Clearinghouse Over-Confidence

Editor’s Note: Mark Roe is the David Berg Professor of Law at Harvard Law School, where he teaches bankruptcy and corporate law. This post is Professor Roe’s most recent op-ed in his regular column series titled “The Rules of the Game” written for the international association of newspapers Project Syndicate, which can be found here.

To reduce the chance that a financial meltdown like that of 2007-2008 will recur, regulators are now seeking to buttress institutions for the longer-run – at least when they can turn their attention from immediate crises like those of Greece’s debt, America’s ceiling on governmental borrowing, and the potential eurozone contagion from sovereign debt to bank debt. Central to their effort has been to bolster clearinghouses for derivatives – instruments that exacerbated the implosion at AIG and others in the last financial crisis. But a clearinghouse is no panacea, and its limits, although easy to miss, are far-reaching.

When a company seeks to protect itself from currency fluctuation, it can reduce its exposure to the target currency with a derivative (for example, it promises to pay its trading partner if the euro rises, but gets paid if it falls). Although the company using the derivative reduces its exposure to the risk of a failing euro, the derivative comes packaged with a new risk – counterparty risk. The company risks that if its trading partner fails – as AIG, Bear Stearns, and Lehman did – it won’t be paid if the euro falls.

Worse, as we saw in the financial crisis, if many financial institutions have many such contracts, a rumor of insolvency can induce all of one institution’s derivative counterparties to demand collateral or payment simultaneously, triggering a run that resembles a classic bank run, which could then spread to other firms.

To reduce the risk of runs in derivatives markets, regulators around the world are poised to require that derivatives trades be carried out through clearinghouses or exchanges. The clearinghouses will have many advantages, but not as many as regulators might think.

But, first, how does a clearinghouse work?

After the company needing currency-risk protection makes its euro-dollar trade with a bank, each of them turns its side of the trade over to the clearinghouse. The resulting obligations between the company and bank become obligations to and from a middleman, the clearinghouse.

The clearinghouse protects itself by getting an up-front deposit from the bank (in case the bank fails in, say, 2015), and by monitoring the bank’s total “book” with the clearinghouse. When the bank wins on a derivatives trade, the clearinghouse pays the bank; when the bank loses, it pays the clearinghouse. When the bank has many trades on the clearinghouse’s books, the clearinghouse is fine if these trades net out to about zero; systemic risk, regulators insist, is thereby reduced, because the financial system needn’t worry about collecting the debts, one-by-one. This is true, but only for as far as the netting process goes.

The clearinghouse also enhances transparency, because it can report its aggregate exposures to the regulator, who is better positioned to regulate a central clearinghouse than to regulate many opaque banks. This, too, this should strengthen the financial system.

But risks – many of them systemic, and many of them big – remain. Unfortunately, the clearinghouse structure obscures them.

Most obviously, as many trades move from the banks to the clearinghouse, the clearinghouse itself will become a systemically vital institution. It will be too big to fail.

Equally problematic is the fact that, while the clearinghouse and its participants can net wins and losses to reduce risk for those inside the clearinghouse, the clearinghouse does not assuredly eliminate the basic risk facing the entire financial system. Often, it merely transfers that risk to creditors outside the clearinghouse.

Here’s why: Let’s imagine that a weak financial institution (say, Bank of America), has two separate contracts, one with AIG and one with Citibank. BofA owes $100 million to each. The contract with AIG is a derivatives contract, which goes through the clearinghouse; but the contract with Citibank is another kind of contract, maybe just a regular loan, and does not go through the clearinghouse. BofA also has a contract with, say, Bear Stearns through the clearinghouse for $100 million, with Bear Stearns on the losing end.

Without a clearinghouse, BofA has a $100 million asset (the $100 million that Bear owes it) and owes $200 million. Having only $100 million (if these obligations are its only assets and liabilities), BofA would have to pay AIG and Citibank $50 million each. Each would suffer a $50 million loss.

If AIG is systemically vital, its inability to collect the full $100 million could cause it to fail. This is where the clearinghouse protects AIG, whose winning contract with BofA nets out against Bear’s losing contract with BofA. The clearinghouse here eliminates counterparty risk for these three, but only by transferring the risk to Citibank, which, instead of losing $50 million, ends up losing the full $100 million.

In this stripped-down example, AIG, Bear Stearns, and BofA – as well as their attorneys, lobbyists, and supportive policymakers – promote the clearinghouse on the grounds that it reduces risk for its participants. And, as advertised, it does — but only for its participants. Citibank, however, now loses $50 million more, because it can’t crack into the clearinghouse’s assets. If that extra loss pushes a systemically vital Citibank over the precipice, the clearinghouse has not reduced systemic risk as advertised.

Whether the clearinghouse reduces systemic risk depends on the relative systemic importance of those inside and those outside the clearinghouse – AIG versus Citibank in this basic example – not on the clearinghouse’s capacity to reduce risk among its members. In this example, if Citibank is precarious and is as systemically vital as AIG, the clearinghouse has obscured that it has saved AIG only by transferring risk from the clearinghouse to Citibank, which then fails.

