Economics of Contempt has a post up where he called the Lynch Amendment, an amendment which would limit the ownership of clearinghouses and exchange for major swap dealers at 20%, and which I wrote in favor of in this post, “Bizarre and Confused”:
Why on earth would we want to discourage the dealer banks—who, for better or worse, are the only ones capable of being market-makers in OTC derivatives—from mutualizing losses? That’s what the Lynch amendment would do. The clearing members are the ones who are ultimately on the hook for a default in a clearinghouse model, so of course they’re going to want to have a say in the kinds of contracts the clearinghouse accepts, and in the clearinghouse’s risk management practices. A dealer is unlikely to trade through a clearinghouse if it’s prohibited by law from having a say in the kinds of contracts that it—as a clearing member—is being put on the hook for. Clearing members should have a say in those kinds of matters—it’s exactly the kind of aligning of economic interests that we’re looking for!
Take a second and read that quote. It’s saying that of course we want the largest swap dealers having a say in what kind of trades go through a clearinghouse and what kind of trades will be pushed back onto the OTC market. It’s an excellent alignment of economic interests, what could possible go wrong?
Po-po
Well, here’s one thing. Bloomberg, Aug 3rd (my underline):
Markit Group Ltd., the data provider majority-owned by Wall Street’s largest banks, is under Justice Department scrutiny for potential anticompetitive practices ranging from requiring customers to buy bundled services to restricting which trades can be cleared in the $26 trillion credit-default swap market.
Markit told a swaps clearinghouse customer to purchase a pricing service as a condition for granting use of its benchmark indexes, said a person with knowledge of the transactions. Markit permitted use of its indexes by another clearinghouse only if every swap guaranteed by the company included a dealer, such as one of its owners, said other people familiar with those negotiations.
“That’s a legitimate area of inquiry,” said Evan Stewart, a partner at Zuckerman Spaeder LLP in New York who has practiced antitrust law for more than 30 years and isn’t involved in the case. “If you want to get into the market with Markit with access to real-time prices, this is where you have to play,” he said. “You don’t have a supermarket of other choices.”
Right now the Department of Justice is investigating the largest players in the derivatives market for anticompetitive practices, one of which is manipulating which types of instruments can clear in a clearinghouse.
To put it a different way, opponents of full financial reform are saying that the a few concentrated market players can be trusted to not manipulate the clearinghouses at exactly the same moment as a few concentrated market players are being investigated by the Department of Justice for manipulating the clearinghouses. Change we can believe in!
I know what the retort is. “Mike, you know that po-po is always fucking with a working man who is just trying to hustle some (financial) product on the corner to feed his kids.” I’m sympathetic to critiques of “po-po” myself. But this was the point of the recent Slate piece on the Lynch Amendment; giving the largest players a legal ability to sit together in the same room and make rules for trading and clearing swaps at the same exact moment they are being investigated for a conspiracy to do that is a terrible idea.
More generally, EoC has very little use for exchanges or swap execution facilities. He believes that if 7-8 major players sit down and report a price that takes place if a trade takes place is enough price discovery. I think having prices at which multiple parties would be willing to trade at a moment in time is far more important. With technology and financial innovation, this will cut into lucrative spreads enjoyed by the biggest banks, hence their completely rational interest in not seeing it go through. I wrote out my arguments for why exchanges and swap execution facilities are better than simply clearing in the previous entry.
Rortybomb 
Steve Waldman nailed the problem with EoC’s critique of the Lynch amendment in comments to that post. Claiming that current clearinghouse structure mutualizes losses is simply wrong. Only if every shareholder of every member bank will be wiped out before any taxpayer money goes to the clearinghouse are the losses mutualized — and in that case letting the members write the rules is probably okay.
It’s my understanding that the clearinghouse being proposed involves a put to the government — that of course necessitates heavy government regulation.
csissoko,
“Claiming that current clearinghouse structure mutualizes losses is simply wrong.”
No, it’s not. Clearinghouses either have assessment rights against clearing members, or the clearing members have indemnification agreements in place with the clearinghouse. Either way, every clearing member would have to go bust before the clearinghouse failed. So your understanding is wrong.
Also, Mike’s concern about “manipulating the clearinghouses” is irrelevant because it’s already against the law. That’s, uh, why there’s a Justice Department investigation. And since when are we legislating based on investigations (especially invevstigations that by all accounts are going nowhere)? I’ll remind you that the Antitrust Division of the Justice Department already approved the combination of ICE and TCC to form ICE Trust (the CDS clearinghouse).
I’ll have a response to Mike’s post when I’m done banging my head against my desk.
csissoko,
Thanks for pointing that out.
