Guest Post: Why Clearinghouses Are a Maginot Line Against Systemic Risk

As discussed in ECONNED and on this blog, clearinghouses are not a solution to the systemic risk posed by credit default swaps, since there is no way to have a CDS counterparty post adequate margin and have the product be viable (to put it more simply, adequate margin make CDS uneconomic). So for CDS, the “derivative” that was and still is the biggest source of systemic risk, a clearninghouse merely serves as another TBTF entity.

Warren Turbeville, in his post, The Murky Realm of (Derivatives) Clearing (cross posted from New Deal 2.0), raises further doubts about the conventional view that clearinghouses are a magic bullet for the counterparty risks posed by OTC derivatives.

From Turbeville:

For clearinghouses to work, we must have regulation that challenges the way we think about them.

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.

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  1. ChrisPacific

    I feel like there is an elephant in the room that everyone’s ignoring here. Doesn’t the comment by Yves (adequate margin makes CDS uneconomic) together with Turbeville’s point #1 imply that the CDS industry would not function without the implied government guarantee of TBTF? If that’s the case then the whole thing is effectively a scam being perpetrated against the taxpayer.

    If so, then we should be trying to shut them down, and clearinghouses have no value except as a means to that end. I suppose that rather than ranting about evil banks stealing our money and being dismissed as conspiracy theorists, it might be better tactics to push for full transparency and let everyone reach that conclusion on their own.

    1. Francois T

      Excellent points!

      We will have to severely restrict anything CDS to a plain vanilla variety, banksters be goddamned.

      It is not because some dude invented the CDS that we must put up with their existence.

    2. Yves Smith Post author

      I’ve been advocating for some time (see ECONNED and previous posts) taking steps to shrink the CDS market, with the hope of shutting it down. The problem is that CDS are so heavily used now that simply banning them and allowing them to run off is likely to produce big dislocations (and believe me, I’d MUCH rather shut them down, I’ve come to this conclusion reluctantly). So you start regulating them like insurance, requiring that protection writers be registered, regulated, and have adequate capital levels, and gradually increase required capital levels to reduce the size of the market (and that is presented as an explicit goal). When the authorities have shrunk the market and have a better understanding of who is doing what to whom (via better supervision) it could then be determined if it is possible to eliminate the product.

      1. Benedict@Large

        “… there is no way to have a CDS counterparty post adequate margin and have the product be viable (to put it more simply, adequate margin make CDS uneconomic).”

        Coming from an insurance background, this was one of the first things I noticed when I was introduced to CDS derivatives. I thought surely I must be missing something. Could an entire industry have merely brushed off a century of knowledge on insurance reserves? I guess so.

        But at least I don’t feel so alone anymore.

  2. Tony W.

    …..”another TBTF”. Feels like a very accurate reflection of the probabilities of where it ends.

    This may be overly simplistic, and repetitive as I have seen the same question before without a bona fide answer, my question: What is the point of all of the action in all of these instruments of leverage? 1) Enrichment of the Finance masterminds (to an obvious end)? 2) Strengthening of the Banking system? (to what end?) 3) Trickle down – generation of more wealth at the top trickles down, raising standards of living for all (to what end?)?

    To what end? Continued consumption of the planets resources at ridiculously unsustainable levels? What the heck is the point, and where is the REAL LEADERSHIP?

    I am 52 years old, and have been a Capitalist all of my life, with a resonable amount of “success” in that system. I believe we need a completely new set of expectations as a society as regards our economic systems and their purpose. A new set of expectations as a Society as regards our PRIORITIES, as a Society, and a very new set of expectations for those we elect to serve US in government.

    What is the point of all the LEVERAGE?

  3. Opinionated Bozo

    The point of the leverage is simply wealth transference, from the assets of Tony W, Joe Sixpack and John Q Citizen to traders and senior executives of hedge funds and TBTF banks.

    1. Skippy

      Beat me to it, was in queue but, its that simple isn’t it.

      The harder you work, the more you put in investment, 401K, anything, just makes it easier for them. Sure would be fun to see all the real value leave this illusionists staged show (Wall st.), to see real physics/math imposed…poof!

      Skippy…rob me gently…so I can scratch at your back door one day…have it held over my head by political parties et al…sigh.

  4. RueTheDay

    If you need any more evidence, Paul Wilmott, the godfather of quant analysis and derivative pricing, has said that CDS should be banned. I don’t have his Quantitative Finance FAQ in front of me, but he said something along the lines of “default is not a random value pulled from a probability distribution, it is a business decision”.

  5. Fred Rust

    There are two ways a clearinghouse reduces risk: 1) The clearinghouse, and the multiple firms backing it, assume the counterparty risk. 2) Derivatives are netted against each other – investors only have the net of their positions at risk, and the clearinghouse is at risk for the net of all open positions.
    Compare this to the situation when AIG collapsed: the full face value of every derivative AIG every wrote, purchased or sold was suspect.

  6. rd

    I think one of the biggest advantages of clearinghouses is allowing the total value of the CDS’s for a given issue to be totaled as they are issued. One of the problems was that the value of the CDS’s previously could be several times the insured amount, as well as not knowing how much institutions had in the game.

    A clearinghouse could require posting additional collateral as the percentage of an issue that was covered by CDS’s increased. A fairly nominal collateral could be posted for, say, the first 20% of an issue and the collateral requirements would increase dramatically so that it would generally uneconomic when demand reached 100% of an issue.

    There would be good profits to be made if you were early into the CDS issuance market, but the profits would decline as the trade became heavy. Similarly, it would make piling on to a failing issue difficult because the issuance would start to dry up as the demand went up.

    This type of approach would allow the original intent of CDS’s, to act as a form of insurance, to be fulfilled without turning them into system-endangering speculative instruments. Early buyers of an issue could buy a CDS on it relatively inexpensively but people looking for insurance late in the game would find it expensive. This could make the financial speculators unhappy because it would be difficult to do this with lots of leverage. C’est la guerre – after all, insurance companies don’t let you buy insurance the morning that the hurricane is forecast to hit.

    In this modern era of computers with instantaneous trading, this should be pretty easy to program into the clearinghouse computers. Something similar has existed for a long time, even before computers, for leveraged traders where the brokerages track the value of assets on margins and issue margin calls when the values are out of line.

  7. Hugh

    The problems with CDS are the same as they have always been.

    The most dangerous CDS are not tradable and have been exempted from exchanges.

    The counterparties can guarantee to pay on their bets.

    The exchanges and/or clearinghouses can’t cover their bets either.

    Karl Denninger with whom I disagree on almost everything has this right. Entering into a contract that you know you can not fulfill is fraud. CDS are fraud. Creating exchanges doesn’t remove the fraud. It simply adds another layer to it.

    Netting means nothing for the same reason. You can’t trust either the counterparties or the exchanges to make good on all your action.

    An implicit government backstop just increases the propensity for moral hazard in instruments that seem inherently structured to accentuate that hazard.

    1. Hugh

      Should read: “The counterparties can not guarantee to pay on their bets.”

      I mentioned CDS mostly in my comment but there are problems with most swaps. LTCM blew up in part over its currency swaps and those are often portrayed as vanilla.

  8. Mike

    Well, as long as the clearinghouses drive the CDS transactions towards Belgium, then…wait, what were we talking about?

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