Central Clearing and Systemic Risk
This guest post is by Ilya Podolyako, member of the Yale Law School Class of 2009 and a friend of mine. Ilya led the Progressive Economic Policy reading group with me and served as an adjunct professor of law at DePaul University this past spring.
One of the key provisions of the Dodd-Frank Act is Title VII, which requires all non-exempt derivatives transactions to go through a central clearinghouse (this report provides a good summary). As James and Simon have explained, the Dodd-Frank Act uses the term “swap” as a big basket that captures most financial products that we would normally call derivatives: options, repos, credit default swaps, currency swaps, interest rate swaps, etc.
Prior to the passage of the Act, most of these products were sold over-the-counter by certain large institutions. That is, in form, a transaction where you wanted to buy a credit default swap triggered by some event (say, the bankruptcy of Ford Automotive) resembled a trip to the car dealership. The dealer had inventory on the lot; this inventory was split into several different models / types of product; individual instances of a given model were relatively homogenous and varied mostly by color and minor adornments (spoilers, leather seats, etc.). If you were looking for a car of a given make and model that had certain extra features, a dealer might be able to get one custom-built for you at the factory, but you’d have to wait for the item and pay extra. Of course, the salesperson would not be able to accommodate all requests – if you show up to your average Chevy dealership and ask to buy a jet-powered car, you are likely to leave empty-handed no matter how much money you have, even though a few other individuals have been able to procure said exotic item.
From a structural perspective, an important characteristic of the new car market and other OTC markets is the absence of publicly available information about other transactions. Thus, when you show up to the dealership, you see only the sticker price, which is unlikely to be what prior customers actually paid to take drive the car off the lot. A related and notable feature of OTC markets is the ad hoc nature of customer-retailer pairings within them. That is, such markets usually have multiple parties independently striking their own deals for the same product; the coupling depends on chance, networks, and amenability to agreement. Predictably, in this environment, the final terms could differ quite drastically from one transaction to the other – prices could vary, some parties could be excused from performance in circumstances where others aren’t, warranties may apply to some sales but not others, etc.
By contrast, a centralized exchange pairs buyers with sellers on terms visible to everyone and pursuant to some fixed queuing algorithm. To switch metaphors for a bit, exchanges are like a reality TV show about a match-making service – a bossy central character sets everyone up while the cameras are rolling and even nonparticipants can witness the results. In this frame of reference, an OTC market is like a college bar – transactions are happening between some parties based on pre-existing relationships, between others who don’t know each other based on clearly indicated mutual interest, and between others still based on mutual acquaintance with an intermediary. The point is that an observer sitting in the corner of the bar might be able to figure out who has successfully negotiated a deal and who hasn’t based on secondary indicators like changes in the number of buyers and sellers remaining on the floor, but won’t have any clue as to the specifics of a given transaction or even the average negotiation.
Dodd-Frank does not mandate that private OTC swap markets convert to exchanges (such a requirement may exceed Congress’s Commerce Clause powers and would be unprecedented in the securities arena). Instead, it uses a more subtle measure to centralize and standardize derivatives trading by requiring most such transactions to go through a clearinghouse. A clearinghouse is sort of like an exchange in that both facilitate trusting interaction between buyers and sellers, but the two types of entities go about their mission in different ways. An exchange makes traders more confident they are getting the best possible price by making the market more transparent. A clearinghouse, on the other hand, makes traders more certain that the seemingly excellent price that their counterparty just agreed to pay is actually the amount of money they will receive when the transaction ends. In an OTC market, that can be far from certain, especially for a longer-term product, like a credit default swap covering a five-year period. In that time, even a CDS seller that was solvent at the time the deal was originally struck could become financially unsound (perhaps, because like AIG, it spent years handing out CDS’s for pennies to anyone who would ask) and be unable to meet its contractual obligations. If the buyer of the CDS found such an irresponsible seller on his own in the OTC jungle, the buyer would have no recourse to anyone else. He could sue the seller or try to extract the money in some other way, but if this money had already leaked out by the time the triggering default event occurred, the buyer would be left holding nothing by a worthless contract in his hands.
A clearinghouse ameliorates such risk by standing behind every transaction and ensuring that it goes through. More specifically, pursuant to previously accumulated legal authority, the clearinghouse takes contracts setting out each deal, “splits” them into two – one setting out a sale and the other setting out the countervailing purchase – and substitutes its name for the counterparty in each half of the transaction. This process, known as novation, ensures that the clearinghouse becomes the seller for every buyer and the buyer for every seller. In doing so, it absorbs all of the counterparty risk from the market, but keeps a posture that is indifferent to changes in the price of the underlying asset because all of its long positions (obligations to buy an asset) match up with short positions (obligations to sell an asset).
