Thursday, April 15, 2010

Some Thoughts on Central Clearing

Original posted on Credit Slips by Steve Lubben:

As the financial reform legislation moves forward, central clearing of derivatives has become a key topic of interest, along with the related, but distinct issue of exchange trading of derivatives. Central clearing refers to having a party that acts as the "hub" in derivatives transactions, so that a bilateral contract actually becomes two bilateral contracts, with the clearing agency in the center. This should generally increase transparency, including with regard to conterparty risk.

Most of the focus has been on the counterparties, and which sorts of counterparties should be required to transaction through a central clearing house. But I do worry that not enough focus is being placed on rules to govern the central clearing agency. As I have argued in some recent papers, the central clearing agency must have robust margin requirements for its members, as well as an ability to draw liquidity from at least the larger members in times of crisis. Otherwise the central clearing agency itself will become a "too big to fail" entity in need of a bailout.

I also continue to believe that repeal of the special treatment of derivatives in bankruptcy (and in the resolution authority, as proposed in the Dodd bill) is needed to give the central clearing party the appropriate incentives to monitor its exposure to counterparties.

On the issue of clearing itself, I think we need to take some of the uproar with a grain of salt. The big players -- banks, large hedge funds and the like -- are already moving toward clearing and posting collateral with third-parties. I suspect that sooner or later they are also going to figure out that they are much better off dealing with a single entity in the corporate chain, or at least entities that are all in a single jurisdiction, to avoid the problems seen in Lehman. Thus, putting all derivative trading into a single sub will make sense anyway.

Why then are some of these same parties so vocal in their opposition? Well, some of it surely has to do with the sale of derivatives to parties who might not be ready to take these steps, and a fear that these parties will simply reduce their derivatives purchases rather than take the steps to comply with the new rules. They might also replace more complex swaps with simpler contracts like futures. Neither is clearly bad or inefficient from a societal perspective, but you can understand why the banks might not like it.

That said, I'm going to challenge the conventional reformist wisdom by wondering aloud if its really necessary to centrally clear everything. Some flexibility might be good. Of course, there needs to be a cost to taking that option, since it could impose a cost on the rest of us -- most obviously, the collateral posting requirements could be substantially higher for trades that are not cleared. Perhaps a multiple of margin required for a cleared trade?

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