Craig Pirrong — aka author of the Streetwise Professor blog — holds up for ridicule Gary Gensler, Chairman of the US Commodities Futures Trading Commission. Pirrong cites Gensler’s explanation of how society benefits from the Dodd-Frank bill’s clearing mandate:
One of the central goals of Dodd-Frank is to redirect much of the OTC derivatives market through exchanges, electronic trading platforms and central clearinghouses that stand behind dealings in derivative contracts.
“What that means to the American public is it’s less likely that the taxpayers stand behind that transaction,” [Gary Gensler] said.
“Instead the clearinghouse stands behind it, and I think that’s what Congress recognized. Moving as much of this into clearinghouses lowers interconnectedness, but also says a clearinghouse stands there, not the taxpayer.”
Pirrong then argues that this is nonsensical to the point of ridicule. Pirrong advances a “conservation of total risk” axiom which he claims Gensler demonstrably and foolishly flouts. The title of Pirrong’s post is “Do You Believe in Magic?” He writes that:
Gary has a magic box, called a “clearinghouse.” You put counterparty risk in the box, and it disappears!
Uhm, but what stands behind the clearinghouse? Where does that risk go? Well, financial institutions—including many major banks—actually stand behind clearinghouses. Meaning that if counterparty losses are big enough, the banks bear a big chunk of the loss (so things are still interconnected). Or, if the banks limit the amount of loss they are willing to bear, the clearinghouse can fail. Who wears the loss in that event?
Gensler might argue that collateralization in clearinghouses makes it highly unlikely the banks will bear any loss, and even less likely that the clearinghouse will fail. Let’s say that collateralization is indeed extremely robust, so that the risk of clearinghouse failure is vanishingly small. Does that mean that everything is great?
Well no, really. The risk still hasn’t disappeared. Given the positions that firms take*, collateralization (and netting, another commonly touted benefit of clearing) affects the distribution of losses arising from the bankruptcy of a derivatives trading firm, not the total amount of the losses. If collateralization is so robust that derivatives counterparties always get paid, that means that the entire loss arising from a bankruptcy falls on the firm’s other creditors. So the magician may point to the magic derivatives clearinghouse box and say: “See! No losses! They disappeared!” But they are somewhere, behind the curtain, borne by somebody else; collateralization changes the priority of claims, not their magnitude.**
But risk can disappear. There is no such thing as a “conservation of total risk” axiom. The rules of the game shape how it is played, and how it is played determines the total risk to society. See posts on this point here, here and here for starters (the last one cites Pirrong’s less combative attention to some of the same points). Gensler is right to argue for regulations that reduce the total social cost by changing the allocation of risk and the rules for play. Whether these regulations are the right ones is a point on which reasonable people can differ. But Gensler’s side in the debate on clearing is logically coherent, at least as far as the critique in Pirrong’s post is concerned. The position Pirrong stakes out for himself is wrong on its premise.
You may have noticed a couple of asterisks in the quote above from Pirrong’s post. Those are in the original post. In a footnote, Pirrong acknowledges the false premise behind his skewering of Gensler on clearing:
* The amount of margin will affect the sizes of positions and the structure of positions that firms take. Netting will also affect positions, …
That’s a start. And it’s a big deal since it is the very heart of the original argument behind clearing which Gensler is making.
Let’s have a good discussion about which rules of the game produce the lowest total social risk and the greatest social payoff from the operation of the OTC derivatives market. It’s a tough problem to tackle. Oversimplification will not do.