The Fantasy of the Clearing House Magic Bullet

As Gillian Tett points out in the Financial Times today, clearing derivatives centrally has come to be viewed in policy circles as a magical solution. As a result, it has not gotten the scrutiny it deserves.

The reason for the enthusiasm is that, in theory, a clearinghouse would make sure all agreements were adequately backstopped, so that if customer defaulted, it would not produce cascading counterparty defaults. The clearinghouse would have enough margin and capital to absorb the loss. And observers take great comfort from the fact that no significant exchange (which also has central clearing) has failed in a very long time.

But that view is based on precedents that have limited relevance for credit default swaps, which is the product that is the biggest source of risk. First, the CDS market is dominated by a comparatively small number of very large counterparties. So the failure of any one would be a vastly more serious blow than any modern exchange has suffered.

Second, the cheery view of the safety of exchanges is based on the airbrushing out of a near failure. In the 1987 stockmarket crash, a large counterparty of the Chicago Merc had failed to make a large payment by settlement date, leaving the exchange $400 million short. Its president, Leo Melamed, called its bank, Continental Illinois, to plead for the bank to guarantee the balance, which was well in excess of its credit lines. The officer in charge said no,. It was only because the chairman walked in and authorized the backstop only three minutes before the exchange was due to open that the Merc kept going.

Melamed has said repeatedly that if the Merc did not open that morning, it would not have opened again, and the head of the NYSE has said if the Merc did not open that morning, the NYSE would not have either, and it might never have repoened either.

Remember that. One decision with three minutes to spare kept the two biggest exchanges in the US from collapsing in the 1987 crash. See Donald MacKenzie’s An Engine Not A Camera for details.

Third, a clearinghouse for credit default swaps is certain to be undercapitalized. That means it is an AIG, a concentrated point of failure. The reason is that the contracts will be undermargined. CDS are not true derivatives, but are the economic equivalent of credit insurance. When a “reference entity” has a “credit event” meaning a bankruptcy or default, CDS prices jump to default. That means they shoot up massively because a payout on the CDS is certain, the only item in question is the precise amount.

A large enough initial margin to allow for jump to default risk will make CDS uneconomic (that’s an outcome I welcome, but that is contrary to the motives for the clearinghouse). So dealers and counterparties will fight for a lower margin, meaning the exchange will be undercapitalized relative to the risks it faces.

Tett has some overlapping concerns:

And yet, as so often in the current regulatory debate, there is a crucial catch: most notably, that a clearing house can only offer that all-important sense of reassurance to investors, if it is always perceived to be absolutely rock solid – no matter what. And what is notable about the reform debate so far this year, is that there has been remarkably little public discussion among politicians – or even among regulators – about how to guarantee that any future clearing house will indeed be strong enough to withstand any future shocks….

I suspect the silence may also reflect delicate political sensibilities. If politicians were to demand that a clearing house should be so utterly rock solid that it could withstand even financial Armageddon, the future members of any clearing platform would have to make massive financial commitments. That would necessarily limit membership, to a small cabal of ultra-powerful banks – not something that most politicians wish to encourage.

However, if a clearing house is made more accessible to a wider pool of members, then it will only carry real credibility if it is ultimately backstopped by the government itself, to ensure that trades are always settled, no matter what. And most politicians are not keen to highlight that option either, given the wider sense of public anger about the degree to which the government is bailing out the financial world.

Nevertheless, a few lone voices are now trying to stir up more debate, Gerry Corrigan, the former governor of the New York Fed, for example, recently declared that any future clearing house be placed under the supervision of central banks. More controversially, he also demanded that any clearing house for credit derivatives should have enough resources to withstand the failure of two large members on the same day and still keep trading. “I believe that the operational and financial integrity of such counterparty clearing facilities must be virtually failsafe,” he sternly declared*.

These strike me as sensible suggestions. And behind the scenes, some policy makers strongly support what Corrigan has demanded. Yet, thus far, it is still unclear whether such tough standards will be imposed – even though some clearing houses are now emerging. And that is precisely why men such as Corrigan are growing uneasy.

