Streetwise Professor

March 3, 2012

Our Three Weapons Are . . .

Filed under: Clearing,Derivatives,Economics,Financial crisis,Politics,Regulation — The Professor @ 6:17 pm

Deus ex Machina has a typically succinct and excellent post on CCPs.  He argues that CCPs perform two functions, derivatives receivable insurer and central margin custodian, and there is no reason why these functions must be combined in a single entity.

Absolutely true. I have made this point several times, notably in this Cato policy review piece.

My only quibble with DEM is that CCPs perform more than the two functions.  In addition to those, it serves as a trade data repository, monitor of the creditworthiness of its members (which, admittedly, could be considered part of their derivatives receivable insurer function), and importantly, default manager.

But DEM’s (and my) fundamental point remains the same: what is the economic rationale for combining in all these functions in a single entity for all derivatives?  Maybe this bundle is optimal for some derivatives (e.g., highly liquid, mainly short maturity futures and options), but not for others.  But why is that the right bundle for all derivatives?  Is there a reason to believe that the market will necessarily settle on the wrong bundle, thereby requiring the mandating of the futures bundle for all derivatives trades?

Vital questions, IMO, but ones that have seldom been asked by people who merrily dictate market structure and contracting practices.  Or by academics for that matter.

DEM’s numbering of the functions of CCPs brings to mind a Monty Python sketch (but then again most things do):

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  1. […] – CCPs perform mainly two functions, or possibly three. […]

    Pingback by FT Alphaville » Further reading — March 5, 2012 @ 2:31 am

  2. A marvelous article, Prof – particularly your description of the 1987 fiasco. The key missing term here is volatility. Collateral as a substitute for credit decisions (i.e. thinking)falls apart when one thinks of the market pricing mechanism as at least a Markov model, subject to violent changes in price volatility or liquidity of the underlying instruments. If we are going to go through the CCP system, it would seem that the only counter to additional balance sheet risk is to change the margin requirements to a combination of the instrument, and the participant’s own credit worthiness: in itself probably a nightmare to enforce and administer. The auction mechanism you suggest seems viable: something very similar happened in the Agency MBS TBA market when Drexel Burnham went under – essentially the book was transferred in a kind of cram down mechanism, with forced closing of some counter-party positions, if I remember correctly, though the actual shutdown was done on a relatively quiet day and affected only dealers.

    The enforced closing part of this, if I understand your argument correctly, would lead us to a paradox: at the time when the protection is most needed e.g. market risk is greatest, hedges would in essence be forced to be liquidated. This sort of throws a murky light the whole process of hedging: in the Cambrian period of banking the old saw was the best hedged risk is the one avoided, and if you cannot do that structure it on your own balance sheet. Modern translation: interdependency can be a bitch.

    Comment by sotos — March 5, 2012 @ 7:52 pm

  3. Sotos-1. Thanks for your kind words. 2. You’re right on target. I’ve argued here and elsewhere that CCPs are severely constrained in their ability to make margins dependent on creditworthiness. There’s an information problem, but also an organizational one: discriminating among members creates an incentive to influence firm-specific margins for competitive advantage.

    The way I envision the auction process, hedges would be replaced/transferred, rather than liquidated. At least, that should be the objective.

    Thanks again.

    The ProfessorComment by The Professor — March 5, 2012 @ 11:20 pm

  4. From an academic perspective, there is a clear rationale for a single CCP with all risk aggregated and netted on a single balance sheet. It is more tidy for unwinding a bankruptcy and could provide a politically “fair” default insurance when all complex derivatives turn to cash settlements (liquidation). But this academic fallacy is doomed by the hayekian impossibility of determining the cost of credit support. SWP, this is your major quibble.

    Determining the creditworthiness of a company is a complex task which changes daily and can only be accomplished in the marketplace through a price discovery mechanism. I would prefer to see “cleared derivatives” trade explicitly alongside their “non-cleared” cousins and provide a market spread for the credit support. Instead of a single CCP, the clearing function should be accomplished by an army of profit-motivated hedgefunds which trade with a focused strategy of “pricing clearing support”. They could hedge their flat price and volatility exposure of the underlying and create a pure credit exposure to their counterparty. The CDS market also provides a x-market abitrage opportunity.

    If systemic financial risk is so dangerous, why not apply the same market mechanisms we have applied to other existential price risks: such as volatility with milk, wheat, oil, gold and currencies? Whenever the financial savants have succeeded in creating a centralized entity to fixed the dangerous volatility of gold, oil or milk, it has ended in misery. If Dodd-Frank succeeds in fixing the price of credit support (clearing) financial markets are in for a miserable spin.

    Comment by scott — March 5, 2012 @ 11:39 pm

  5. @Scott-You put a different twist on my basic arguments, but I think we’re basically on the same page. Your argument, like mine, is essentially an argument against mandating clearing. A big part of the reason I’ve made that argument for years is that a CCP is unlikely to be able to price credit risk properly, and that profit-motivated entities–I was thinking dealers, but they could be hedge funds, or insurance companies, or a combination of these firms–who would trade, absorb, and crucially price credit risk. They would produce and utilize private information that would permit them to price accurately. And you’re right, CCPs could free ride on this price discovery to improve their margining.

    Basing CCP margins on CDS could serve the same function. Just as dealers are employing CVA based on CDS spreads, so could CCPs. But that doesn’t appear to be likely to happen soon.

    You are so right that price fixing is a disaster. I’ve noted over and over that relying on a single entity to set prices-whether it is a CCP, or a Basel committee-creates systemic risk. It is a monoculture that will collapse when confronted with the next financial equivalent to smallpox.

    The ProfessorComment by The Professor — March 5, 2012 @ 11:47 pm

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