Streetwise Professor

Betting the Business has a recent post that is a paean to central clearing.  I have some major problems with it.

The problems start with the title: “Central clearing lowers end-user costs.”  That short, unqualified, declaration begs major questions.  Most importantly: If clearing is more efficient, why did cleared markets lose market share to the putatively less efficient alternative, bilateral uncleared OTC trades?

I’m not suggesting that such inefficient outcomes are possible, but I take it as a rebuttable presumption that competitive processes tend to result in the displacement of the inefficient by the efficient.  So I’d like to see a convincing story at least, backed by some anecdotes at least, that would represent a plausible rebuttal.  That’s a low bar: it would be preferable, of course, to have a rigorous model supported by empirical evidence.  But I’ve yet to see anyone clear even that low bar: indeed, very few have tried.  To be honest, BTB don’t in this piece.

And by “convincing,” I don’t mean stories that rely on bankers’ Svengali-like hold on their customers, or customers suffering from some variant of battered spouse syndrome.  These stories are facially implausible, and indeed, counterfactual during the period during which OTC derivatives markets grew dramatically, the 1980s and 1990s.  This was a period in which banks were suffering “disintermediation”: they were losing business and customers to capital markets that customers found more efficient sources of capital.  So, the Svengali thing wasn’t working so good when it came to traditional loan business.  Ironically, many of the big loan customers that banks lost simultaneously began trading OTC derivatives with them.  Also ironically, one of the major reasons that the CDS market began was that banks were losing their traditional loan business.  JP Morgan in particular made a strategic decision to develop CDS business aggressively because it was facing more intense competition from capital markets in making traditional loans.  Which all means that customers–especially big ones–have the ability to adopt more efficient ways of financing and managing risk.

My other big problem with the BTB piece relates to netting:

Central clearing, if managed appropriately, helps to reduce the volume of credit risk by cancelling out many offsetting positions, disappearing some credit risk and leaving us with a smaller, residual credit risk from derivatives trading. One of the problems with OTC markets is that brokers wanting to closely guard their clients don’t have an incentive to cancel out offsetting exposures to counterparties. Critics of the clearing system keep overlooking the fact that risk can in fact disappear. The derivatives market system, depending upon how it is structured and operated, can have more or less total credit risk.

The notion that multilateral netting necessarily reduces risk is incorrect regardless of whether one focuses on credit risks in derivatives alone, or takes the proper perspective of looking at credit risk in toto.

With respect to credit risk in derivatives taken in isolation, clearing some products and not clearing others–which is inevitable given the unsuitability of some products for clearing, and indeed, the refusal of CCPs to clear them–may exploit some scale economies from multilateral netting in a particular product, but can destroy cross-product scope economies.  For instance, clearing a credit index but not all the names in the index destroys the scope economies that a bank can realize by holding positions with customers in both the index and the components.  Or if an interest rate swap is cleared but an interest rate swaption is not, netting economies across these products are lost.  These are simple examples, but they could be multiplied ad infinitum.

Indeed, these cross-product netting opportunities are one very plausible explanation as to why clearing lost ground to bilateral markets dominated by dealers.  Dealers trading multiple products can exploit cross-product netting economies and thereby offer their customers lower costs.

What’s more, when we consider clearing-as-it-will-be-in-this-messy-world, as opposed to the Platonic ideal of clearing, even within a single product clearing mandates may reduce netting economies.  Jurisdictionalism is likely to result in the creation of multiple CCPs for a given product type.  For instance, it is likely that regulators in the US and Europe insist that CCPs for particular products be established in their jurisdictions, and that financial institutions subject to their jurisdiction will use these “home” CCPs.  That creates operational headaches and reduces the netting benefits of clearing.

A proper, systemic approach also demonstrates that the disappearance of risk, like a magician’s trick, is often an illusion that works because the audience’s eyes are fixed in one place, and therefore they miss where the real action is.  As I pointed out several years ago, taking derivatives positions and the capital structures of market participants as given, netting redistributes risk from derivatives counterparties to other holders of liabilities on these derivatives market participants.  Yes, multilateral netting (and bilateral netting supported by collateral, rights of offset, etc., for OTC deals under bankruptcy laws) reduces the credit risk in derivatives trades, but the risk doesn’t disappear down the magician-CCP’s hat: it is reallocated to those who have lent money to the firms that hold positions in the netted derivatives.  Netting puts derivatives counterparties closer to the front of the line of creditors in bankruptcy.

Now the issue of the proper priority of derivatives is a sticky one, and I don’t claim to have the answer.  Giving derivatives counterparties priority tends to reduce their incentive to run, but it can increase the incentive of other creditors to run.  And in equilibrium, capital structures will depend on priority rules.  So it may be the case that clearing reduces the risk of runs on derivatives dealers by their derivatives counterparties, but increases the risk of runs by their repo counterparties, or the buyers of their corporate paper. It’s unclear how that cuts.  (No pun intended.)

Though I don’t have the answer as to the optimal priority rules, I do realize that netting does affect priority–and that this means that statements about netting “making risk disappear” are not generally true, and are typically wrong, because these statements are based on only a portion of the total risks.  The risk no more disappears due to a change of priorities achieved through netting than the rabbit really disappears into the magician’s hat.

It should be noted, moreover, that this issue of netting and priority has long been understood in other contexts, notably in payment systems.  Work in the 1990s and early 2000s (by Charlie Kahn, among others) emphasizes that netting systems and real time gross settlement have different affect the priority of payment system participants relative to other creditors of those systems.

There are some other problems with the BTB analysis, but I’ll just mention them in passing.  They say:

Margins are paid by those who use the system. In the OTC markets, banks either correctly price risk, or trade with clients by granting these subsidies from the taxpayer, or from wealth transfers by their bond holders. Clearing and margining is a potent dissuader of free riding on the system by negligent brokers, and also helps to mitigate agency conflicts between bonus motivated bankers and the bank’s stakeholders, which, we have learned, includes the taxpayers/citizens of each country.

I can’t say that I fully track that paragraph, but I will say that I am struck by the free riding analysis.  It suggests a sort of transubstantiation, where bankers are agency-conflicted, or perversely incentivized due to too big to fail subsidies when acting individually, but somehow become less conflicted and better incentivized when they act collectively through a CCP (and most CCPs will be bank dominated).  It’s not obvious how that works.  Indeed, collective action problems and multi-task/multi-principal agency problems usually result in weaker, not stronger incentives.

In this regard, it should also be noted that the homogenization of credit risk in a CCP creates problems.  CCPs make all trades by all members fungible, even if those members bring differing amounts of credit risk to the system.  This tends to reallocate trading activity away from the more creditworthy to the less creditworthy.

I also consider this unrealistic:

And to protect the public, it is necessary for regulators to see and be able to manage the true volume of credit supporting derivatives trading. Clearing is part of making that possible.

Given the fungibility of credit, you will never unambiguously know how much credit is used to support derivatives trades, even in a cleared system.

I have other issues (I can just imagine you exclaiming: “I’ll say!”), but I’ll leave it at that.  Suffice it to say that there are major holes in this clearing paean, and that it certainly does not provide a firm basis for mandating the adoption of central clearing.