Streetwise Professor

I truly admire Natasha de Teran’s reporting on derivatives markets. Her work is head and shoulders above everybody else’s. If you are interested in these markets you should read her in efinancialnews (registration required).

Yesterday Natasha gave some very nice coverage to my work on clearing. She does a very good job at condensing the avalanche of words I’ve written on the subject on SWP into a concise, accurate, and readable summary. Moreover, she adds a couple of very illuminating stories that provide excellent real world (and near real time) illustrations of some of the pitfalls I’ve been writing about.

Thanks again, N. Hopefully this will increase the visibility of some of the concerns I’ve raised as the CDS clearing express train roars down the tracks. (Matt Leising of Bloomberg tells me that there is an MOU in place to give the Federal Reserve primary regulatory authority over a CDS clearinghouse, and that President Bush will announce this at as part of a plan to be announced at a gathering of world leaders to discuss the financial crisis later in the week.) Rushing ahead without giving adequate considerations to these issues could lay the groundwork for greater problems in the future.

* Apologies to the Rocky and Bullwinkle Show. And Natasha de Teran has nothing in common with Natasha Fatale. Especially the accent;-)

Given the difficulties that some folks have had getting access to the article, here it is:

OTC clearing as a cure-all could be OTT
Natasha de Terán
10 Nov 2008

The promotion of clearing as a cure-all, tax on and apology for the over-the-counter derivatives industry is a neat one – but history demonstrates it may not act effectively as any of those things, and specialists worry it could do far worse.Regulators, when caught on the back foot, habitually rush to put out directives and convince lawmakers to rubber-stamp them at the double. Frequently such measures are ill-thought-out, delivering little more than a short-term injection of credibility and a longer-term expansion of their authority.

The participants, in this case the banks, will counter that their markets are self-correcting and that alternatives of their own devising will better assuage any regulatory concerns. Often their principal concerns are to protect their vested interests and preserve the status quo.

And when, between these poles, merchandisers – in this case the exchanges – spring up claiming to have devised tools to resolve this conundrum and boasting that their particular version is superior to those of their rivals, it is the profit motive that is generally their paramount concern.

As a result, and although all of the above groups’ claims about OTC clearing have some weight, they should be seasoned with healthy doses of scepticism. For when an experienced academic, with acknowledged expertise and no skin in the game, weighs in with serious concerns about the proposed rules, the participants’ interpretation of them and the suitability of the apparatus on offer, it is time to sit up and pay attention.

Craig Pirrong, a finance professor and director of the energy institute at the University of Houston, has spent his career studying derivatives markets, exchanges and clearing houses. Recently he has been giving a lot of thought to the issue of over-the-counter derivatives clearing – and he is far from convinced that rushing to clear OTC business is going to help anything. Worse, he worries that it could cause serious problems.

At the risk of being too simplistic, his principal concerns could be boiled down to one issue: that of information asymmetries.

First, he worries that clearing members could have better information about the price of OTC risks than a central counterparty that clears them. When the CCP’s insurance of OTC risk is underpriced, they will avail themselves of it, and when it is overpriced they will not.

This will result not only in an incomplete insurance of OTC risk, but – in the extreme – it will make the risk-sharing device altogether inefficient.

Second he worries that clearing members might have better information about the balance sheet risks of other OTC players and be able to react more quickly to any real or perceived deterioration in their balance sheet strength than CCPs.

This is because the broad spread of members’ business activity with each other should afford them greater insight into their relative balance sheet strengths than a CCP would have. Also, CCPs do not typically charge for balance sheet risks. Instead, they determine criteria for membership based on capital levels, and then set thresholds for collateral postings based on the risks of the instruments the members hold in the CCP. That means that any two given members with the same portfolio, but potentially vastly different balance sheets, will post the same amount of collateral.

On the rare occasions when CCPs do attempt to address this balance sheet issue, they cannot use the soft and hard information mix that OTC counterparts rely on. Instead they must use transparent rule-based mechanisms, typically requiring members with lower credit ratings to post more initial margin than those with higher ratings. If this crisis has shown anything, it is that those ratings are nothing better than rudimentary laggard indicators of balance sheet risks.

Given the above, it is worth considering two things: where exchanges get their information from to price risks and what a counterparty active in both cleared and uncleared OTC markets might do about the perceived deterioration of another’s balance sheet strength.

First, pricing information. Clearing houses manage price risks by looking to liquid, transparent datapoints. In futures and options markets, they can do this easily by looking to the prices on listed markets. In the case of interest rate swap risk, such as that managed by LCH.Clearnet’s SwapClear, the pricing is based on a large number of liquid, observable prices that can be derived from multiple data points.

But when CCPs start clearing OTC credit derivatives risks, they will have much more limited data: they will have to base their assumptions on a smaller number of less liquid, less transparent variables and derive their pricing from just a few sources. In stressed scenarios they might not be able to mark to market at all. Instead they will be marking to model.

Second, what might a clearing house member do in the event they suspect that the balance sheet of other OTC counterpart and clearing house members is being unduly stretched? They could cease trading with that counterpart, they could require that the counterpart post surplus collateral to cover this risk, or they might continue trading with the counterpart but require all the OTC trades be novated to the CCP.

In doing so, they would be parking the unsavoury risk at the clearing house and buying “cheap” insurance from it.

Unlikely? Consider this. In the last few days before the Lehman Brothers collapse, two different behaviours were evidenced in the cleared OTC marketplace.

In the repurchase agreement market, a large dealer refused to take Lehman’s name even though the trade was going to be novated to LCH.Clearnet’s repoclear facility. The trader’s decision was predicated on the belief that Lehman’s counterparty risk was too bad to take.

Not only did he therefore not want to carry it himself, but also he didn’t believe that he should oblige others to share it with him.

In the swap market, another dealer is meanwhile alleged to have attempted to offload to LCH.Clearnet’s Swapclear facility a legacy portfolio of interest rate swap trades that he had on with Lehman. At that time LCH.Clearnet would have been more than aware of Lehman’s risks and would have been able to make an informed decision about whether the assumption of new risks reduced or added to the sum of Lehman’s risks.

In the event, the swap issue proved immaterial since the swap portfolio was not novated to the CCP, but this second incident clearly demonstrates the difficulties that might arise from information assymetries and the potential for abuse of risk-sharing mechanisms. Worse is this: if the actions of the swap trader were known to the repo trader, the latter’s incentive to behave prudently and shun the profit motive in favour of the co-operative’s greater good would have been eliminated.

Thus it is easy to see how the use of a CCP could encourage a wholesale adoption of this worst practice kind of behaviour – taken to the extreme, why would OTC market counterparts ever need to bother who they deal with if someone else is managing it and others insuring it?

Pirrong is a great advocate of clearing and he is also a supporter of derivatives, but his concerns about mixing the two into a ready-made soup are considerable. More OTC clearing could include the potential for excessive and irresponsible risk taking, the mispricing of risk and the exploitative use of information asymmetries.

Natasha tells me that the editor did some fine surgery with a chainsaw (my characterization), lopping off the last 400 words, hence the rather abrupt ending. But you all should get the drift.