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Opinion

CCP: The great derivatives subsidy

And so it has come to pass. Central counterparty clearing is to set to become, well, central to the financial markets landscape. It is seen as a cure to the concentration of risk that was held by the world’s largest trading firms in the lead-up to the financial crisis.

However, this is a false proposition. Indeed it amounts to little more than a shuffling of the deck chairs on that great cruise liner called Wall Street by creating new too-big-to-fail institutions that will be backstopped by the Federal Reserve. The Dodd-Frank legislation requires swap dealers to push trades into clearing houses. That concentrates the risk of these derivatives in a few central counterparties, which are interconnected to all derivatives participants and other markets.

Among the main derivatives dealers there’s a general consensus that 80% of their trades could be pushed onto clearing houses. This means the US government could be on the hook for almost $2.2 trillion of market risk that will eventually be held in clearing houses. The Bank for International Settlements has calculated that the credit risk of the entire market is about $2.7 trillion, which is greater than the combined bondholdings of Fannie Mae and Freddie Mac, now under government stewardship.

While some Washington politicians showed their opposition to the backstop by introducing amendments to prohibit financial support in the bill, Congress ploughed ahead by providing explicit statutory support for derivatives. Should the clearing houses get into trouble the Federal Reserve can lend to them under two separate programmes: through the discount window and under the Fed’s Emergency Lending Authority.

Even the main proponents of central clearing – chief among them Gary Gensler, head of the CFTC – said that providing the Fed backstop would be a dangerous precedent. But legislators saw the inherent risks in condensing all trading into a few clearing houses. Good risk management was considered not to be good enough.

And there’s more. Despite the Fed backstopping them, clearing houses were exempted from being regulated by it and they won’t have any reserve requirements imposed on them, even though they now have many of the characteristics of a bank.

That’s a pretty good result for the clearing houses, but not for the US taxpayer. To be sure, backstop-financing facilities do perform an essential role for clearing houses when there’s a need for liquidity in stressed markets – they enable them to turn their collateral into cash in a hurry – but this is the first time the clearing houses have been given direct access to central bank funding.

For instance, during the stock market crash of 1987, both the Chicago Mercantile Exchange and the Options Clearing Corporation avoided failure when the Fed managed to pool emergency bank loans for both. Perhaps access to Fed funds is tacit admission that the concentration of risk that central clearing creates means, in the event of a crisis, unprecedented action will have to be taken.

Gensler admits in this month’s cover story that risk just doesn’t disappear, which is why clearing houses will have to be very well regulated (See Gary Gensler: Banking's enemy #1, Euromoney September 2010).

Bankers have tried to make the case that moving risk on to clearing houses will not provide a safety net. One senior banker who used to work with Gensler says: "I looked Gary in the eye and said: 'You cannot seriously think that central clearing eliminates risk?' He didn’t reply."

And, as another banker told Euromoney recently: "The recent regulatory focus has been on credit risk, which is what CCPs address. CCPs do take care of some risks, but there is a danger that they distract us from the much more important job addressing the remaining significant settlement risk. This is where regulators should focus."

Perhaps, as Darrell Duffie of Stanford University says, too big to fail isn’t as bad a problem for a clearing organization as it is for a big investment bank or money-centre bank, because it’s a utility with a very limited range of risk-taking activities. The moral hazard is much less, because its only risk is counterparty failure. Making it too big to fail does not necessarily mean you’re giving it the licence to take all kinds of extra unnecessary risks.

The question now will be whether or not the UK and Europe will do the same: give clearing houses the keys to the door, without a curfew. 

Former head of the CFTC Philip McBride Johnson responds: “Clearing makes the system safer, period” 

"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?"

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