In my Current State of Financial Reform I tried to develop the argument for regulating derivatives as a 1-2-3 process: (1) first as an issue of derivatives clearing through a clearinghouse, and then (2) trading on an exchange, and then (3) what to do with those that can’t/won’t go through a clearing and/or exchange.
Tim Fernholz and Economics of Contempt both bring up the clearinghouse/exchange distinction. It’s good stuff.
I want to post two small scans from NYU Stern’s excellent Restoring Financial Stability, a book that is a collection of arguments and explanations of financial reform related topics across the board. It is one of the few very meaty books on reform that will walk you through most of the topics.
First image is what a clearinghouse does. If the idea of what a clearinghouse does doesn’t make much sense, it does immediately after you see it visualized:
Look at the tangled web of counterparties in the OTC market in the top of the chart – in a panic, if one collapsed, you could see why everyone else would freak out. So have one institution, a centralized clearinghouse (CCH in the bottom graph), stand in-between all the trades. Note that this centralization of counterparty risk is a different function that seeing a price posted on an exchange, along with all the recording keeping and valuable Hayek-ian information that comes with having pre-price transparency of an exchange. The exchange is something that would go on top of that bottom graph structure, something that would enforce pre-trade price transparency. (It is possible to have an exchange without clearing, but that’s not really likely in the debate we are having.)
Restoring Financial Stability also has an excellent discussion of the differences between the current OTC market we are in, and possible alternatives, each incorporating the step before it. The first potential step is a “Registry”, which would centralize some of the record keeping and collateral holding but not counterparty risk. It would not go as far as the graph above. The next level is a clearinghouse, and the one after that is an exchange. Here is a chart displaying some of the differences between the three that is very helpful:
The chart explains the differences between each of the types of derivatives reform by certain characteristics. I’m all about informing the public, so if you want a further explanation on what one of the characteristics means, leave a comment and I’ll do my best to explain.
Rortybomb 
Perhaps this is too basic of a question, but who exactly would run the central clearinghouse and/or an exchange. Put differently, who do you think should be in charge of the aforementioned? Would an exchange operate largely like a stock exchange and would the SEC be intimately involved in monitoring the central clearinghouse?
Noompa,
Mike can answer this question better than me, but I would assume it would be the CFTC, Commodity Futures Trading Commission. Gary Gensler is the Chairman of that Commission Noompa. The chances of that happening are slim though (at least a registered exchange has a very slim chance, Clearinghouse has a better chance because industry lobbyists would prefer a Clearinghouse to a registered exchange) because of Republican opposition to finance reform.
Again, I’m not certain, Konczal can answer that better than me.
Intercontinental Exchange runs the CDS clearing house.
So have one institution, a centralized clearinghouse (CCH in the bottom graph), stand in-between all the trades.
Haven’t you just piled up all the counterparty risk in one big haystack that is waiting for someone to come along with a match?
ISTM that the clearinghouse is exposed to everyone and everyone is exposed to the clearinghouse. So how do you crisisproof the clearinghouse? Especially if you want to do it without moral hazard?
Terrific post Mike. One of my pet peeves with the Economics/finance blogs right now is very few people are covering this topic. I’ll probably link to this later after I have a deeper grasp of it in my own mind. Let me say for the record though I think I know ENOUGH about the topic to say REGISTERED EXCHANGES is the superior choice here.
I’m not going to EoC’s site because I smell an agenda with EoC. I’ll check out Fernholz later after I get a grasp here of your stuff. Absolutely terrific post Mike, outstanding.
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