Wallace Turbeville on the Clearinghouse Governance Issue

There’s been a lot of blogosphere attention to this Louise Story article in the New York Times, A Secretive Banking Elite Rules Trading in Derivatives (see Felix Salmon, Kevin Drum).

For those who are interested in the regulation of derivative clearinghouses after the Dodd-Frank Act, I’d highly recommend this paper by Wallace Turbeville, Derivatives Clearinghouses In the Era of Financial Reform (pdf). It was presented at the Roosevelt institute’s The Future of Financial Reform conference.

Turbeville is a derivatives specialist at Better Markets and a visiting scholar at the Roosevelt Institute; he formerly led VMAC LLC as its CEO, which he left in late 2009 to devote his efforts to financial reform, energy, and environmental policy issues. He’s an expert in clearinghouse issues. This paper is fantastic, both as an overview and as a detailed response to many arguments.

For instance, in relation to the New York Times article:

Decision Making and Governance. In the Reform Act, the public has entrusted the clearinghouses with an enormously important role in the economy. Much has been written about potential influence of the clearing members, in particular the banks, on clearinghouses. Our legal colleagues have been concerned with formal governance issues and ownership shares and the CFTC has promulgated proposed regulations limiting ownership by clearing members and requiring independent directors. These issues are important. But far more important is the influence of dealer banks as sources for clearinghouse volume and, as a consequence, revenues. Banks control and direct volume. The Reform Act even provides rules allowing a non-bank counterparty to choose the clearinghouse to be used for a trade. But if that counterparty depends on a bank to be available when it needs a price hedge or credit, it is naïve to think it will resist the desires of that bank.

The real business of a clearinghouse is credit management. This is typically controlled by a tremendously powerful risk committee. Dealer bank involvement on risk committees is common and freely acknowledge. Clearinghouses assert that bank knowledge of risks is helpful; and that their influence is appropriate since the clearing members represented by the banks are at risk if something goes awry.

But 2008 tells us that the public is also at risk if the clearinghouse does not properly balance prudent risk
management with the mandate of the Reform Act. At a minimum, the public’s interest should be represented by membership on the risk committees of major clearinghouses. Regulatory representation, or representation by other public interest organization, would legitimize the process as long as resources and expertise were provided to challenge decisions such as which derivatives are cleared and which are not.

At a recent roundtable held by the SEC and CFTC on clearing, a representative of JP Morgan said that the financial sector would support a governmentally owned clearinghouse that was guaranteed by the government. It is an intriguing idea, especially if the italicized language were dropped. A government guarantee might even make sense, so long as it kicked in after the clearing members bore all of the losses they could; a!er all, that is where we are anyway.

To the general argument about “Why hasn’t clearing happened itself if it is such a good idea? Why would end-users resist a mandate, or not create one themselves?” which is central to the debate:

Why the preference of bi-lateral transactions over clearing? Here are some possibilities:

• Financial institutions can offer credit to customers in the form of foregone collateral to cover risk. The credit is tied to an advantageously priced derivatives trade. The price of the credit, embedded in the derivatives price, is obscured. In practice, derivatives embedded lending is considered by banks as much more lucrative than straightforward corporate lending.

• Customers may value the hedge and the embedded credit extension more than a derivatives price which is tight to the market. O!en, their primary task is to hedge and the price is secondary. Think of a regulated utility whose fuel and purchased power costs are passed through to consumers, but who need to hedge to please the ratings agencies and equity analysts.

• The credit extension is not reported by the customer the same as direct lending, so their balance sheets appear healthier. These motivations are predominant among end users.

I recommend reading the whole thing.

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One Response to Wallace Turbeville on the Clearinghouse Governance Issue

  1. TC says:

    He leaves out the major reason banks hate clearinghouses: The Standardization required by clearinghouses creates transparency and third-party liquidity.

    I was involved with the Clearing Corporation quite closely – I know many of the people that made the transition to the ICE and their CDS clearing platform. They were very clear with the banks – there is no way to clear anything without some standardization of the product specifications. Remember, the Clearing corporation was the old CBOT clearing organization and was really just a futures clearing place. Their technology has been upgraded post acquisition, but to clear derivatives requires futures-like standards for products.

    Once the ICE got involved, the new 1% 5% and dating “standards”became common. Prior to this, every CDS contract was bespoke, so once you were in the contract the only way out was to counter trade with the counterpartry, or to make another trade and then novate. Of course, getting out of the trade is a huge profits center for any trading desk. Can you imagine the instant message? “Hey JR, remember those 2.42 GM 5years from 7 months ago… ” with the reply “sure, I can help you”, the desk would lick their chops for this message.

    Now, with more standardization, it must be massively easier to get competitive quoting on exiting trades – which cuts into profit margins for the desk.

    Additionally, it allows more pricing transparency. Yes, running excel sheets is great, but lets face it, pricing a bunch of 5% CDS is far easier than creating curves from a pile of randomly struck yields.

    While the credit issues he mentions are valid, transparency is far more important. The most expensive part of any illiquid trade is the bid/ask spread. Market makers make money by selling the ask and buying the bid over and over again. If the product is customizable in every way, competitive quoting is far more difficult, and the b/a is easier to justify.

    Clearinghouses traditionally impose position limits on individual traders and institutions. Also, cleared and traded volumes are known by someone. This is all valuable information that was controlled in a bilateral trade

    Also, I think that every analysis of clearinghouses that I have read misses a 2 massive reasons clearinghouses work, and that combine to form an excellent form of policing.

    1. clearinghouses have the ability to take nearly all the assets of a clearing member. Clearing members give this power to the clearinghouse to become a member.
    2. After the company loses all of its money, other firms are exposed for large losses.

    AIG could have never happened if it went through a clearinghouse. The other clearing members would have stopped AIG from trading long before it got as large as it did, simply because they would have been on the hook for huge sums if the bets went bad. If goldman had to cough up $4bn to pay clients off after AIG went bust, well you can be sure that it would have said no to AIG.

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