Hard Lessons Make Us Streetwise

In previous posts about the clearing mandate for OTC derivatives codified in the Dodd-Frank bill we have discussed the impact on end-users. Craig Pirrong (University of Houston), a specialist in the organization of exchanges and commodity markets, reviews our position in his blog Streetwise Professor.

We seem to agree on two points.

First, the clearing mandate only impacts how credit is obtained and booked, not whether credit is used. Much of the public criticism of the clearing mandate appears to be misrepresented by the presumption that it implies that the new system will force firms to borrow more money, whereas under the old system they could engage in derivatives trading without having to borrow. This is clearly wrong, for it represents some sort of free-lunch. Pre-reform end-users had to borrow; post-reform end-users will have to borrow! On this precise matter, there is no impact on end-users through directly changing the quantity of borrowing required.

Second, the relevance of the clearing mandate (together with other elements of the reform) should be evaluated by its systemic consequences. Will it lower the total risk in the system?  If so, then end-users will find the total level of credit required and the total cost of that credit will be less. This is what is really at stake.

Differences potentially arise as we and Pirrong parse the chain of impacts of a particular regulation.

The only sensible way to evaluate this or that individual regulation is with the overall goal of OTC derivative reform in mind and an appreciation of the overall architecture of the Dodd-Frank legislation.

The pre-reform system was very imperfect and an easy target of abuse. It lacked transparency. Neither the end-users nor the public authorities had adequate information about the market. This lack of information has handicapped end-users in getting good prices. The lack of transparency has hampered competition. The lack of transparency promoted unsound accounting. Opacity perverted incentives. It distorted compensations. We could go on… It also handicapped the authorities in supervising the marketplace. A major objective of the reform is creating transparency, which will then make it possible to improve the functioning of the market.

The pre-reform system multiplied the risks from leverage and systemic risk. The reliance on bilateral arrangements meant that exposures that offset one another at the system level were not offset. Individual market makers did not have sufficient incentives to cooperate with one another to cancel offsetting exposures. A major objective of the reform is to encourage the canceling of offsetting exposures and reducing systemic risk by substituting standardized instruments and clearing, among other things, where possible.

There is no guidebook for which specific regulations will accomplish these two goals. And no single regulation, such as the clearing mandate, can be evaluated in isolation. But let’s be clear: the old system was defective and imposed costs on society, including end-users. Institutional reform is the most important determinant of economic development, and doing nothing is a dead-end path.

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  1. […] of views on OTC derivatives markets, John Parsons and Antonio Mello at Betting the Business respond to my response to their response to my post on Gensler’s beliefs about the efficacy of […]

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