Streetwise Professor

Like its American regulator counterparts, the European Commission has been pushing major banks to form a CDS clearinghouse.  In December, the Commission secured a draft industry agreement whereby a clearinghouse would be set up by mid-2009. Although they had agreed in principle to the arrangement, the banks, have refused to commit, and Charlie McCreevy is peeved:

“A firm engagement was expected from the involved industry and regulators. This engagement has not been given,” a spokesman for EU Internal Market Commissioner Charlie McCreevy said.

The introduction of central clearing for over-the-counter (OTC) contracts is a core plank of EU efforts to apply lessons from the credit crunch to make markets less risky for investors.

“The commissioner will therefore have to consider the appropriate next steps,” the spokesman said.

According to Reuters, “The deal collapsed over McCreevy’s insistence that clearing of EU-based trades must be done inside the 27-nation bloc.”  Perhaps.  But perhaps this is a pretext.  There seems to be foot dragging in the US as well.  Methinks that there is a more fundamental concern among the banks about plunging into clearing.

The conventional wisdom is that the reluctance stems from the banks’ belief that clearing will increase competition, and thereby erode profit margins.  I’ve made similar speculations over the years (dating back to the 1990s, with respect to interest rate and currency swaps), but I’m not fully–or even largely–convinced that this is the case.  

The formal modeling I’ve done shows that under certain circumstances, clearing helps the least creditworthy members of a CCP at the expense of the more creditworthy ones.  That is, the effect on profits is not uniform.  Thus, one would expect more division among potential members, with some enthusiastically supporting clearing, with others being more reticent.  That doesn’t seem to be the case now.

Moreover, although it’s definitely not a perfectly competitive industry, the OTC derivatives market is a heck of a lot more competitive, with more viable major players, than most major industries.  There are a good dozen major dealer firms–name another big industry with as many major players.  It’s unlikely that clearing would encourage substantial entry into the industry.  Indeed, if the major incumbents are the members of the clearinghouse, they could probably use their control thereof to impede entry.  (I’ve also shown that a clearinghouse can facilitate cartelization of the industry.)  I am skeptical, therefore, that the move to clearing would dramatically increase the competitiveness of the market for intermediating CDS trades.  

So why the resistance?  I suspect it boils down to the understanding among the major dealers that clearing involves costs to them that exceed the benefits they will reap.  There is obviously the cost of setting up and operating the clearinghouse, but in my view this cost pales in comparison to the costs associated with asymmetric information inherent in clearing CDS trades executed by huge financial institutions posing balance sheet risks.

Think of it this way.  Why are banks reluctant to lend to one another today?  Because of concerns about the balance sheet risks of the borrowers, and the borrowers’ superior information about their own financial condition.  That is, banks face adverse selection problems when lending to other banks.  This is always true, but it is especially true today.  But a clearinghouse arrangement effectively forces banks to take on an exposure to the balance sheet risks of other clearinghouse members.  If they are reluctant to do this in the interbank market, why should one expect them to rush out and do it through a clearinghouse?  

The reluctance therefore reflects, in my opinion, an understanding by the banks that the private costs exceed the private benefits.  Moreover, in my further opinion, these costs are real costs–to the banks and to society.  

Forcing a clearing solution, as Charlie McCreevy is clearly (no pun intended) contemplating in Europe, reflects a different belief.  He must believe the competition argument I dismissed above, or that there are other systemic benefits that the banks are ignoring.  

I am skeptical that clearing unambiguously reduces systemic risks.  Indeed, I can make an argument that clearing can increase systemic risk.  I’ve written about this at length in a working paper, and will expand on the argument in a future SWP post.  Suffice it to say for now that the arguments as to why clearing reduces systemic risk are incomplete, and not generally true.  They ignore the distributive impacts of clearing, the potential effect of clearing on the size of the markets, and the potential for clearing to exacerbate moral hazard and adverse selection problems due to mispricing of default risk.

Maybe I’m wrong.  But maybe I’m not.  At the very least, the banks’ resistance should provoke some serious questions.  Maybe their position is self-serving.  But maybe it reflects a deeper understanding of the true intricacies and dangers of clearing than is possessed by regulators on either side of the Atlantic.  Before plunging ahead with a clearing solution, regulators would be well-advised to undertake a much more far-reaching analysis of this complex issue than they have performed so far (at least, they have given very little public indication that they have in fact thought about these issues in a serious way.)

This is serious business that will have serious consequences.  Fools rush in where angels fear to tread, and rushing to force clearing without thorough regard for the potential pitfalls would be a foolish thing indeed.