Guest Post: Derivatives Clearing – At the End of the Beginning

Yves here. We were skeptical of derivatives reform efforts as inadequate to deal with the product that needed to be reined in, credit default swaps, and subject to evisceration depending on how various details were sorted out. And if the types of contracts that wind up being covered are reasonably broad, the new derivatives clearinghouse is merely another too big to fail entity. Our concerns appear to be coming to pass.

By Wallace C. Turbeville, he former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co., who writes for New Deal 2.0

An SEC/CFTC roundtable exposes how little is being done about the next financial time bomb.

Just after the first Allied victory of the Second World War at El Alamein in Egypt, Winston Churchill spoke to the House of Commons: “Now is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.”

Any doubt that this aptly describes the circumstances following the passage of financial reform was erased by the public roundtable sponsored by the SEC and CFTC on August 20. The topic was “Governance and Conflicts of Interest in the Clearing and Listing of Swaps,” and it was held in order to “assist both agencies in the rulemaking process” in implementing financial reform.

The primary news to report from the roundtable is that there are indeed conflicts of interest and significant governance issues. Some of us have been writing about these issues for months, and it was perversely rewarding to hear that they are freely acknowledged by the industry. What remains to be resolved is the matter of what, if anything, can be done about it.

During the roundtable, there were several complaints about the structure of clearinghouses. They have clearing members, mostly banks. Customers do not transact with the clearinghouse. They access clearing through the clearing members. The complaint was that it was difficult to become a member of the club. According to the complainants, the clearing members (dominated by ten or so large financial institutions) block new memberships. Clearinghouses used to be owned by the clearing members and were operated like public utilities, serving the interests of the members, but they went public over the last few years. It is widely known that the clearing members still exert great influence through their control over volume and revenue as well as participation in key decision making. Less has changed than might be expected from the transfer of ownership to public shareholders.

The first major topic addressed the methods of determining which derivatives can be cleared and which cannot. Derivatives that can be cleared fall under the new legislation’s clearing requirement. It was acknowledged that rather than eliminate the risk of derivatives trading, the clearing process transfers and concentrates default risk in the clearinghouse. The risk is peculiar in that there is no cap on it. If you loan money to someone, you can only lose the principal. If you buy a stock, you can only lose the price paid. With almost all derivatives, there is no such limitation.

Clearinghouses provide a central and transparent methodology for managing risk. This management system is the trade-off for concentration of risk. But risks cannot be managed if they cannot be measured. This means that the current value of the swap, defined as the price at which a replacement transaction could be executed immediately, must be known. It also means that the clearinghouse must be able to estimate how much it might lose if it took some time to replace the swap. This is measured statistically using historic market price moves and multiple assumptions.

It was also acknowledged that there are many derivatives for which risks cannot be measured. These derivatives cannot be cleared without creating imprudent systemic risk at the clearinghouses. One could sensibly question whether banks should be entering into transactions if the risks cannot be measured with sufficient accuracy to justify clearing. But the roundtable focused on the influence of banks on the question of what is clearable and what is not. If banks do not want a category of derivatives cleared, could the clearinghouses be influenced inappropriately to “err on the side of caution”?

Several points were raised on the topic:

• The clearinghouses acknowledged that the dealer banks have a great deal of influence. As clearing members, they sit on the all-important risk committees and assist the clearinghouse officials in shaping new cleared products.

• The clearinghouse representatives justified this influence because the clearing members are at risk if the clearinghouse defaults. Clearing members put up the default reserve funds that would be tapped to cover losses. They would have to participate in covering off a default. As a result, they deserve a say in the decision to clear a class of derivatives. Nobody pointed out that the American taxpayer is also at risk, as demonstrated by the financial crisis. If clearinghouses might be Too Big to Fail, shouldn’t the government also participate in the risk committee process?

• One industry participant made the point that cleared derivatives are just as profitable as uncleared derivatives. Why would the banks ever resist expanding the scope of clearing? I wonder what the fight was about during debate of the Dodd-Frank bill. In fact, banks may prefer that clearing be available for certain derivatives. After all, they may have used up all available risk capacity for specific counterparties and cannot transact bi-laterally. A clearinghouse guarantee may be required to transact with that counterparty. But it is clear that they do not want clearing mandated. I think it may have something to do with profits.

The roundtable moved on to the possibility that clearinghouses might be tempted to imprudently clear some classes of swaps as they compete for market share. This may appear to contradict the prior concern, but it does not. Clearinghouses could be discouraged by banks from clearing some types of derivatives even when the risks are acceptable, and still imprudently clear other types. The fact is that clearinghouses have been acting imprudently for the last few years; the financial crisis simply did not involve their activities. It is a real problem, but no solutions were suggested.

Ownership and board seats were then discussed. The subjects of influence were the same; the methods for exerting influence were different.

A representative of JP Morgan said that his firm fully supported the concept of government-owned and fully guaranteed clearinghouses. I hoped that someone would inquire as to JP Morgan’s position if the italicized language were deleted. But the fact is that the meaningful clearinghouses are, or soon will be, Too Big to Fail. The gentleman from JP Morgan raised an excellent point. Clearinghouses should be publicly-owned utilities, whether guaranteed formally or not. If anyone in government with the courage to support such a notion can be found, this is really the only sure answer to the questions raised at the roundtable.