February 28, 2012
Will A Clearinghouse For Derivatives Work?
Posted by David Zaring

If you haven't seen it, Mark Roe's article urging us to rethink the priority counterparties have in bankruptcy for derivative and other financial contracts is pretty interesting.  I'm thinking about derivatives these days, and Roe also makes the case for why the moving of derivatives onto exchanges - the centerpiece of Dodd-Frank reform in the area - is unlikely to work.  I've broken his quote into bullets because, hey, this is a blog:

  • First, it's unclear whether the exchange would itself be properly incentivized to handle counterparty risk, particularly if the major derivatives dealers themselves control the clearinghouse.
  • Second, many types of derivatives just cannot be handled by a clearinghouse, because there's no market price against which the clearinghouse employees can mark the cleared but open transaction. Worse, one major class of derivatives-- credit default swaps--face “jump-to-default” risk. They look fine until the underlying security has a credit event and a huge payment is due. Collateralizing these on an exchange or clearinghouse has proven to be difficult thus far, and no easy solution is available.
  • Third, and insidiously, a clearinghouse is a very large netting organization. It reduces risk for the participants and can enhance transparency in these financial markets. The risks netted do not disappear, but are borne by the creditors outside the exchange's netting mechanisms. If the only systemically important risks are those netted inside the exchange, fine. But if systemically important firms are outside the exchange, they bear more risk due to the exchange, and we accordingly might not reduce systemic risk enough.
  • Fourth, and even more insidiously, a clearinghouse ups the ante on “too big to fail,” because the clearinghouse will itself be too big to fail. That's fine, but only if it doesn't fail. Recall though that fast-moving Russian exchange rates brought down Long-Term Capital Management and its Nobel Prize-winning managers. And fast-moving revaluations of subprime assets in 2008 may have moved faster than a clearinghouse would have been able to react to. If the clearinghouse can run as fast as a fast-moving market, we're safe; if it can't, we're not.

Mark J. Roe, The Derivatives Market's Payment Priorities As Financial Crisis Accelerator, 63 Stan. L. Rev. 539, 586-87 (2011)

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