Streetwise Professor

July 27, 2009

SWP in FTAlphaville

Filed under: Commodities,Derivatives,Economics,Exchanges,Financial crisis — The Professor @ 12:04 pm

I am a guest poster on today’s FTAlphaville.  The subject: clearing.  The post riffs off an article in the FT that notes the importance of price information for clearing to work efficiently.  The basic points are that price information is necessary but not sufficient for clearing to work; that clearinghouses are consumers of information, not just producers of it; and that the debate about standardization has focused on what is really a red herring–contractual standardization–and overlooked the difficulties of economic standardization.

Many thanks to Stacy-Marie Ishmael for providing this opportunity.

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  1. Interesting post, Craig

    My background is as a former director of the IPE fwiw, and I’ve been doing a lot of work i recent years in the area where the internet and markets converge.

    I prefer to distinguish the guarantee of obligations from the clearing and settlement (netting) of obligations.

    It’s not actually necessary to have a central counterparty, and IMHO it constitutes a “single point of failure” in the same way that Fannie Mae and Freddie Mac were. Central counterparties clearing CDS are an accident waiting to happen. cf AIG

    Instead, you can have:

    (a) bilateral (Peer to Peer) obligations subject to a mutual guarantee backed by provisions into a default pool held by a custodian; and

    (b) netting of un-guaranteed bilateral obligations using a shared transaction repository and a “clearing agent” like (say) Ripple

    The result of such a “clearing agent” approach to netting would be of “book-outs” as with Brent 15 day forward contract daisy chains. Of course netting requires contract fungibility.

    Comment by Chris Cook — July 27, 2009 @ 5:51 pm

  2. Chris–

    I know of you. . . just read the piece on market manipulation you did for The Oil Drum. Was going to blog on it when a moment was free.

    The point you make is an essential one. And it’s one that I’ve made in a piece I wrote in Regulation Magazine in January, and a working paper earlier this year. (Will post/send links later).

    My mantra is: Centralize what should be centralized, don’t centralize what shouldn’t be centralized. Like you say, creating a single point of failure is a disaster waiting to happen. You can net without having mutualization (i.e., centralization) of performance risk. NetDelta is an example of how you can do that.

    I go crazy when people use the argument “the financial system is too interconnected” to justify creation of a CCP. Well, what the hell is a CCP other than an interconnection between all the big players? Indeed, I think that the interconnections in the OTC market have some very desirable features that a CCP would destroy.

    Gotta run now . . . hopefully more later. Thanks for reading, and for commenting.

    The ProfessorComment by The Professor — July 27, 2009 @ 5:59 pm

  3. Chris:

    Here are the papers I mentioned. The (very long) working paper. I should have a skinnied down version done in a few days. Here’s the piece from Regulation. Would be interested in your comments.

    The ProfessorComment by The Professor — July 27, 2009 @ 9:11 pm

  4. I can’t really fault your logic, Craig.

    I have long thought that when the Shells and BPs of this world deal with clearing houses they must be assuming implicit sovereign guarantees (not an unreasonable assumption bearing in mind recent events in the banking world) because clearing houses are clearly undercapitalised for the risks of market discontinuities which they actually run.

    Your point re CDS clearing of distinguishing position risk and balance sheet risk is the key point. In energy markets the balance sheet risk of most end user participants is negligible: in CDS it’s the balance sheet risk that is the biggest risk (and IMHO we are only at the End of the Beginning).

    I like the example of the Tin Crisis. When the tin market collapsed because the sovereign players stopped supporting the price (put not your trust in Princes….) then the LME had central clearing imposed on them.

    That meant they were better placed information wise, but as Riess pointed out, it didn’t help stop Hamanaka/Sumitomo.

    But note that the overnight collapse – a market discontinuiity – in price from $800 to $400 per tonne would have destroyed any clearing house even had there been one.

    Metallgesellschaft is another case. I heard that it was only the fact that the US twisted the arm of the German government that prevented the German banks from walking away from MG, and goodbye NYMEX in the ensuing market discontinuity. I had already seen in London the scale that Art Benson had been operating, but although I picked up on the London end of one of his big plays the LCH were quite happy to rely upon their relationships with the five brokers involved, and ignored the systemic risk that clients can pose. The SIB as it then was (now FSA) had no idea.

    I could go on.

    IMHO the first requirement is for a generic transaction repository in neutral hands – I set out my thoughts re market architecture and the internet here

    8 years ago, and people are just beginning to pick up on it.

    Oh well!

    Comment by Chris Cook — July 28, 2009 @ 6:09 am

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