Internalizing the Concept of Too Big to Fail Clearinghouses

Craig Pirrong submits: I’ve written frequently about the problematic evolution of financial market structure under a clearing mandate. One concern is the proliferation of CCPs [central counterparty clearinghouses]. One potential reason for this proliferation is that exchanges will want to control their own CCPs.

Craig Pirrong submits: Oh, yeah. The WSJ seized on Ben Bernanke’s “Puddin’head Wilson” speech about the need to be especially vigilant about the risks inherent in huge CCPs, including those engendered or expanded by Frank-n-Dodd mandates (h/t Carl E and Mark B):

Craig Pirrong submits: There are a lot of jokes about economists that go something like: “An economist and a physicist are on the top floor of a skyscraper. Someone runs in screaming ‘the building is on fire. The stairways are all blocked.’ The physicist immediately panics, then looks at the economist, who is amazingly calm. The physicist says, ‘How can you be so calm? We’re all gonna die.’ The economist smiles wanly and says, ‘No we’re not. First, assume a 100-story ladder.’”

Craig Pirrong submits: On Monday, Fed Chairman Ben Bernanke gave a speech on clearinghouses to the Atlanta Fed’s annual conference. Ironically, Bernanke echoed the theme of my talk at that conference in May, 2009: central counterparties (CCPs, i.e., clearinghouses) could fail, and are a potential source of systemic risk:

Craig Pirrong submits: Gary has a magic box, called a “clearinghouse.” You put counterparty risk in the box, and it disappears!:One of the central goals of Dodd-Frank is to redirect much of the OTC derivatives market through exchanges, electronic trading platforms and central clearinghouses that stand behind dealings in derivative contracts.

Craig Pirrong submits: The U.K.’s Financial Services Authority (FSA) released a report on OTC derivatives market reforms in December. In contrast to most government reports I’ve read on the subject, this one is thoughtful and arrives at pretty well reasoned judgments. It recognizes the trade-offs involved. It is a little too sanguine on the merits of clearing for my taste, but does not recommend mandates.

Craig Pirrong submits: The issue of the systemic risks posed by a clearing mandate that expands the scale and scope of central counterparties has come to the fore of late. Too late, perhaps, but even at this late date it is an advance. The focus of this concern is now on whether CCPs will be too big to fail, and whether they should have access to the Fed’s liquidity provision facilities.

Craig Pirrong submits: The scariest kind of counterparty risk is “wrong way” risk. This kind of risk occurs when there is a dependence between the size of the exposure (i.e., the amount that can be lost in the event of a default) and the probability of the counterparty’s default. In particular, wrong way exists when the exposure is large when the probability of a counterparty default is large.