EoC,
I’d be willing to chip in to buy you a holiday present: a heavy-duty bicycle helmet we’ll call the “Internet Helmet”, for you to wear while reading financial blogs, especially mine. Though that would probably do more damage to your desk, so you’d have to consider that tradeoff.
Seriously though, I’d love to hear your thoughts to the previous post I wrote.
EoC
I looked this up and I’m willing to retract the forcefulness of my statement (i.e. “simply wrong”). However, from what I can see the mutualization of losses will depend wholly on the question of whether our regulators will have backbones at the date that a failure takes place — and let’s say that recent history does not lend support to this view.
My understanding about the clearinghouses in question (i.e. not the clearinghouses of the early 20th century) was that the maximum capital call that any member bank can face would be set in advance. Now, I’m not saying that that capital call won’t hurt — but the unlimited liability associated with a mutual structure is very different from the limited liability of a fixed maximum capital call. I thought that most clearinghouses formed these days have done away with the unlimited liability structure that was the norm historical.
I find the following from reading the Fed order on the ICE CDS exchange:
“Should the defaulting participant’s [i.e. dealer bank’s] margin collateral and guaranty fund contribution be insufficient to cover any losses on the defaulted obligations, ICE Trust would be authorized to use, as needed, other participants’ guaranty fund contributions to satisfy any remaining obligations of the defaulting party. If the guaranty fund in total is inadequate to cover losses on the defaulted obligations, ICE Trust would have the ability to assess additional guaranty fund contributions on nondefaulting participants.”
Now the “ability to assess” in a world where bailing out financial institutions is considered by many to be one of the obligations of the authorities strikes me as far to weak to be read “all shareholders will be wiped out”. On the other hand, it’s better than I was expecting from what I recalled of the clearinghouse debates of April 2009.
Recent history might have some relation to Federal Reserve Chairman Alan Greenspan (an all bets in proponent of the free market) and ALSO some relation to Phil Gramm threatening to withdraw SEC funding if regulators did their jobs, and ALSO eight years of “W” Bush. (the illiterate Pres who sent Christmas card invitations for a Hanukkah celebration).
csissoko,
The additional assessment is only fixed insofar as the clearinghouse can’t assess clearing members more than is necessary to make up the shortfall in the guaranty fund. But that’s all we care about anyway.
In any event, cleared derivatives are marked-to-market and margined daily, so every day the clearinghouse collects enough variation margin from clearing members so that if a member defaulted, its counterparties would be made whole with just the money in its VM account. That means the maximum amount a clearinghouse would have to pony up itself is the one-day move in prices on the defaulting member’s open positions on the day it defaults — i.e., the jump-to-default risk.
So for any clearing member to default as a result of the clearinghouse’s assessment rights, the one-day move in prices on the defaulting member’s open CDS positions would have to exceed (a) the defaulting member’s initial margin posted; (b) the defaulting member’s guaranty fund contribution; (c) every other clearing member’s guaranty fund contributions; and (d) 8x or 9x a non-defaulting member’s entire capital base (since the additional assessment would be made on a pro rata basis among the non-defaulting members). The major dealers all have a capital base of at least $50 billion, so this means that for a clearing member to default as a result of the clearinghouse’s assessment rights, the one-day move in prices on the defaulting member’s open positions would have to exceed several hundred billion dollars.
Since no dealer has ever even come close to losing $10 billion on open derivatives positions in a single day — let alone several hundred billion dollars — I feel pretty safe in saying that a clearinghouse’s additional assessment rights pose minimal threat to clearing members’ solvency. There is, in fact, such a thing as over-insuring.
OK, here it is a a nutshell EoC, Can you give a SINGLE example of a time when clearinghouses lowered risk or stopped a trade due to lack of capital?????? ONE EXAMPLE??????????
The Suffolk System in New England from the 1820s to the 1850s:
http://www.nber.org/papers/w5442
Not the cool Mike—-
ONE example, from almost 180 years ago. Assuming that example is true, your Mom must be so proud. How many CDS or other derivatives were traded back then?? Phil Gramm said CDS didn’t exist when he and the bank lobbyists wrote Gramm-Leach-Bliley. Although it specifies in the wording/text of the G-L-B bill that “swaps” cannot be regulated. But I’ll take you at your word, that that ONE example from 180 years ago is true.
Don’t you guys ever get sick from the taste of the words of your mouth, or from your keyboard???
Excuse me!?! Who the fuck are you to talk to me like that?
EoC:
Sounds to me like you have forgotten October 20, 1987 — the day the CME was within 5 minutes of failing to open, because dealers had not posted margin. (see Donald MacKenzie, An Engine not a Camera.)
This was the first federal reserve bailout of the investment banks. (See page 19 of this paper, quoting a contemporaneous WSJ article.)
Since there is even more gap risk in CDS than in stocks, I don’t buy the over-insurance argument.