After all, one lesson that financial history shows is that the issues which blow up the financial system are not usually those which caused the last crisis. Instead, the biggest threats tend to come from the areas swathed in a lazy consensus, or where there is a strong political impetus to clutch at easy solutions. That might yet apply to the clearing houses. In theory, I still believe that clearing houses could – and should – make the derivatives world safer. In practice, though, they could also end up creating new dangers if they are not put on a sound footing, particularly if the fact that no clearing house has ever failed before creates a false sense of complacency

Clearinghouses are the wrong remedy for CDS, but that horse has left the barn and is already in the next county. And I must confess, they sound deceptively appealing (I was a proponent early on) until you dig further into how they would work for CDS. They need to be regulated intrusively, with the intent of shrinking the market considerably over time, and like insurance, with tough capital requirements and frequent examinations of the capital adequacy and claims-paying ability of the sponsor. But the real need is to cut off the air supply to CDS to reduce the size of the market so the product itself no longer represents a systemic threat.


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  1. M

    Not saying that your comments have no value at all, but some of them are not realistic.
    The clearinghouse is not a counterparty to the trade as in a risktaker, but it is a central counterparty to two counterparties that don’t face each other. As both are margined daily (actually more often than daily in the case of LCS) both will want to make sure the amount margined is correct, cash is king. The clearing house will “just” need to make sure that what comes in on one side is the same as what goes out on the other side. If one of the parties does that not correct, they will suffer in case of default, not the clearing house. Ie if their original cpty will default, the exchange has the collateral and can make good using that collateral either be replacing that cpty with another or settling the trade with the cpty that did not default.
    Different from AIG, both cpties are margined daily, therefore any movement in CDS prices will immediately hurt a AIG-type counterparty and therefore any problem will surface immediately. Could still be problematic, but as credit markets are much more forward looking than stock markets it is less likely a sudden event. The AIG problems were caused by not margening for a long time where it should have, therefore a process that should have been gradual became a sudden painfull process.
    I am not sure you can substantiate the claim that CDS perse were a systemic threat. In that way you can claim mortgages are a systemic threat. However, the use of them in certain circumstances (CDOs, non-margening cpties etc) caused the crisis. A clearing house can be, with the right oversight and rules and regulations, a good tool to make sure the CDS market, and the credit market in general, is functioning more smoothly.

    1. Yves Smith Post author

      I have spent quite a bit of time investigating this issue and tested my views and understanding of the facts with well-recognized experts on CDS and also spent time with people who sold products that depended on CDS for their existence, and I have to beg to differ on most of your points.

      First, CDS are not economic if adequately margined. Adequate allowance for jump to default risk makes it very unattractive on a ROE basis. The way around that pre-crisis was making AIG and the monolines the bagholders. That game is over, but the Street is hooked on the revenues.

      Second, you are wrong re incentives. The only incentive is bonus maximization. The firms systematically overpaid themselves and operated with too little capital. You never would have seen the behavior witnessed in the last cycle in the days of partnerships. The world of OPM means that the bonus incentives are what drive behavior, not prudence.

      Third, in invoking AIG, I am saying that an undercapitalized clearinghouse is a concentrated point of failure and a very big one too, a systemic risk all of its own. I do not say how that risk is comes about is like that of AIG. But you attribute to me an argument I make nowhere in the post.

      Fourth, CDS was the product at the heart of the crisis. It was the mechanism that turned subprime losses, which should have been an absorbable, albeit serious, macroeconomic shock into a global financial crisis. I demonstrate that in my book, so you have to wait till March for that piece of the argument.

      1. carol

        “First, CDS are not economic if adequately margined. Adequate allowance for jump to default risk makes it very unattractive on a ROE basis. The way around that pre-crisis was making AIG and the monolines the bagholders. That game is over, but the Street is hooked on the revenues.”

        Thanks for the reply. These sentences should be written in each and every article about CDS’s. This captures it all: they are not economic, but the Street is hooked. Prohibit new ones and slowly wind existing ones down.

        “Fourth, CDS was the product at the heart of the crisis. It was the mechanism that turned subprime losses, which should have been an absorbable, albeit serious, macroeconomic shock into a global financial crisis.”

        I hear Bernanke’s ‘it is contained and it is only $50 billion’. So he did not understand the impact of the CDS. Now that Obama has rewarded him for his failure with a second term, I hope they both have pre-ordered your book!

      2. Siggy

        Excellent, you have it right. You are at the core of the problem on the two very critcal points about CDS; if properly margined, they are uneconomic, and, it is bonuses that drive their sale.

        Also important is that partnerships would not generally pursue the CDS trade. In that consideration lies a key to how you can constrain bonuses and aggregious behaviour. Make the officers and boards of the corporate financial institutions jointly and severally liable for failure and malfeasance.

      3. M

        “Third, a clearinghouse for credit default swaps is certain to be undercapitalized. That means it is an AIG, a concentrated point of failure.”

