Streetwise Professor

Jeremy Grant is going to town with stories and video interviews on the implications of clearing mandate on his FT TradingRoom site.  One that particularly caught my attention was this interview with Guy Sears.  They discussed the implications of clearing mandates on pension funds.  Sears says (about the 5:55 mark):

It’s about the governance and who carries the risk in this model.  Clearinghouses work by seeing an instrument and worrying about the risks of failure in an instrument.  How far away has it got from its original price?  What’s the market risk in the instrument?  At the end of the day, of course, what really matters is whether the guy holding the instrument is good for his money.  We would say that the pension schemes and savings pools are good for their money.  Making them provide margin to pay for everyone else’s risk is asking them to take part in socializing risks they really should have to pay for because they aren’t risky.

Sears makes a point that I’ve emphasized from early on that has largely been overlooked.  Specifically, two factors interact to determine the risk of default: instrument risk and balance sheet risk.  CCPs price instrument and generally don’t price balance sheet risk, except in the crudest and most problematic of ways.*

As Sears says, balance sheet risk–the risk that “the guy holding the instrument is good for his money”–is crucial.  Not pricing it leads to distortions in the allocation of trading activity across market participants.  It also means that those who use clearing do not pay a price for adding balance sheet risk, which distorts their risk taking decisions.

Sears effectively objects to charging pension funds the same price for risk as a hedge fund pays.  This is a fair objection.  It harms pension funds directly, but it can also distort trading activity, causing hedge funds to trade derivatives relatively more than they should, and pension funds relatively less.  Does this reduce systemic risk?  That seems difficult to argue.

Moreover, different entities have different ways of effectively undoing the effects of clearing.  High and frequently adjusted margins on cleared products mean, essentially, that market users are not in a credit relationship with the CCP, in the same way that they can be in a bilateral dealing.  But this means that mandating clearing frees up credit capacity that can be used to undo, in whole or in part, the debt-reducing effects of clearing.  Some entities, notably pension funds, have less ability to leverage up (and indeed, given their high creditworthiness, are not really in that much of a credit position relative to their counterparties in any event).  This means that a clearing requirement would hit pension funds particularly hard, and unjustifiably.

Pension funds will respond by (a) reducing their usage of derivatives, and (b) reducing their investments in higher return assets in order to accumulate the cash needed to post margins on the derivatives they do trade.  Response (a) means that these funds will incur higher transactions costs to achieve their investment and liability management objectives, and will bear more risks.  Response (b) means that pensions will be less remunerative.

The Frank-n-Dodd bill exempts retirement funds from the clearing mandate to the extent that they utilize derivatives for risk management/hedging purposes.  It is ambiguous whether this exemption would, for instance, cover a fund’s use of an equity derivative or commodity derivative contract to achieve an investment objective.  But the recognition that retirement funds might deserve different treatment is one good thing I can say about Dodd-Frank.  (Although it’s not evident whether this exemption was the result of a fluke moment of lucidity, or the lobbying power of pension funds–including public and union funds.  The latter would be rich indeed.)

But Sears’s main point holds.  Balance sheet risks are an important determinant of counterparty risks.  CCPs don’t price this risk.  This lack of risk pricing is costly.

* CCPs often impose capital requirements, but these are generally multiples of margins.  Since margins don’t vary with balance sheet risk, these capital requirements don’t either.  Moreover, CCPs sometimes condition margins on credit ratings.  Given the crudity of these ratings, and the perverse feedback that results from ratings change-induced increases in margin, this is a coarse and potentially destabilizing way of pricing balance sheet risk.