The Murky Realm of (Derivatives) Clearing

Mandating clearing was a convenient and simple approach for Congress to shift the basic derivatives trading risks in an appreciable percentage of the market away from the banks to reduce systemic risk.
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Matt Taibbi's latest article in Rolling Stone appropriately characterized the financial reform act as neither an "FDR-style, paradigm-shifting reform, nor a historic assault on free enterprise." While generally describing the act as a "cop out," he identified the Fed audit requirement and the Consumer Finance Protection Bureau as positive developments. But he viewed the requirement that many derivatives be cleared as "the biggest win of all." Alas, Matt may have been too generous, or at least premature.

Mandating clearing was a convenient and simple approach for Congress. The idea was to shift the basic derivatives trading risks in an appreciable percentage of the market away from the banks to reduce systemic risk. The problem is that very few people are equipped to understand just how the mandate might work in practice.

How much of the market? What are the consequences? I have not seen evidence that anyone on the government's side can answer these questions effectively. This is not intended to demean anyone's intellect. Clearing theory is complicated and arcane. It was always a backwater of finance and was taken care of by people at the clearinghouses and in the back offices of the banks. Clearinghouses were largely allowed to regulate themselves through a process of self certification. This limited the Commodity Future's Trading Commmison's practical involvement with the markets.

Then clearing became the centerpiece of derivatives reform. We decided to concentrate the most dangerous financial risks in the galaxy in a couple of organizations.

As fate would have it, I am one of the few people around who knows something about the clearing business and theory and is not employed by an investment bank or clearinghouse. At the end of my career on Wall Street, I was hired to perform a financial autopsy of the special purpose derivatives clearinghouse set up by California as part of an innovative power market structure. It had failed in the state's power crisis of 2001-02.

Observing the tremendous systemic risk generated by using conventional clearing techniques for all but straightforward derivatives, I embarked on a seven year quest. I formed a company that designed a mathematical, IT and legal structure to provide a transparent and orderly system to manage the risks of those derivatives which shouldn't be cleared conventionally.

Imagine my surprise when the banks decided against using the system. They preferred taking advantage of the opaque and chaotic bi-lateral derivatives market. The profit potential of the shadowy chaos outweighed efficiency, transparency and sensible risk management. At least I can claim to have been ahead of the times.

There are two dangerous forces at work in the endeavor to push derivatives into clearinghouses:

1) Concentrating risks only makes sense if the risks associated with the cleared derivatives can be adequately managed. There is no way to collect enough collateral to cover all potential losses if a derivatives trader defaults. The credit risk embedded in a derivative is, by definition, limitless. Clearinghouses use statistics to measure probable losses. They will require sufficient collateral so long as the statistical analysis reflects reality. The further a type of derivative strays from the standard, liquid markets, the less valid is the statistical measurement of risk. It appears that most people involved with the reform legislation thought "unclearable" transactions were only one-off deals with non-standard contractual terms. The far greater issue concerns commodity classes and financial indices for which statistical risk measurement is unreliable. Historical market data may be too meager or the daily volume may make predicted prices "untransactable." For certain classes of derivatives, statistical risk measurement is simply impossible, not just unreliable.

One might think that clearinghouses would only take on these types of derivatives if the risk of doing so were prudent. One would be wrong. A byproduct of financial deregulation is fierce competition among a handful of clearinghouses. Profit depends on volume. Even before the crisis, competition had already pushed clearinghouses to the edge of prudence and beyond. We cannot assume that clearinghouses will be rational or that the government, so invested in clearing as an answer to the derivatives dilemma, will enforce prudence. Sophisticated and well-capitalized banks recently evaporated because they transacted business that, in retrospect, made no sense. Why not clearinghouses?

The risk is that we revisit the world of "Too Big to Fail."

2) Dealer banks have enormous influence over clearinghouses because they can control volume. Of the two major US clearinghouses, the IntercontinentalExchange (ICE) and Chicago Mercantile Exchange (CME), ICE is more susceptible. After all, the banks created ICE, largely to compete with CME. But CME is under bank influence as well. ICE and CME raced to clear credit default swaps after the market collapse in September 2008. The ICE effort was successful, in part because the special purpose clearinghouse it set up agreed to give the banks a 49.9% share of the revenues. CME naively created a structure with a trading feature attached, assuming that real-time CDS price transparency would be an attractive add-on. The transparency feature angered the dealer banks, which were already inclined to prefer the ICE structure for obvious reasons. The dealers have largely declined to support CME's massively expensive effort. Privately, CME has vowed never again to take on a project that the dealer banks don't support.

Clearinghouses may take on derivatives imprudently, but the banks may use their influence to limit clearing. These do not balance one another. The banks might well support clearing of some risky derivatives and, at the same time, use their influence to resist clearing of other derivatives which should be cleared.

These pitfalls can be avoided. Regulatory implementation and oversight can establish defenses. However, the process must aggressively challenge conventional notions of how clearinghouses work. Most of all, the regulators and proponents of reform have to be aware that the banks and clearinghouses are not necessarily friends. The banks will try to use their superior knowledge, resources and influence to craft a structure that allows them to continue business as usual. I despair that there is no practical counterbalance to the banks, such as AFR and other public interest groups that were so effective during the legislative process.

It turns out that this part of financial reform is a marathon, not a sprint.

Cross-posted from New Deal 2.0.

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