losses resulting from a particular default result in the same size of loss in bilateral or cleared markets; clearing just changes the allocation.   Indeed, it can make this allocation worse, not better.   Moreover, a CCP concentrates counterparty exposure, meaning that there is a concentrated point of potential failure.   That hardly contributes to market stability.

Note too that the SEC completely ignores any incentive issues.   It recognizes that bilateral counterparties spend considerable resources to manage counterparty risk because they bear the loss in the event of a default.   The letter is completely silent on the incentive of the CCP (compared to bilateral counterparties) to manage this risk.   It is also completely silent on the information available to the CCP as compared to bilateral traders to evaluate, manage, and price counterparty risk. The letter is also silent on the potential moral hazard problem that mutualization of performance risk through a clearinghouse creates.

Thus, in expressing a preference for one way to manage performance risk over another, the SEC makes not the slightest effort to analyze the incentives or abilities of agents to perform this task under alternative arrangements.   It just makes conclusory statements with no logical, factual, or analytical basis.

To put it bluntly, the mere fact that a CCP “assumes” counterparty risk in no way implies that it improves market stability.   The chasm between one the conclusion (clearing improves market stability) and the alleged basis for that conclusion (the mere fact that a CCP assumes performance risk) is wider than the Grand Canyon.   Assumption of risk is not the same as making that risk disappear.   Given the incentive and information issues, it is quite possible that it makes the risk worse.

The SEC then falls back on the other main justification for clearing:

A CCP would also reduce CDS risks through multilateral netting of trades.13 Trades cleared through a CCP would permit market participants to accept the best bid or offer from a dealer in the OTC market with very brief exposure to the creditworthiness of the dealer. In addition, by allowing netting of positions in similar instruments, and netting of gains and losses across different instruments, a CCP would reduce redundant notional exposures and promote the more efficient use of resources for monitoring and managing CDS positions. Through uniform margining and other risk controls, including controls on market-wide concentrations that cannot be implemented effectively when counterparty risk management is decentralized, a CCP can help prevent a single market participant’s failure from destabilizing other market participants and, ultimately, the broader financial system.

Most of the benefits of netting mentioned are private benefits.   If they are so large, market participants would have been incentivized to capture them long ago.   Instead, they are only forming CCPs under the threat of even more draconian government intervention.

Sadly, this letter is representative of virtually every regulator’s and legislator’s advocacy of clearing.   That includes the US Treasury, CFTC, various legislators (e.g., Barney Frank and Colin Peterson), and the EC.   Based on such shallow justification, said powers are about to re-engineer the largest and most sophisticated financial markets in the world.

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