Streetwise Professor

I was in DC yesterday, participating in a joint SEC/CFTC Roundtable on CDS clearing.  These Roundtables are intended to provide information to staffers charged with the daunting task of writing the avalanche of rules mandated by Frank-n-Dodd.  This particular Roundtable focused on margin setting, default resolution, and CCP access and governance.

The quality of the panelists was quite impressive, and the discussion largely informative.  My main impression was that in 3 hours the panelists were able, at best, to scratch the surface of the surface on a relatively small subset of issues confronting the agencies.  That’s a pretty sobering fact.

Substantively, the issue that engendered the most back-and-forth related to the access and governance issue.  Not to say I told you so, but I told you so–and have been doing so since about 1997, and especially since 2006 or thereabouts.

As I’ve written, the fundamental tensions are clear-cut (no pun intended).  Yes, limiting access can be a way of exercising market power, and those on the outside might lose out on economic rents.  But against that, more expansive rules on CCP access raise serious concerns about risk and governance.

More expansive access means that less financially secure firms are in the CCP, which increases default risks.  But that’s not all.  More expansive access means that CCP membership will be more heterogeneous. This opens new cans of worms.

First, CCP margining and guarantee fund calculations depend primarily on the risks of the portfolios of cleared derivatives, but the default risk posed by any individual member depends not just on those risks, but on the interaction between these risks and the balance sheet risks posed by that member’s other assets and liabilities.  CCPs generally take that risk into account in a crude way, if at all, and do not really take into account the correlation between balance sheet risks and the portfolio risks–which is absolutely critical.

This is problematic because it means that the price levied for default risk does not vary across members in a discriminating way.  This distorts the trading activity across members: riskier ones tend to trade too much, and less risky ones too little.  The more heterogeneous the membership, the more difficult the problem.  A one-size-fits-all margin calculation (or one with limited conditioning on member-specific information) inevitably distorts incentives, all the more the more heterogeneous the members.

Second, heterogeneity raises governance costs.  Heterogeneity means that members differ in their desired margining and capital policies.  There is more politicking and rent seeking, the greater the heterogeneity.  This is costly in and of itself, and also can lead to distorted decisions regarding risk pricing and policy.  Indeed, this heterogeneity tends to lead to more cumbersome, committee-driven governance processes.

Things will only become more problematic if, as seems almost inevitable, there is a requirement to include other constituencies, such as end users, in critical governance functions (most importantly, the risk committee).

This is an interesting economic issue, in the abstract, related to club theory: what is the optimal membership of the clearing “club”?  It is a hard question, but heterogeneity imposed by regulatory fiat–engineering of the organization and governance of CCPs–is rife with potential for disaster.  There is a serious potential for misalignment of incentives and distortions in risk taking.  Which kind of defeats the entire purpose of a clearing mandate.

The issues in clearing are all the more acute because fundamental economic forces, related to the nature of netting and diversification, create economies of scale and scope that make clearing a natural monopoly, or at least a natural oligopoly.  This means that the normal club good outcome in the absence of such strong economies, with the formation of multiple heterogeneous clubs with relatively homogeneous memberships, isn’t viable in this context.  So the market power-access-governance battles are likely to be intense and never-ending.  We’ve seen such battles in security markets for years, and they will be coming soon to a derivatives market near you.  No need to hurry to watch, though, for they will never go away because the fundamental economic drivers are enduring and  inhere in the nature of the service.  (This is the subject of my next book, BTW.)

One question from an SEC staffer made me uneasy.  (I’ll try to remember to post a link to the transcript when it comes online here.)  The premise of the question was that a premise of Dodd-Frank was that the OTC market is too concentrated, and insufficiently competitive, and that clearing was a way of opening up the market and making it more competitive.  The staffer expressed concern that access policies would have to be regulated to achieve this outcome.

That would make access policy a political football.  Again, I am sympathetic to the view that CCPs can potentially utilize their membership and access policies to exercise market power.  But I am also very sensitive to the very real possibility that a la Fannie and Freddie, political pressure to benefit some market participants will lead to policies that compromise the financial strength of CCPs.

My response to the staffer’s question was that it was mistaken to start from the premise that the market was too concentrated and insufficiently competitive.  I said that before making policy choices, it was imperative to try to understand why the market structure evolved as it had.  Concentration was not mandated.  It was the result of an economic process.  I can think of “bad”  reasons why the market became too concentrated (TBTF subsidies, for instance), but I can also think of “good” reasons (economies of scale and scope).  Policies not based on an understanding of the underlying economics are likely to have fundamental flaws that will manifest themselves in the worst way.  Fighting against fundamental economic forces is a recipe for policy failure.

I am appreciative of the opportunity to have participated in this Roundtable, and hope I made a positive contribution to the debate.  I am sure, however, that I will have other opportunities to do so–as will many others.  That is because we have not yet even begun to fight, really, on matters of clearing market structure, organization and governance.  The war will be a long one.  This is a reflection of the fact that Frank-n-Dodd failed to come to grips with most of the most fundamental issues inherent in its litany of mandates.

PS.  Here’s an article by Matt Leising and Shannon Harrington at Bloomberg that mentions some of my remarks at the Roundtable.  Thanks, as always, guys.