        My point is that a central counterparty is different to a exchange in the stock world and to AIG, who took a single sided risk and worse did not do the margening properly (inclusive of pricing margening cost in the deal). A central counterparty continues to face two counterparties where there is a plus and a minus to the same trade. Net margin at the exchange should be zero.

        Cpty A sells a 5yr CDS to cpty B. Upon acceptance both cpty A and B face the central counterparty C. Cpty B makes a string of payments to the central counterparty C during the life of the CDS, being the price of the CDS, and cpty A will receive this string of payments from the central counterparty C. Zero sum for the central counterparty C. During the life of the trade, the CDS will be marked to market and based on that value cpty A has to post margin, and cpty B will receive margin. Both from the central counterparty C, both at the same time on the same day, zero sum for the central counterparty C.

        Upon default, cpty A will have to come up with the agreed payout. However, the posted margin at central counterparty C will be already very close to the expected payout, unless something really out of the ordinary just fell out of the sky. Remember the margin is happening 4 times a day. central counterparty C then will use that collateral or the payout to make good with counterparty B, who will receive the same amount. Again zero sum for central counterparty C.

        The main point of the central counterparty C is to make sure the margining is happening daily (or more often) in order to make sure that in case of a default nobody is under collateralized. If counterparty A defaults as well as the CDS event happens (pretty rare occasion to happen at the same time, but admitted, AIG showed it can happen) there is at least still all the collateral representing if not todays NPV at least yesterdays. But definitely not last years or none at all like with AIG. Counterparties falling over due to this type of event will have been building up huge exposures that, obviously if proper monitored using the central counterparty data, should have been flagged way, way in advance of that event.

        So a AIG will not be able to exist anymore. Their trading will show quickly a loss as they have to post collateral and the cost of collateral will show up in their results. This is significantly different to what happened to AIG before, as they believed they would never have to pay out and they ignored any cost of collateral. The main reason of them blowing up was not that there were to many defaults, but because the risk of defaults was so high that counterparties starting to ask for collateral, and the request for collateral was what blew them up, not the actual trade outcomes themselves. They were thinking like insurers not like swap traders, ie only if the actual event happens there will be a payout.

  2. percy

    M underplays the significance of adequate financial backing for an effective clearinghouse. The basic thesis of a reliable clearinghouse is that a collective of other clearinghouse member firms’ credit backs to obligation of the clearinghouse to settle open obligations in the event the posted margin proves inadequate. When the fit hits the shan, as it did in the ’87 Crash, proving that the daily margin requirements for futures were inadequate for that period (something never corrected for very long, by the way — take a look back there), other credit had to be provided, as Continental Illionos did, ultimately. I believe that, behind the scenes (well, except for those involved, and who were urging just this to the Fed as essential to avoid Doomsday), the Fed played a part in precipitating that bank decision because it truly was as close as we’ve come to the end of the financial world. Now we have all these new clearing agencies for standardized derivatives owned and backed for the most part by the biggest players (and there are so few) in that game, though there are now suggestions out there that this is not such a hot idea — which it isn’t since the big players’ credit is already on the line for the underlying obligations for which settlement is to be guaranteed, as it were, by those new clearing agencies. That is, the whole smoke and mirrors arrangement is owned, backed and controlled by those same big players whose commitments create the need for something lke this. Of course, absent that, there will be no clearing agencies for this stuff and poof goes the “solution.” What can rescue this idea? Only the same thing that rescued FNMA — an implicit guarantee by the U.S. government. For now, that may provide some comfort. (That is, we said this would work and that you can trust it, and we’ve already shown you that we can bail out anything. We’re not saying we will, but . . . you know.)That is, Tett’s observation is correct.

    Great situation, isn’t it?

  3. i on the ball patriot

    Magic bullet … hmmmmm …

    Control of financial products (credit, money creation, creation of derivative products, insurance products, etc.) should be looked upon as very similar to gun control. Why? Because, financial products when misused have all of the powers of guns; to kill, enslave, coerce, hijack, exploit, etc.

    Would you put the ownership of guns (financial products) in the hands of a very wealthy elite few?

    Are guns (financial products) even necessary?

    Should the wealthy elite few be allowed to create and own bigger guns (more powerful financial products) while the common folk are allowed none or simple pea shooters?

    Just as we need gun control we also need financial product control. The clearing house described, to follow the gun analogy, would only serve to regulate; bunker busters, cluster bombs and nukes.

