Philip McBride Johnson, former chairman of the CFTC, responds to Euromoney’s editorial CCP: The great derivatives subsidy, warning of the dangers of central counterparty clearing.
One of the cornerstones of financial regulatory reform in the United States as manifested in the Dodd-Frank Act (also known laboriously as the Wall Street Reform and Consumer Protection Act) is to eliminate the handshake as "collateral" for derivatives transactions and to substitute a "show me the money" approach. This includes (but, as noted below, does not substitute) a central counterparty clearing system where an organization very highly capitalized from private sources acts as a final recourse for counterparties owed money on their derivatives deals.
Getting there is not an easy task. First, the original debtor must exhaust its resources and suffer an effective bankruptcy. Then, its broker – required by law to be well capitalized – must pay all of its own funds toward the debt and, if inadequate, join the debtor as a pauper. Typically, a third layer called a "clearing member" must then embrace the shortfall with a capital base that often approaches some nations' gross domestic product. It is only in the remote event that all of these sources crash and burn that the clearinghouse's wealth comes into play. The fact that no clearinghouse has ever failed to meet a debt in full puts the odds of such a default statistically at zero although nothing is truly impossible.
And yet, some people criticize the clearing system as "concentrating" credit risk in a single entity that, in the end, might prove to be a new species of "too big to fail." On the contrary, it adds one more safety net to the markets beyond the resources of the immediate parties and their intermediaries. The mechanism emphatically does not encourage reckless behavior by the underlying parties, as some opponents assert. To underscore that point, would we expect soldiers to risk their lives needlessly if they knew that a powerful ally would intervene but only when all of them were dead?
Clearing makes the system safer, period.
Philip McBride Johnson
The author is a past chairman of the US Commodity Futures Trading Commission and a member of the exchange-traded derivatives regulatory practice at Skadden, Arps, Slate, Meagher & Flom in Washington.