Clearing Houses Could Be the Next Source of Chaos

Op-ed in the Financial Times

June 17, 2014

Financial shadows are dangerous. Even more dangerous are interactions between poorly understood shadows and essential financial intermediation activities. And most dangerous is when officials and private sector executives encourage a class of transactions that supposedly provide modest risk mitigation, while really building a disguised form of systemic risk on a grand scale.

It was not mounting losses at Countrywide, the failure of Lehman Brothers, or the imminent collapse of AIG that spelled disaster in September 2008. It was the connections between those lightly regulated businesses and Citigroup, Bank of America, Goldman Sachs, Société Générale, Barclays, UBS, and Deutsche Bank.

Where is the next generation of systemic risk hiding in plain sight? Look carefully at central clearing counterparties, or clearing houses, which are expanding due to the post-crisis requirement that standardized swaps—derivative transactions, including credit default swaps, that have standard terms along important dimensions—be cleared centrally.

Clearing houses are an old and simple idea: A collective entity takes on at least some of the credit risk otherwise associated with trading; you receive a claim on the clearing house as part of a cleared transaction with a counterparty. This should provide greater assurance that you will be paid, reducing the risk of a run on any financial institution or broader loss of confidence. The clearing house in turn holds collateral from transactions, has a guarantee fund provided by members, and is backed by some equity capital.

But is this really how it will work? Loading risk on to any private entity is not the same thing as having state-backed deposit insurance or a central banking liquidity backstop. In fact, this is why clearing houses made way for central banks more than 100 years ago. In a real panic, either you have access to the balance sheet of the government and the credibility of the central bank or you do not. There is no halfway house.

BlackRock, the asset manager, is uncomfortable with clearing houses because their resolution process is unclear—we do not know who will be paid out in a bankruptcy and in what order of precedence.

Clearing houses function fine in calm conditions and this kind of structure has worked well in some markets for a long time. But in a system-wide storm, there is a danger we will end up back where we were in 2008: Either the government will need to provide some form of bailout or we risk global meltdown.

In effect, we have built up clearing houses as an officially sanctioned form of credit protection, along the lines of AIG or state-backed mortgage finance lenders Fannie Mae and Freddie Mac. And no one feels good about where that led—to big distortions in the pricing of risk.

The intentions are good. But bilateral over-the-counter derivatives transactions, whereby parties trade with each other directly, can become a problem when people fear for systemic stability. Concentrating risk with the laudable goal of reducing opaqueness means that these clearing houses have, in effect, become too big to fail.

It is hard to refute the logical implication: Clearing houses should be subject to more stringent oversight. They should be funded with a great deal of equity relative to the potential losses.

BlackRock calls for clearing houses to be allowed to fail while arguing "end investors should be protected" from any such failure. Who will step in to fill any liquidity gap, or even to provide support in the face of potential insolvency? Under current arrangements, the answer is the US government and presumably the Federal Reserve, along with other relevant central banks and governments for transactions in currencies other than the dollar. (All G-20 countries have agreed to this approach.)

For more than a century, we have recognized that the availability of central bank liquidity support creates the potential for serious moral hazard. This is the logic behind the development of bank regulation. Clearing houses either have ultimate official support, in which case the implied moral hazard is enormous, or they will be allowed to fail, making the post-Lehman chaos look relatively benign.

Eight financial market utilities in the United States have been designated as "systemic" under the Dodd-Frank Act. But they are not subject to the tougher prudential requirements in title I of that act.

We have again created the perception of risk mitigation, while allowing ambiguity to develop about who will bear what kind of risk.