    Do we really need that clearing house? Or, more importantly, do we really need financial products that are that powerful and could cause that much harm?

    Deception is the strongest political force on the planet.

  4. Kid Dynamite

    yves – regarding “jump to default” risk – aren’t many kinds of insurance which are essentially “binary” like this? earthquake… life… auto… why couldn’t it work for CDS? yes – i understand that the margin requirements need to be higher than they are now – and it’s conceivable that they’d need to be high enough to become economically unfeasible – but that’s not really a result of the binary payout is it?

    1. csissoko

      KD, Financial insurance is not comparable to traditional insurance. With traditional insurance products, there is no possibility (absent an event of war which is excluded) that correlations will go to one: a major earthquake in CA and a serious hurricane in FL can be treated as independent. Thus, actuaries can ensure that an insurers is adequately reserved for all likely scenarios.

      Because of the cyclic nature of the economy, financial products tend to go bad at the same time — the only issue is whether the recession will be typical (in which case the insurer can be reserved) or whether the recession will be deep in which case there is no reasonable measure of appropriate reserves. I believe that it was precisely because actuarial evaluation does not work with financial products that New York created the monolines — at least if they default they don’t take down traditional insurers.

      Amusingly the monolines long claimed that they only insure products on which they have zero probability of loss.

  5. Siggy

    We would all do well to investigate what drives the perceived need for CDS. What I see is a market looking for guaranteed yield, as high as possible. That search begins with an imputed compond loss rate in purchasing power north of 3%. To that we add compensation for loss of use of the funds (alternative opportunities), plus something for profit, plus something against which we can amortize the risk of default and loss. The 3% floor helps you to get to a big number in hurry. In the current market, Treasury debt is being accomodated by the Fed and the resulting yield curve is well below what might otherwise prevail. This is what drives the demand for CDS.

  6. David Merkel

    The simplest way to reduce the size of the CDS market is to require insurable interest, or enforce gambling laws. Only bona fide hedgers may initiate trades. No cross-hedging.

    Bonds are not exchange traded, they aren’t generic enough. Only generic derivatives could be exchange traded. My view on using clearinghouses/exchanges for derivatives is let it be tried with simple derivatives first, like interest-rate swaps, which are pretty vanilla then progressively more complex derivatives, until there is not enough volume to make an exchange worthwhile.

  7. Michael

    If 95% of CDS exposures are held at the 5 top dealers, as is generally reported, doesn’t it make sense to focus attention on those exposures while the debate about clearinghouses rages.

    DTCC is already the information clearinghouse, since practically all CDS are settled through them.
    I assume the top dealers don’t really need the capitilization benefits a clearinghouse would provide since their counterparties are for the most part already TBTF and gov’t guaranteed.

    What’s missing from the debates are hard numbers about the exposures. For example how much exposure is concentrated at US banks, vs fgn banks, vs non banks.

    Even summary exposure reporting would have provided markets with the information that huge amounts of CDS exposure was written by non banks (i.e AIG) and purchased by banks before the crash. That would have been useful information to have.

    Where are the calls to create a mechanism for reporting the DTCC exposure data publicly, while a clearinghouse or other solution is debated?

  8. Mike S

    Hi Yves,

    I’ve recently come around to the “All CDS are bad” view. I had been a huge supporter of CDS and in particular the clearinghouse of CDS.

    I had been involved with the guys from ICE trust – good guys and know their stuff.

    Anyway, one of the things about clearinghouses that make lots of sense is that THE POSITIONS ARE TRANSPARENT TO THE CLEARINGHOUSE. Therefore, the positions are transparent to the regulator, and the government. We can and should be able to stop positions from getting too large prior to any risk being transfered to the taxpayer.

    Then, there is another huge advantage of a clearinghouse. In a clearinghouse, the member firms have to make good on the debts of the defaulted positions! There will be no excuse “we didn’t know how much they had on” or “We shouldn’t have to pay for their bad decision”. In a clearinghouse structure, member firms agree to this.

    Now, I do not like CDS. I think they are dangerous derivatives that can be used to force companies into bankruptcy. They are non-linear in risk profile, so when combined with the huge size of the bond markets, make them extremely dangerous.

    However, these are not reasons to dislike the clearinghouse. The single point of risk argument becomes much, much less worrisome when we can peek under the hood at any time. You can bet if Goldman is going to be on the hook when AIG fails they are going to stop doing CDS with them much, much sooner than they did.

    I hate Goldman.

