Streetwise Professor

May 20, 2009

More Conventional Ignorance on Clearing

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

I like Jeremy Grant of the FT, and his colleague Gillian Tett is a media darling right now, flogging her book on the financial crisis.  But in their article on the Geithner derivatives proposals (along with Aline van Duyn), they laid an egg.  They repeat the conventional wisdom on clearing, and the supposed benefits of forcing OTC trading onto exchanges.  Actually, it would be more accurate to say that they repeat the conventional ignorance on the subject.

They say that on exchanges “[t]rades are then ‘cleared’ on a central platform, which completes a deal even if one counterparty collapses.”  Similarly, they say that in OTC markets, “[t]hat means in many cases there is no centralised system to monitor prices or deals nor any third party to ensure a trade is completed if a counterparty fails.”  These quotes suggest that counterparty risk does not exist in a cleared market like it does in an OTC market.  This is wrong, because the clearinghouse can fail.  More to the point, given the size of the position of a defaulting party, clearing only affects the allocation of losses, not their total amount.  Now, this allocation can be superior, but not necessarily so.  But I grind my teeth at the suggestion that clearing magically makes default risk disappear.  

This also has implications for systemic risk.  In a cleared market, the default risks are borne in the first instance by clearinghouse members, who are typically systemically important banks.  Clearing can actually concentrate and increase the counterparty risks that these systemically important banks bear.  This point is seldom made, but it is important.  Grant, Tett and van Duyn overlook it altogether.  

Most egregiously, they say this:

The proposals Mr Geithner, Ms Schapiro and others have unveiled try to tackle these problems in four ways. First, they demand all “standardised” derivatives are  centrally cleared to remove counterparty risk, even if they are not traded on an exchange.  [Emphasis added.]

No. No. No. NO!  Clearing DOES NOT REMOVE COUNTERPARTY RISK.  The three FT reporters should be sentenced to write that sentence over and over again on a blackboard, Bart Simpson-like, until they get their minds right.  Moreover, to atone for this, the FT should be required to devote an entire front page consisting entirely of “CLEARING DOES NOT REMOVE COUNTERPARTY RISK” in headline-sized type.  

Again.  Clearing redistributes the losses arising from counterparty default.  It does not remove it, or make it magically disappear.  What’s more, it does so in a way that can reduce efficiency, and increase systemic risks.  

Sheesh.  Grant et al state: “A public debate about derivatives is long overdue.”  I agree.  It would be nice if that debate would be based on a thorough, fact-based, understanding of the actual tradeoffs involved in clearing and exchange trading.  Instead, this article just recycles the same old bromides.  

The article does the service of quoting this gem by new SEC head Mary Shapiro (which I had wanted to call attention to when I saw it last week, but got distracted):

As Mary Schapiro, chair of the Securities and Exchange Commission, says: “OTC derivatives, particularly credit derivatives . . . contributed to the financial mess we are cleaning up today.”

Just how did they contribute?  Yes, like the Treasury letter, you can point to the OTC posterchild, AIG, but that would be incredibly dishonest (as it was when Treasury did it).  It is dishonest because the type of contracts AIG traded would never be cleared, and never traded on exchanges, and hence would be/have been unaffected by the Treasury proposal.  But although credit derivatives have been accused over and over again of contributing to the financial crisis, the type of products that would be affected by the Treasury proposal are conspicuous by their absence from any honest accounting of culpability for the crisis.  

This only goes to show that Mary Shapiro’s replacing of the execrable Chris Cox has not increased the intelligence or market knowledge at the SEC.  And that is a very scary thought.

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