One of the most controversial aspects of the financial reform in the US and Europe is the mandate that many derivatives trades will have to be cleared in central counterparty clearinghouses (CCPs). CCPs stand behind the losses in the event that a trader defaults. To protect the clearinghouse against trader defaults, users of derivative contracts processed in CCPs will need to post margins.
But margins are expensive; they require traders to have spare cash or unused credit capacity; and margins need to be explicitly accounted for. Opponents of clearing have directed their criticisms at these points, complaining that margins crowd out other corporate investment. They also argue that margins have negative implications at a more macro level: variation margins can trigger panics; and out of concentrating risk, CCPs will become dangerous dens of systemic risk. Altogether, clearing under the proposed rules won’t change things for the better, they argue.
Central clearing, if managed appropriately, helps to reduce the volume of credit risk by cancelling out many offsetting positions, disappearing some credit risk and leaving us with a smaller, residual credit risk from derivatives trading. One of the problems with OTC markets is that brokers wanting to closely guard their clients don’t have an incentive to cancel out offsetting exposures to counterparties. Critics of the clearing system keep overlooking the fact that risk can in fact disappear. The derivatives market system, depending upon how it is structured and operated, can have more or less total credit risk.
Clearinghouses were a major innovation of the 19th century. They reduced total risk. The enormous return of OTC trading as structured in the late 20th century reversed this, multiplying the total credit risk in the derivatives markets, although in part the increase in credit risk was due to thriving financial innovation that offers a great deal of choice to traders. The purpose of financial reform is to reduce total credit risk to a minimum. Central clearing is a part of doing that.
Clearing also clarifies the principle of the user-payer. Margins are paid by those who use the system. In the OTC markets, banks either correctly price risk, or trade with clients by granting these subsidies from the taxpayer, or from wealth transfers by their bond holders. Clearing and margining is a potent dissuader of free riding on the system by negligent brokers, and also helps to mitigate agency conflicts between bonus motivated bankers and the bank’s stakeholders, which, we have learned, includes the taxpayers/citizens of each country.
Clearing also explicitly separates out the residual credit risk from the underlying transaction, so that the two can be traded in separate markets and explicitly managed. Moving the credit risk is helpful as a part of the total reform. The very fact that there is now great focus on bank lending to support margins is an illustration of the value of making explicit the credit being extended to support derivative trades. A firm can only manage what it measures. And to protect the public, it is necessary for regulators to see and be able to manage the true volume of credit supporting derivatives trading. Clearing is part of making that possible.
The overriding objective of the financial reform is to create a safer system that is cheap for end-users and fosters innovation. In previous posts we have argued that margins are not more costly than unmargined contracts. Because central clearing can reduce the total credit risk in the system, the system’s cost to end-users will be less.
Of course, reforms such as central clearing require their own structure of management and regulation. The credit risk concentrated at CCPs must be carefully managed. But it is an exaggeration to pretend that this concentration of risk is more dangerous than the concentration that exists at the largest derivative dealer banks. The events of 2008 won’t be so easily forgotten.