During a conference hosted yesterday by two Dodd-Frank regulatory agencies, one of the panels focused on central counterparties (CCPs), the institutions that Dodd-Frank promises will help to avert the next financial crisis. But will they? The answer to that question remains very uncertain, and the panelists (all proponents of central clearing) highlighted some of the risks that we should be thinking about.
Because many derivatives last for months or years, a firm entering into a derivatives contract would normally want to know something about the company on the other side. Is this counterparty going to be able to hold up its end of the bargain, or, when it comes time to pay up, will that company have empty pockets. With a CCP on the scene, two parties enter into a transaction and then they go to a CCP, which takes the opposite side of each party. Voila! Each party to the transaction no longer has to worry whether the other is, or might become, a deadbeat. Instead both can rest in the comfort that now standing on the opposite side of the transaction is a nice, safe, conservative, highly-regulated CCP. Wonderful! Or is it?
There is a certain wonder to CCPs. They can make markets work more smoothly. The CCP "nets" a firm's transactions, which means that offsetting positions are matched against one another. That allows firms to know what their bottom-line exposure to the CCP is. Netting also lowers margin payments--the payments that parties to derivatives make to one another during the life of the derivative contract to reflect the changing value of their respective positions. CCPs diminish the likelihood of panic among big financial firms when one of their own fails. The dying firm is the CCP's problem, not theirs. The CCP should have protected itself by collecting margin before the dealer failed, so its exposure should be limited too. Moreover, the CCP will also have a cushion in the form of that dealer's contribution to the CCP's guaranty fund. So, if the CCP did its work right, its experts should be able to smoothly wind down its positions with the now-defunct dealer.
So what's the problem? The problem is that "if." What if the CCP didn't do its job right. What if it didn't correctly figure out how all of the different derivatives contracts relate to one another? What if it didn't collect enough collateral or collected illiquid collateral? What if the CCP recklessly invested the collateral? What if it didn't have a nuanced understanding of the derivatives it was clearing or of the firms with which it is dealing? What if its worst-case scenarios were a bit too rosy? What if another CCP fails and, in turn, creates havoc at other CCPs? Maybe these what-ifs are remote worries, but, given the size and reach of CCPs, if the remote risks become reality, we are in for a lot of trouble.
CCPs have existed for a long time and have a pretty good track record, albeit not a perfect one. But the types and volumes of derivatives being cleared as a result of Dodd-Frank and comparable foreign regulatory frameworks make it more likely that something bad will happen. These derivatives are more complicated than the futures and options that clearinghouses are used to handling. At least the Office of Financial Research and Financial Stability Oversight Council are contemplating the risks associated with clearing, but it would have been better if Congress and the regulators had thought about these issues more rigorously before they designed the derivatives regime that is such a large piece of Dodd-Frank.