In an earlier post, we took a first step in answering the question ‘Which system is more expensive to the end-user, one in which both parties can agree to an uncollateralized trade, or one in which collateral is required by virtue of the fact that all trades must be cleared?’ The first step took the macro context as given across the two systems and analyzed the cost differential at a micro or single firm level. The result was that the two systems were identical in cost. In this post we take the second step and address how each system affects the macro context.
One key purpose of the OTC reform is to reduce the aggregate credit risk in the system. Proponents and opponents disagree on whether the Dodd-Frank bill or other proposals succeed in reducing aggregate risk. There are lots of valid areas for debate here. It is easy to imagine ways in which the requirement for centralized clearing may reduce aggregate credit risk, and it is also possible to imagine ways in which systemic risk may end up increasing. For more detail on both of these, see this report by the New York Federal Reserve Bank. This is where the real bottom line cost to end-users will be decided. If the reform ends up reducing aggregate credit risk, then the cost of trading derivatives will go down, regardless of whether collateral is mandated or not. If mandating clearing—together with other provisions and implementing rules—ends up reducing aggregate risk, then end-users will see a lower cost of financing their derivative positions. The cost will be paid explicitly in the form of fees for explicit credit lines, instead of implicitly in the form of bid-ask spreads on uncollateralized trades, but the aggregate cost will be lower.
So attention needs to shift. End-users need to stop talking about the free lunch they will no longer be getting. Focus needs to be put onto aggregate credit risk. Is it lower or not? If it is not lower, are there steps that can be taken that will make it lower? Lowering the aggregate risk is the key to lowering the cost of the lunch. You know you’re paying for lunch, the question is just what does it cost to make the lunch?