Thursday, November 12, 2009

Many clearinghouses may raise OTC derivatives risk

Posted on Reuters by Karen Brettell:

Efforts by US regulators to move privately traded derivatives to central clearing houses are unlikely to be a cure-all for the industry, and may increase systemic risk if exposures are dispersed among too many counterparties.

Regulators around the world are pushing for the majority of contracts in the $450 trillion over-the-counter derivatives markets to be cleared through central counterparties, as futures and options contracts have been for years, in order to reduce the systemic risk posed by the web of connections between large financial institutions.

If there are too many clearing houses though, regulators run the risk of increasing the systemic risk posed by OTC derivatives trading, said Darrell Duffie, professor of finance at Stanford University.

"A clearing house through its opportunity to net across many asset classes and dealers can lead to a very substantial reduction in risk and also a very big increase in efficiency," Duffie said.

"However, that only works if you have very few clearing houses," he said. "Many clearing houses could be very bad. You would have increased counterparty exposure and excessive use of collateral, with multiple points of failure. This could add systemic risk."

Clearing the majority of derivatives through one counterparty is advantageous as market participants can offset all contracts in which they owe or are owed money against each other, a process known as netting.

The amount of collateral needed to back their exposures would also be radically reduced in this scenario.

Creating too many clearing houses, however, increases the amount of exposure a participant could have to a failed dealer, as it would be spread across several entities.

There are currently at least five clearing houses in the U.S. and Europe that clear or plan to clear credit default swaps, contracts that are used to insure against a borrower defaulting on their debt.

Other clearing houses clear, or plan to clear, other derivatives, including contracts in the $414 trillion OTC interest rate derivatives market.

REDUCING RISKS

Debate has increased recently over whether central clearing will successfully reduce risk posed by OTC derivatives, as some participants fret that difficulties in determining appropriate capital requirements for certain contracts could make concentrating exposures in clearing houses risky.

To some, CDS contracts are too risky in or outside of central counterparties.

David Einhorn, president of Greenlight Capital, said at a recent investment conference that CDSs cannot be made safer and should be banned, citing the "anti-social" incentives to let companies fail that may motivate protection holders who also own corporate debt.

"The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialized risks by moving the counterparty risk from the private sector to a newly created too-big-to-fail entity," he said.

Myron Scholes, Chairman of Platinum Grove Asset Management, believes one option to remove potential risk from clearinghouses is to embed them with a trigger in which contracts will be terminated at their mid-market price, in the event a clearinghouse becomes too risky.

A mid-market price is halfway between a security's bid and offer price.

"You have to set up a system that will close itself out efficiently and at no cost, that's the mechanism that has to go forward," said Scholes, speaking at a conference on derivatives at the New York University Stern School of Business held last week.

The move could also significantly reduce the amount of collateral that needs to be posted, he added. Scholes co-designed the Black-Scholes model for pricing stock options and was a founder of hedge fund Long Term Capital Management, which was bailed out by a consortium of banks in 1998 after it was unable to meet margin calls on leveraged exposures.

At present, derivative contracts are settled at the replacement cost of the contract to the non-defaulting counterparty, a process that can take years and creates many disputes over the value of the contracts.

The replacement cost can include a premium to account for the change in the value of the contract due to the failure of the counterparty.

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