Much recent regulatory activity has focused on enabling, enhancing, and requiring clearinghouses for these kinds of financing arrangements. Yes, clearinghouses offer many benefits, including greater transparency, better pricing, and better regulatory focus, and we should try to make them viable. But regulators world have overestimated their overall benefit. Too much of what is justified as reducing systemic risk is really just offloading risk onto others.

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  1. Aaron Brown
    Posted Thursday, November 3, 2011 at 2:16 pm | Permalink

    I agree with your point that clearinghouses reduce some risks and increase others. But I think the one you mention is not among the issues.

    No one thinks a clearinghouse can create money out of nothing. In your example, $100 million is missing and someone has to take the loss. The clearinghouse does not claim to direct the loss to the party that can bear it better or the party of less systemic importance, and certainly does not claim to make the loss disappear.

    The main thing the clearinghouse does is speed up the resolution. Instead of accounts frozen for months or years of argument, AIG is saved and Citibank has a clear-cut loss, both known on the day of the filing. Your example obscures the importance of this by using only two derivative contracts. Suppose BOA had 10,000,000 contracts on which the net value is zero. Netting those out immediately with legal certainty will simplify the remaining proceedings enormously and limit the follow-on damage of BOA’s default.

    The secondary benefit of the clearinghouse is to direct losses away from an interlocking network where they cause confusion. AIG probably has an offsetting derivative with another counterparty, which is connected in a daisy chain of offsetting contracts that affects every dealer and even comes back to AIG. Even if every dealer owes money to BOA net, so there is no net loss on derivative contracts for anyone, the system can freeze up and inflict multiple needless bankruptcies.

    It’s true that loss on a $100 million loan may kill Citibank, but only if it really is insolvent. In that case, it should go bankrupt (or be rescued, but that’s another question). Moreover, the loan is on Citibank’s balance sheet and not daisy-chained to every other lender. The reason to pay AIG ahead of Citibank is not that AIG has a superior legal claim, but that paying AIG reduces the chance of an event against the public interest. Of course, in practice, both AIG and Citibank will have both kinds of claims on BOA, and likely both of them have more to lose from freezing of derivative markets than some reassignment of recovery dollars which on average does not help or hurt them.

  2. Craig
    Posted Monday, November 7, 2011 at 12:09 pm | Permalink

    MF Global had quite a few of the smartest men in the financial industry managing their assets. They also had access to the ultimate insider info, because their CEO, Jon Corzine, was a Federal Reserve Bankster insider. So, how could so many of the nation’s brightest make such boneheaded decisions?

    Once again I want to emphasize that for every loser in the financial derivatives market, there is an equal and opposite winner, making tons of cash.

    Since 70% of the 1500 trillion dollar derivatives market is bets against interest rates going up or down, one would think that the former Chairman of Goldman Sachs would have some kind of clue on what the banksters were doing with interest rates. Some would argue that the loss of $40 billion dollars was a huge mistake. I would argue that there are no mistakes when it comes to the Satanic Psychopaths!

  3. Stephen R. Ganns
    Posted Monday, December 5, 2011 at 5:14 pm | Permalink

    Dr. Roe,

    A couple of anecdotes on opacity:

    1. In late 2008, Congressman Peterson of MN was Chairman of the Agriculture Committee in the House and introduced legislation to put an end to the majority of “naked swaps”—this brought an onslaught of criticism by the banking and insurance lobbies;
    2. In 2009, I was hosting a panel for the Research and Statistics Division at the Board of Governors of the Federal Reserve regarding commercial real estate and capital markets and wanted to find out what amounts were referenced and appended to commercial real estate and CMBS financing. I contacted ISDA and the Pension Real Estate Association research departments —they no data;
    3. I had lunch with officials from OCC and inquired if I could see the back-up data to their call reports delineating a breakdown of OTC derivatives by type of securitized products or asset classes, i.e. how they broke out by the various groups (residential loans, commercial loans, credit card debt, student loans, etc.). The reply was that their data was “not that granular”.
    4. I won’t mention here the “steam rolling” of Brooksly Born by Larry Summers, Phil Graham and Alan Greenspan—but it was pivotal in setting up the debt crisis.

    From a paper of mine Speculative Economics which enumerates factors to review:

    “A review of derivatives, especially the unregulated swaps or OTC markets, and how their existence and use has acted to magnify the bursting of an otherwise severe but manageable series of “asset bubbles” into a complexity at a higher “order of magnitude” than has been contemplated in modern times—which has virtually frozen the capital markets. As a note, these instruments are termed by some as “welfare enhancing” credit risk transfer instruments — which create diversification and liquidity. However, the speculative nature and volume of these unregulated instruments have been daunting to the international financial system and hard on real economies.”

    The opacity of these markets is the primary driver in holding the U.S. and global economies in suspended animation—markets can’t clear—simply because derivatives still remain uncontrolled and unaccounted. At least a clearing house would be a start.