    1. Yves Smith Post author

      Mike, I’m told by multiple sources in a position to know that the Fed is now regularly reviewing all derivatives exposures at regular players, and that they are demanding to see everything. That means less than it might seem, since the data is formatted differently by dealer. So the clearinghouse would lead to presumably more consistency in data formatting, which would be valuable for analysis, but not necessarily further disclosure.

      And the bill has a massive out, custom derivatives, and many CDS can or can be made to fall in this category, are excluded. So we will increase transparency in the products that are comparatively benign, like interest rate swaps, and let the ones that are demonstrated to be dangerous escape.

      1. Michael

        “That means less than it might seem, since the data is formatted differently by dealer”

        If the data comes from the DTCC data warehouse inconsistent formatting is not a problem.

        At the risk of sounding insufferably naive, clamoring for the DTCC data, which according to the DTCC press release, is being provided to the FED, seems like a productive place to start if we want to address the opacity issues in the CDS markets. All trades, not just ‘standardized contracts’ are recorded there. Each trade has a current exposure value, regardless of it’s ‘customized’ structure.If current exposure is a standardized measure, and its readily available, reporting and disclosing it would be of tremendous benefit to the markets.

        Can you check with your souces to see if they think the information available at DTCC is robust enough to provide a summary view of the total exposures and concentrations of those exposures?

        1. Richard Smith

          Michael – yes, you are right, DTCC’s warehouse (TIW) should be a relatively much better data source than anything else around. It seems to have near-complete coverage of the outstanding CDS now. That includes the strange old deals too, (though I don’t know how much of the strangeness they’ve been able to capture in TIW).

          The CDS exposure info should be fairly good. Other very interesting things, such as the detail of the non-std legacy contracts perhaps, and the actual economic exposure of the CDS counterparties to the reference entities (the cpties might actually be bond holders or trading partners or whatever), are obviously not so easy to get at, and it’s unfair to expect TIW to be able to provide them. But it’s certainly going to help understand what’s going on. It would be great if the data could be published in some form.

          It will be interesting to see how the pull develops between Ops & regulators (who will like standardization) and Front Office (who will like bespoke). That may determine whether over time we just get another pool of opaque, OTC, tailored CDS-like products quietly building out of sight, or whether the CDS really do all stay visible.

  9. ScottB

    Great post (again). I agree with Carol above, put a stop to any new ones and let the current ones unwind.

  10. john bougearel

    You know,

    At the risk of reduncancy, lawmakers just do not get it. As Buffett pointed out years ago, and later burned his fingers on, these OTC derivatives, particularly CDSs are weapons of mass destruction being used to eventually take down large institutions. And if these products are being peddled by Wall St and lobbied through congress and the admin, Wall St peddlers are nothing more than financial terrorists.

    The risk of CDS products is so great that they should not be regulated, but eliminated by congress. No need to discuss initial and maintenance margins, just legislate the products away, kick it into the history trash bin.

    As sensible as it appears to “sound” I do not buy Gerry Corrigan’s belief that a clearing houses can be made “virtually failsafe” any more than I believe the govt can regulate so-called too big to fails.

    Lawmakers are absolutely delusion and have learned nothing from this episodic crisis. You can’t regulate TBTF and you can’t make CDS clearinghouses “failsafe.” This insistent belief that a few rules and regs will make the financial system is a pipedream, its a pig in a poke they are selling to the American public.

  11. gordon

    G. Tett (quoted in post): “That would necessarily limit membership, to a small cabal of ultra-powerful banks – not something that most politicians wish to encourage”.

    Pretty amazing statement, given that Govts. are bending over backwards to save a few TBTF banks and in the US the Govt. is presiding over a holocaust of small/medium banks which FDIC is winding up every week. Ms. Tett seems to have it exactly backwards; Govts. in fact are very definitely encouraging “a small cabal of ultra-powerful banks” with every means at their disposal. If this has any implication for a clearinghous, it is that Govts. will definitely want to create one.

  12. caveat bettor

    I agree that that margin requirements commensurate with a central clearing exchange are not a magic bullet. I think we could say that about ANY construct, under Godel’s Incompleteness. And had AIG been required to actively post and increase margin on its credit derivative positions, I believe things would not have gotten as bad as they did. Yes, I know the hindsight bias in my last statement, and I HATE that policymakers are always closing the barn door ex post facto, but I also believe, like any great athlete the ex-ante strategy of avoiding making the perfect the enemy of the good. So the clearinghouse idea still appears good.

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