Streetwise Professor

December 9, 2008

Paging Captain Obvious

Filed under: Commodities,Derivatives,Economics,Exchanges,Politics — The Professor @ 5:36 pm

I quote from the Book of Duh:

Top executives from four major financial exchanges told federal lawmakers Monday they believe the clearing of certain kinds of credit derivatives should be mandated by law.

. . . .”Clearing should be mandated for most [credit-default swap] instruments,” said Johnathan Short, vice president and general counsel for Atlanta-based ICE.

Terry Duffy of the CME chimed in (this is from Bloomberg–no link yet): “We do believe there should be a mandate for clearing of credit-default swaps.”

Eurex also joined the party, although they were a little more restrained in their remarks, with the exchange’s Thomas Book (whom I participated with in a panel at the SFOA in September) asking only for:

As a consequence, Congress should take into account whether the regulatory enhancements that it is considering will reinforce and be supportive of the migration of (credit-default swap) transactions from the current bilateral structure to regulated and transparent (central counterparties)

Well of course the exchanges want Congress to force clearing onto exchanges because, as Thomas so mellifluously put it:

It should be noted that although the benefits of clearing are significant for the integrity of financial markets, it cannot be assumed that centralized clearing will be automatically and broadly accepted by current (over-the- counter) market participants.

That is, the banks are unlikely to do it voluntarily, so it’s necessary to force them to clear. And if they’re forced to clear, guess who’s just licking their chops to do that business?: ICE, CME, Eurex.   Surely a coincidence.

Which begs the question, often asked here: If it such a great idea, why don’t the banks do it on their own initiative?

[Crickets chirping.]

I’ve beaten this horse so many times that I’m sure PETA is already filing a complaint with local law enforcement, so I’ll try to keep it brief and make my getaway.

One should pay considerable deference to the survivorship principle.   Although path dependence can complicate matters, the survival of a particular institutional arrangement in the face of viable alternatives suggests that it offers efficiency advantages over these alternatives. I have laid out a case as to the likely sources of such an efficiency advantage of bilateral arrangements over central clearing: lower costs associated with asymmetric information.

Only if one can identify some sort of market failure (e.g., a coordination problem) or externality is a mandated change in default risk sharing arrangements justified.   Although there has been a lot of serious talk about “systemic risk” and “financial stability,” there has been no real identification of a concrete externality, or a demonstration that mandated clearing would fix it.     Apropos yesterday’s analysis of the Allen-Gale book, the discussion of clearing has been carried out without reference to any credible theoretical or logical framework.

So, my challenge to the advocates of clearing: What externality that justifies the impostion of clearing?   If the individual firms who would belong to a clearinghouse don’t internalize the externality, why would a clearinghouse?   Why, despite the fact that the concept of clearing is very well known and tested, have wide swaths of the OTC market deliberately eschewed it?   What are the likely equilibrium responses to the imposition of clearing?   How exactly will clearing reduce systemic risk?

The political economy of this is very interesting.   The congressional committee (House Ag) with jurisdiction over the futures markets and the exchanges is pushing legislation to mandate clearing.   (Chairman Peterson has indicated that he hopes to have a bill in January.)   This suggests that this is being driven by politics and the concentrated economic interests of the exchanges, rather than a serious deliberation over the pros and cons.   (Well, “Duh” again.)

I will close with an entertaining quote from a Chicago trader and CME clearinghouse member who understands very well the risks (notably the balance sheet risks) that CDS clearing could pose:

Howard Simons, one of the Chicago traders who always loathed the New York CDS dealers, speaks for many of his comrades in rejecting the trading of CDS on the futures exchanges. “The clearing members of the CME [Chicago Mercantile Exchange] think trading this stuff is the stupidest idea in the world. I didn’t work my whole life so some investment bank can take all our capital. Do I look like Hank Paulson?”

One of the most succinct descriptions of balance sheet risk ever uttered.   Couldn’t have put it better myself.

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