And you still haven’t answered the issue that there is no guarantee that an additional assessment will ever be made — since systemic risk will definitely be an issue in the event that a clearinghouse is at the edge of failure.
I’m going to have to agree (at least in part) with The Contemptuous One here.
A major motivation for the bailout was uncertainty over the location and concentration of risk. The clearinghouse would not only make risk more transparent to regulators, but would spread the damage more widely and thereby diminish the threat to any single firm’s solvency. There’s also the more efficient netting capacity, which would prevent overestimates of losses. The probability of a bailout would be substantially less under these conditions.
I also interpret the CME’s fate differently. The fact that it did open, despite all of the pressure on it, is indicative of strength to me. There may have been some brinksmanship going on, but in the end nobody was willing to risk going over the edge.
Not Mike
I don’t understand how a massive Fed funded bailout of a clearinghouse can be an indicator of strength. Did you read the link to the Board of Governors economist’s paper on the bailout?
“Whatever you need we’ll give you.” And the taxpayers are still eating those words.
My impression was the Fed supplied liquidity, not capital. After the dust had settled, were the members of the clearinghouse made whole? Taxpayer funds come from the Treasury.
The Fed was founded to provide liquidity to the banking system. In 1987 the Fed told the banks to whom they provided liquidity that they simply had to lend the money on to the investment banks to protect the global financial system.
Thus, the Fed expanded it’s lender of last resort role from deposits to market making activities. Yes, it was only liquidity — because the dust settled and everything worked out okay.
But it was the precedent of expanding lender of last resort activities to market making that led the Fed to get involved in transactions that went far beyond liquidity and that led to bailouts of 2008 and the massive losses to taxpayers.
I think Paul Volcker is the one who understands this situation, so “strength” is not a word I would use in relation to the US banking system.
Thanks for clarifying. Your argument makes more sense to me now–you were thinking a couple of moves further than I was.
Rereading the discussion, I come to the conclusion that limitations on individual members’ ownership of the clearinghouse is not the relevant issue here. It’s that the government, as implicit guarantor of the clearinghouse, should have a seat on the board, if not total veto power over the board’s decisions. Diffusing control does not address the moral hazard problem.
Here’s how that Clearinghouse works:
EoC says to his dealer Pal: “I didn’t see that systemically threatening trade (wink wink) did you???” Dealer pal: “NO I didn’t see it” It’s like a drug dealer and a drug seller clearing trades.
EoC’s logic is so self-serving he must make himself sick.
drug dealer and drug buyer, whatever, you got my point.
Drug Seller: “Maybe we shouldn’t transact this trade, because 2 or 3 neighbors maybe killed when we transact this drug deal ( drug deal read CDS Clearinghouse).” Drug Buyer: “Oh yes, of course EoC you’re right, what were we ever thinking?”
Mike, I haven’t visited EoC’s website, have you posted there???
csissoko,
No, I haven’t forgotten about 1987. But a clearinghouse not opening is fundamentally different from a clearinghouse defaulting. I know Yves Smith has been pushing that CME story, but it’s not even close to a proper analogy. In any event, the CME of 1987 was structured much differently than the clearinghouses we’re talking about now.
And yes, there is a guarantee that the additional assessment will be made if necessary. The clearinghouse would have a legal duty to assess clearing members to cover a default. That’s not an issue.
Do you honestly believe that prices on a dealer’s open CDS positions could move several hundred billion dollars in a single day? (And remember that dealers run matched books.) I very seriously doubt you believe that, since there’s only about $2.6 trillion net CDS outstanding in the entire world, and again, dealers run matched books. That’s the only issue here.
EoC says “matched books”. Well, problem solved. If EoC had mentioned “matched books” before we would not even have needed to quarrel. I’m sure many dealers out there appreciate your ability to find a simplistic answer to justify CDS and derivatives dealers socially insured profits. We can make EoC poster boy for CDS traders lies. EoC, Phil Gramm, and Melissa Bean can now fuck us over to their hearts content, because, well, they have “matched books”.
EoC:
I hope you are right about the “legal duty to assess clearing members”. Is there a case where a clearinghouse was in fact required to meet such an obligation?
As to the claim that dealers run matched books, the OCC derivatives data,\a> demonstrates that this claim is false.
I’ll talk about Goldman Sachs because its credit derivatives book is most mismatched relative to it size. GS has sold $408 billion and bought $530 billion. The $122 billion difference exceeds GS total assets and is more than 5x GS risk based capital.
Note that the fact that GS bought more CDS than it sold does not solve the problem — because clearly somebody has to be on the other side of these mismatched trades. If overall market makers are buying protection from end users instead of running matched books — that says a lot about prices in this market too, doesn’t it.
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