Questions About (OTC) Clearing

1. Questions About (OTC) Clearing Craig Pirrong Bauer College of Business University of Houston

2. 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?

3. 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?

4. 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.”

5. 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)

6. 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

7. Netting • 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) • NETTING IS NOT NECESSARILY A SOCIAL BENEFIT BECAUSE ITS FIRST ORDER EFFECT IS TO ALTER PRIORITY RULES IN BANKRUPTCY, THEREBY REDISTRIBUTING WEALTH FROM OTHER CREDITORS (EG, BONDHOLDERS)

8. 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?

9. 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)

10. 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 • PORTFOLIO RISKS! (DEPENDENCE A MAJOR ANALYTICAL ISSUE IN CDS) • 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)

11. 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 • CCPs ARE CONSUMERS OF TRANSPARENCY, NOT PRODUCERS • CCP information disadvantage about values likely to be most acute for illiquid products

12. 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

13. 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

14. 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

15. 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)

16. 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

17. 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)

18. 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

19. 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!