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Questions About (OTC) Clearing. Craig Pirrong Bauer College of Business University of Houston. Meta-Question 1. Why haven’t market participants voluntarily adopted clearing in for large quantities of OTC transactions? Private Cost>Private Benefit What are the Costs and Benefits?.

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questions about otc clearing

Questions About (OTC) Clearing

Craig Pirrong

Bauer College of Business

University of Houston

meta question 1
Meta-Question 1
  • Why haven’t market participants voluntarily adopted clearing in for large quantities of OTC transactions?
    • Private Cost>Private Benefit
    • What are the Costs and Benefits?
meta question 2
Meta-Question 2
  • Is it efficiency-enhancing to mandate clearing of some OTC products? If so, which ones?
    • Social Benefit>Social Cost
    • Why might there be divergences between private and social costs & benefits?
meta question 3
Meta-Question 3
  • Are there measures short of mandatory clearing that are more efficient than clearing?
  • “Centralize that which should be centralized: Keep decentralized those things that should not be centralized.”
the costs and benefits of alternative market arrangements
The Costs and Benefits of Alternative Market Arrangements
  • Clearing has been presented as a panacea for many of the ills currently plaguing world financial markets
  • To answer the questions posed above, it is necessary to evaluate the costs and benefits of alternative institutional arrangements
  • CCP vs. Bilateral (perhaps with changes short of clearing)
efficient risk bearing
Efficient Risk Bearing
  • Sharing of default risk of a CCP can reduce the default losses suffered by non-members
  • This can improve hedging effectiveness, leading to more welfare improving trades
  • This benefit is a private one captured by the participants to the transactions
  • Netting is the most often cited source of clearing benefits, but:
    • Netting generates private benefits
    • Lower repricing risks also largely private
    • Netting can be achieved by methods short of the formation of a CCP (e.g., TriOptima, NetDelta)
the costs of risk bearing asymmetric information
The Costs of Risk Bearing-Asymmetric Information
  • A CCP is a risk sharing mechanism
  • All risk sharing mechanisms incur costs arising from information asymmetries (adverse selection and moral hazard)
  • Costs can differ across alternative sharing mechanisms
  • Are asymmetric info costs greater for bilateral or CCP arrangements?
  • Does the answer to this question depend on the nature of the instrument, and the types of firms trading it?
asymmetric information and risk pricing
Asymmetric Information and Risk Pricing
  • Default risk sharing mechanisms in both bilateral and cleared markets effectively price risk through collateralization
  • Who has the better information, and hence can price the risk more accurately?
  • Poor risk pricing can distort risk taking decisions, thereby generating private AND social costs (including costs arising from systemic risk)
asymmetric information product complexity
Asymmetric Information: Product Complexity
  • Different instruments have different risk characteristics
  • Especially for complex products that are new, knowledge about risk characteristics is limited, and likely very unevenly distributed
  • Arguably big bilateral market players would have an information advantage relative to a CCP
  • “The one-eyed man is king in the land of the blind”
  • When I think of the CCP evaluating risks of complex products, I think of rating agencies (not a comforting thought)
asymmetric information price transparency
Asymmetric Information: Price Transparency
  • Existing CCPs rely on the price discovery process on liquid, transparent markets for the prices used to mark positions and determine collateral
  • CCP information disadvantage about values likely to be most acute for illiquid products
asymmetric information balance sheet risk
Asymmetric Information: “Balance Sheet Risk”
  • The risk of default depends BOTH on the riskiness of a firm’s derivative positions, and the values of other assets & liabilities on its balance sheets
  • Many products (e.g., CDS) traded by big, opaque institutions with complex balance sheets
  • Bilateral market participants (a) arguably have better information than a CCP regarding counterparty balance sheet risks, and (b) can price counterparty risks to reflect risk differentials, whereas a CCP treats all members alike
  • Homogeneous treatment of CCP members especially problematic in current environment, where there is a demonstrable difference in the performance risk posed by major financial institutions
more on balance sheet risk
More on Balance Sheet Risk
  • It is interesting to note that cleared markets take into account the desirability of differential pricing of balance sheet risks
  • CCP members (and prime brokers) make individualized risk assessments of their customers’ balance sheet and position risks, and charge differential risk prices
  • Thus, even CCPs recognize that they are at an information disadvantage in evaluating some performance risks
risk concentration and interconnections
Risk Concentration and Interconnections
  • Systemic risk concerns arise from the interconnections among large financial firms
  • CCP does not eliminate interconnection, it reconfigures it
  • Indeed, it reconfigures it in a way that can increase concentration of default risk, and increase the amount of default risk that some systemically important firms bear
  • CCP capitalization, “Maxwell House” rules, and potential for CCP failure
regulatory transparency
Regulatory Transparency
  • Advocates of clearing often cite the benefit of improving transparency, and regulators’ knowledge about risk exposures of systemically important firms
  • But . . . These objectives can be achieved without sharing default risks via a CCP
  • “Data hub” (a la the Energy Data Hub I advocated in the early 2000s)
systemic risk
Systemic Risk
  • Not clear that CCP reduces systemic risk: It may INCREASE it
  • Concentration and CCP capitalization issues discussed above
  • If CCP operates at an information disadvantage, relative to bilateral market alternative, poorer risk pricing may exacerbate systemic risks
more on systemic risk
More on Systemic Risk
  • Clearing may increase scale of trading activity if purported benefits of netting and more efficient collateralization are realized
  • Clearing can shift risk to other systemically important market participants (due to the redistributive effects of the change in priority rules inherent in netting)
dealer self interest
Dealer Self-Interest
  • It is often argued that dealer’s profits would decline from the adoption of a socially efficient CCP (I advanced this hypothesis over 10 years ago)
  • Maybe. . . . But (a) OTC market structurally very competitive, and (b) apparent profitability may be misleading because conventional profit measures don’t take into account important costs (esp. related to performance risk)
  • This is an interesting hypothesis, but by no means is it proven, or more plausible than alternatives
questions answers
Questions & Answers
  • Do I have all the answers: NO!
  • But, I believe I have asked important questions and identified important issues that have gone largely overlooked in the debate over OTC clearing
  • I also think that there is a case to be made that centralized risk sharing via a CCP is less efficient than modified bilateral arrangements
  • Let the debate begin!