Streetwise Professor

My work on clearing was mentioned in the lead editorial in today’s Wall Street Journal.  For the most part, I agree with the editorial.  Hell, I could have written most of it.  It makes many of the points I’ve been writing about here on SWP, and in working papers and presentations, since the financial crisis began (and even before the crisis).  Even the initial sentence, which refers to the widespread belief that clearinghouses are a “miracle cure” echoes the title of my Regulation magazine piece from January, 2009–“The Clearinghouse Cure.”

The initial point is the most telling one: if clearinghouses make counterparty risk disappear (as its cheerleaders repeatedly suggest) why is there need for any CCP to have access to the Fed discount window?

Exactly.  They don’t make counterparty risk disappear.  They become repositories of counterparty risk that can fail, with potentially disastrous consequences for the broader financial system.

I was on board with the editorial until the last paragraph, in which the Journal says “Congress should strip out Mr. Dodd’s discount window provision. As important, Americans should understand that Congress isn’t ending financial risk in derivatives. It is merely redirecting that risk, while making taxpayers the ultimate backstop.”  Yes, it is merely redirecting that risk.  (Finally!)  No, it isn’t ending financial risk in derivatives.  (Finally!)  No, taxpayers should not be the ultimate backstop.  (Absolutely.)  But access to the Fed discount window does not mean a taxpayer bailout.  At least as long as the Fed acts as a traditional lender of last resort, along Bagehotian lines, lending to provide liquidity against good collateral.

During market shocks, large margin flows create spikes in the demand for liquidity.  It is appropriate for the Fed to accommodate such demands for liquidity through the discount window and market operations.  Bulking up clearinghouses through mandates, but denying them access to liquidity, is a recipe for disaster.

But one of the casualties of the financial crisis, and the Fed’s response to it (and even more so, the ECB’s response to the Greek crisis) has been the  devolution of the LOLR function.  Central banks have treated insolvency crises like liquidity crises, thereby socializing losses.

This is indeed a problem.  But it is a problem that is not limited to derivatives.  If Congress believes that it is a problem, it needs a thoroughgoing reform of the Fed.  Just denying CCPs access to the discount window will not fix it.

But back to the rest of the editorial.  Implicit in the whole debate over the relationship between CCPs and the Fed is the fact that the CCPs can fail.   If they fail, they can cause huge knock-on effects, just like the failure of a large dealer.  Potentially worse, in fact.  And this reality means that in the breech, it is likely that by hook or by crook Congress or the Treasury or the Fed will find some way to bail out a failing CCP.

This is an issue that Congress and the administration have refused to acknowledge.  In his speech at the ISDA Annual General Meeting in San Francisco, Deputy Treasury Secretary Neal Wolin pointedly refused to admit that clearing mandates could create too big to fail institutions, thereby exposing taxpayers to losses.  This refusal to recognize the very real consequences of a clearing mandate is sowing the seeds for the next crisis.