Thursday, November 5, 2009

Gillian Tett: The Clearing House Rules

Posted in the Financial Times by Gillian Tett:

For the last year, as politicians have grappled to get their heads around the perils of complex finance, many have been seeking a handy magic wand that might produce a reform fix (or, at the very least, give them something they can explain, and wave to voters on prime time television.)

The phrase “clearing house” has often been regarded as one such, seemingly-magic wand. After all, even the most financially-illiterate politician can see how many trillions of derivatives deals currently exist. They can also understand how the complexity and opacity of these contracts contributed to the financial panic in the autumn of 2008 (even if derivatives per se, did not cause this drama).

Thus the idea of putting these opaque contracts into a central clearing forum, where they can be properly monitored and settled even amid a panic, has now turned into the regulatory equivalent of Apple Pie.

After all, as entities such as the Chicago Mercantile Exchange love to point out, one notable feature of last year’s panic was that trading on financial exchanges, such as the equities market, continued, even as other sectors seized up.

And the key reason for that was not simply the presence of exchanges – but, more importantly, the fact that investors had confidence that trades would be settled, via a clearing platform, even if other investors suddenly imploded. Thus introducing clearing platforms into the credit derivatives world, say, seems to be one way to make the system far more resilient than before; or so the current political rhetoric goes.

There is certainly much merit to this. And I, for one, welcome the appearance of various clearing houses for credit derivatives on both sides of the Atlantic. 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.

In part, that silence may simply reflect a lack of imagination; after all, politicians and regulators have never seen a situation where a clearing house has ever collapsed, since that has almost never happened in history before (leaving aside one small exception in the commodities world, a few decades ago.) However, 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.

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