The business of a clearinghouse thus closely resembles that of a specialized (monoline) insurer. The clearinghouse makes money in a similar way too – by charging a fee for every transaction it processes. Clearinghouses are usually mutually owned by the members / clients whose transactions it will stand behind. These may include banks, hedge funds, large broker-dealers, and exchanges (who own two of the largest existing American derivatives clearinghouses, CME Clearing and the OCC). These members are responsible for contributing money to an emergency rescue fund in rough proportion to their trading activity, maintaining capital accounts that satisfy a performance margin , and, in some situations, usage fees (though capital contributed free of charge and not subject to an interest rate obviously counts as an implicit fee). Clearinghouses may also call on their members to contribute additional capital or absorb the positions of a member that cannot meet its obligations at any time. Their business model is thus subject to significant network externalities, because a clearinghouse that includes only a few small companies will process exponentially fewer transactions than one that includes all of the major market participants. Moreover, the smaller clearinghouse may attract less financially stable participants and thus carry more counterparty risk on any transaction than a large one. These parameters explain why the existing private-sector clearinghouses enjoy a near-monopoly in their markets.
Clearinghouses aren’t unique to the derivatives arena. They serve as key intermediaries for the stock market and electronic fund transfers. The Federal Reserve is a clearinghouse of sorts, in that it facilitates transfers of assets from one bank to another. Indeed, in the era prior to the existence of the Federal Reserve, banks formed their own regional clearinghouses as a means of assuring investors that an individual bank failure would not jeopardize their savings. These structures proved popular but not particularly effective.
Herein lies the problem. A clearinghouse is a private business that puts its own money on the line. It works by ensuring that its members are actually well-capitalized institutions capable of paying for bets they made, and thus closely scrutinizes the risk profile of each participant’s portfolio on an ongoing basis. This access permits a clearinghouse to observe otherwise opaque OTC markets with great precision and provide valuable data on concentration, exposure, and capitalization to regulators. Meanwhile, under normal circumstances, the clearinghouse can neither borrow from the Federal Reserve nor receive government backing for its capital. So what could go wrong with using these organizations to grab control over derivatives?
Well, while in theory the model sounds good, history has demonstrated that private sector risk aggregators routinely underprice systemic, correlated risk. AIG provides the most startling example of this behavior. From 2005 to 2008, its Financial Products group essentially acted like a clearinghouse gone mad, willing to become the counterparty to nearly every bet by writing billions of dollars (in then-notional, subsequently real value) worth of credit default swaps without holding on to capital or hedging its reference product risk. A similar tendency to charge too little for catastrophic risk undermined the finances of MBIA (initially formed by a consortium of principal insurance companies in a structure reminiscent of the OCC) and AMBAC, the main monoline insurers, whose credit ratings were rapidly cut during the credit crisis. Fannie and Freddie are even better examples, because government housing policy exacerbated their natural tendency to underestimate the likelihood of fat-tail events and charge too little for their guarantees of conforming RMBSs.
Now that clearinghouses have become ingrained into our official market framework, they are likely to become susceptible to the same business pressures that led other too-big-to-fail institutions to dance while the music is playing and not worry about what happens after. In the absence of mandatory clawback requirements, the people who own CME Clearing, OCC, and any other entity that can successfully break into the oligopoly will be able to benefit enormously by charging nonrefundable fees to process every transaction that the DF Act shoves onto their platforms from the previously scattered OTC markets. Realistically, they will continue to carefully monitor their members to avoid costly liquidation of individual portfolios, which cost real dollars from proprietary emergency funds and may decrease trade volume (and revenue) by frightening relatively cautious investors. But the possibility that these sophisticated, logical actors will overlook the fact that Congress has just anointed them as systemically critical parts of the U.S. economy (on whom farmers, power plants, and steel mills will depend to provide a backbone to their trades)* seems slim. I need not belabor the dangers of such awareness on this site.
Of course, social absorption of losses may be a fair price to pay for transparency, stability, and liquidity, at least in some circumstances. For example, the FDIC does just that, and it is widely recognized as a drastic improvement over earlier approaches to the banking system. On the other hand, a lack of centrally cleared derivatives did not cause the economic crisis; lax or nonexistent capital requirements for portfolios of these derivatives did. Clearinghouses can and do impose a version of these, but for the reasons stated above, their requirements are not likely to adequate. The Dodd-Frank Act is still a step in the right direction because it allows the government to survey the derivatives market in real time and stage precise rescue operations when necessary, but in this arena, as in many others, the reforms carry a significant cost.
*Most of these institutions should be able to avail themselves of the End-User exception in Section 723(h)(7)(A) of the Act, but their counterparties are likely to be large financial conglomerates who rely on clearinghouses to manage, clear, and hedge their exposure to any given farm or steel mill.