Questions About (OTC) Clearing

Craig Pirrong

Bauer College of Business

University of Houston

Meta-Question 1 Why haven’t market participants voluntarily

adopted clearing in for large quantities of OTC transactions? Private Cost>Private Benefit What are the Costs and Benefits?

Meta-Question 2 Is it efficiency-enhancing to mandate clearing

of some OTC products? If so, which ones? Social Benefit>Social Cost Why might there be divergences between private

and social costs & benefits?

Meta-Question 3 Are there measures short of mandatory

clearing that are more efficient than clearing? “Centralize that which should be centralized:

Keep decentralized those things that should not be centralized.”

The Costs and Benefits of Alternative Market Arrangements Clearing has been presented as a panacea for

many of the ills currently plaguing world financial markets

To answer the questions posed above, it is necessary to evaluate the costs and benefits of alternative institutional arrangements

CCP vs. Bilateral (perhaps with changes short of clearing)

Efficient Risk Bearing Sharing of default risk of a CCP can reduce

the default losses suffered by non-members This can improve hedging effectiveness,

leading to more welfare improving trades This benefit is a private one captured by the

participants to the transactions

Netting Netting is the most often cited source of clearing

benefits, but: Netting generates private benefits Lower repricing risks also largely private Netting can be achieved by methods short of the

formation of a CCP (e.g., TriOptima, NetDelta) NETTING IS NOT NECESSARILY A SOCIAL

BENEFIT BECAUSE ITS FIRST ORDER EFFECT IS TO ALTER PRIORITY RULES IN BANKRUPTCY, THEREBY REDISTRIBUTING WEALTH FROM OTHER CREDITORS (EG, BONDHOLDERS)

The Costs of Risk Bearing-Asymmetric Information A CCP is a risk sharing mechanism All risk sharing mechanisms incur costs arising from

information asymmetries (adverse selection and moral hazard)

Costs can differ across alternative sharing mechanisms

Are asymmetric info costs greater for bilateral or CCP arrangements?

Does the answer to this question depend on the nature of the instrument, and the types of firms trading it?

Asymmetric Information and Risk Pricing Default risk sharing mechanisms in both

bilateral and cleared markets effectively price risk through collateralization

Who has the better information, and hence can price the risk more accurately?

Poor risk pricing can distort risk taking decisions, thereby generating private AND social costs (including costs arising from systemic risk)

Asymmetric Information: Product Complexity Different instruments have different risk characteristics Especially for complex products that are new, knowledge

about risk characteristics is limited, and likely very unevenly distributed

PORTFOLIO RISKS! (DEPENDENCE A MAJOR ANALYTICAL ISSUE IN CDS)

Arguably big bilateral market players would have an information advantage relative to a CCP

“The one-eyed man is king in the land of the blind” When I think of the CCP evaluating risks of complex

products, I think of rating agencies (not a comforting thought)

Asymmetric Information: Price Transparency Existing CCPs rely on the price discovery

process on liquid, transparent markets for the prices used to mark positions and determine collateral

CCPs ARE CONSUMERS OF TRANSPARENCY, NOT PRODUCERS

CCP information disadvantage about values likely to be most acute for illiquid products

Asymmetric Information: “Balance Sheet Risk” The risk of default depends BOTH on the riskiness of a

firm’s derivative positions, and the values of other assets & liabilities on its balance sheets

Many products (e.g., CDS) traded by big, opaque institutions with complex balance sheets

Bilateral market participants (a) arguably have better information than a CCP regarding counterparty balance sheet risks, and (b) can price counterparty risks to reflect risk differentials, whereas a CCP treats all members alike

Homogeneous treatment of CCP members especially problematic in current environment, where there is a demonstrable difference in the performance risk posed by major financial institutions

More on Balance Sheet Risk It is interesting to note that cleared markets take into

account the desirability of differential pricing of balance sheet risks

CCP members (and prime brokers) make individualized risk assessments of their customers’ balance sheet and position risks, and charge differential risk prices

Thus, even CCPs recognize that they are at an information disadvantage in evaluating some performance risks

Risk Concentration and Interconnections Systemic risk concerns arise from the

interconnections among large financial firms CCP does not eliminate interconnection, it

reconfigures it Indeed, it reconfigures it in a way that can increase

concentration of default risk, and increase the amount of default risk that some systemically important firms bear

CCP capitalization, “Maxwell House” rules, and potential for CCP failure

Regulatory Transparency Advocates of clearing often cite the benefit of

improving transparency, and regulators’ knowledge about risk exposures of systemically important firms

But . . . These objectives can be achieved without sharing default risks via a CCP

“Data hub” (a la the Energy Data Hub I advocated in the early 2000s)

Systemic Risk Not clear that CCP reduces systemic risk: It

may INCREASE it Concentration and CCP capitalization issues

discussed above If CCP operates at an information

disadvantage, relative to bilateral market alternative, poorer risk pricing may exacerbate systemic risks

More on Systemic Risk Clearing may increase scale of trading

activity if purported benefits of netting and more efficient collateralization are realized

Clearing can shift risk to other systemically important market participants (due to the redistributive effects of the change in priority rules inherent in netting)

Dealer Self-Interest It is often argued that dealer’s profits would decline

from the adoption of a socially efficient CCP (I advanced this hypothesis over 10 years ago)

Maybe. . . . But (a) OTC market structurally very competitive, and (b) apparent profitability may be misleading because conventional profit measures don’t take into account important costs (esp. related to performance risk)

This is an interesting hypothesis, but by no means is it proven, or more plausible than alternatives

Questions & Answers Do I have all the answers: NO! But, I believe I have asked important questions and

identified important issues that have gone largely overlooked in the debate over OTC clearing

I also think that there is a case to be made that centralized risk sharing via a CCP is less efficient than modified bilateral arrangements

Let the debate begin!