Not At All Clear

I came across a post on Project Syndicate by Mark Roe, a professor at the Harvard Law School. “Clearinghouse Over-Confidence” says that “a clearinghouse is no panacea, and its limits, although easy to miss, are far-reaching.”  The professor offers two
reasons why a clearinghouse falls short of alleviating the derivatives problem.

After a brief description of how a clearinghouse works, the gist of the professor’s first argument is that only those derivative positions held inside the clearinghouse can be netted, winners against losers, allowing collateral payments to be made and collected.  Because of this the clearinghouse structure actually obscures the risks it purports to
mitigate.  He presents an example with counterparties having positions both inside and outside the clearinghouse, and shows how the risk is not lessened, merely shifted, and may increase the risk to certain counterparties.

If I read this correctly then, the disadvantage of the clearinghouse system is that, unless all positions are held within it, it fails.  This seems to be somewhat unfair.  If derivatives traders choose to structure deals to keep them out of a cleared environment, and they will, then how is that the fault of the clearinghouse?  Do you blame your health club if you choose not to go and remain 25 pounds overweight?

The second argument is that “the clearinghouse itself will become a systemically vital institution.  It will be too big to fail.” Absent political meddling or outright fraud, this is inaccurate.  As an institution, it cannot be too big to fail.  The purpose of clearing is to ensure that winners get paid and losers pay up.  At the end of every day, all the ledgers should total to zero, as that day’s gains and losses are a zero-sum game.  Funds are debited and credited, and any excess collateral is in segregated accounts for the benefit of the market participants.  While the clearinghouse holds the money, it doesn’t own the money.

There is a further function of a clearinghouse that may or may not be implemented. A process called novation interjects the clearinghouse as the buyer to every seller and the seller to every buyer.  Once a trade is sent to be cleared, the original buyer and seller no longer have a bilateral agreement.  The clearinghouse steps in between.  This is possible if there is a standard form of trade, such that every trade of a particular type,
e.g. a vanilla swap, is identical and fungible.  Then the counterparty, and therefore the counterparty credit risk, is irrelevant, as it is always the clearinghouse.

Having spent 35 years in the exchange-traded futures and options markets, actually in the trenches of the pits, I have lived in a clearinghouse world.  It works well and, here in Chicago, has been used in its present form without blemish for the past 85 or so years.  I could confidently trade billions of dollars’ worth of contracts with counterparties that I wouldn’t lend ten dollar to.

Other than the too big to fail statement, there is nothing inaccurate in professor Roe’s article.  The example makes a good point as it is constructed.  While the risk to one of the counterparties is increased, the overall risk of the aggregated deals is lessened.  And we can agree that there are limits to clearing, but I suggest that the real problem lies not in the clearinghouse environment, but in the misplaced expectations of what clearing can and cannot do.  It is not, as he says, a panacea. But within its limitations it works well. For those trades that can be cleared, that part of the market will have
increased transparency, and will be sufficiently collateralized to reflect the true risk of the position.  To the extent that this is done, risk can be mitigated.

But, the market will continue to look for ways to keep collateral requirements to a minimum, and to structure deals so they can charge a wider spread for the trade.
Specifications will continue to be complex, putatively to “fit their book,” but as much to avoid clearing.  This is not a flaw in the clearinghouse system, not does it obscure
risk.  Furthermore, it is not overconfidence.  It is lack of understanding.  The fault lies not in our clearinghouse, but in ourselves.

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