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Federal Reserve Bank of Atlanta
Financial Markets Conference
May 12, 2009
STANDARDIZATION AND
CLEARINGHOUSES AS TOOLS
FOR LESSENING SYSTEMIC
RISK IN FORWARD
TRANSACTIONS
Edward J. Kane
Boston College
1
IN MARKETS WHERE IT EXISTS, SYSTEMIC
RISK ARISES AS AN EXTERNAL OR SOCIAL
COST GENERATED BY PRIVATE TRADERS
THREE CATEGORIES OF PRIVATE COSTS
• Explicit Transactions Costs
1) Entry Costs
2) Exit Costs
• Costs of Ameliorating Counterparty Risk (i.e.,
reducing the probability of “fails”)
1) Predeal data gathering, assessment, and
pricing
2) Postdeal monitoring and contract
enforcement
• Costs of Aligning contract terms with
idiosyncratic portfolio goals
2
EFFECT OF SAFETY NET
•
COSTS INCURRED BY SAFETY-NET
MANAGERS SUBSTITUTE for Costs of private
amelioration and increase with the leverage
imbedded in positions traded and in the
volatility of returns on underlying instruments
1. Costs of Systemic Risk Measurement and Analysis
2. Costs of Designing and Executing Out-of-Crisis
Mitigation Programs
3. Costs of Planning and Implementing Schemes for
rescuing over-extended traders or mitigating the
losses their counterparties might suffer
3
WHAT IS THE PUBLIC-POLICY
PROBLEM?
• It is not devising policies to minimize private trading
costs over time. (Counterparties have strong incentives
to do this by Bonding, Transparency, and Deterrency)
• In forward markets, systemic risk develops from
incentives for managers of difficult-to-fail financial
institutions to devise new and hard-to-monitor ways of
extracting implicit subsidies from the safety net:
Taxpayer is viewed with little empathy as a sucker who
does not deserve an even break.
• Private benefits from any financial innovation have an
efficiency component and a regulatory component (its
safety-net implications).
• Under the current regime, the implicit value of safety-net
benefits do not begin to become explicit until authorities
undertake to rescue distressed (i.e., overextended or
insolvent) firms (such as GSEs or AIG) or to “liquify” the 4
markets for troubled instruments.
SAFETY-NET SUBSIDIES TO
CDS DEALERS
•
In an OTC swap market: each dealer bonds its promise to perform
its side of a swap with its reputation, its alleged expertise, its
enterprise-contributed capital, and explicit and implicit guarantees
from its government.
Whenever (as now) authorities treat major CDS dealers as too
difficult to fail and unwind (TDFU) and (2) liquidity in this market as
important to sustain, TDFU dealers will enjoy substantial safety-net
subsidies. Moreover, these subsidies will grow when either
enterprise-contributed capital or reputations falter.
This is and the monopoly rents the subsidies support explain why
members of ISDA, though willing to make concessions with respect
to clearing, are fighting hard to keep control of trading rules.
•
In a traditional exchange: the safety net is better insulated:
1.
Brokers screen traders and guarantee the performance of trades they
are allowed to book on the exchange;
2. The exchange monitors and disciplines brokers and sets trading rules;
clearing members jointly and severally guarantee performance to back
up broker guarantees;
3. The exchange may or may not itself be TDFU.
5
TDFU SUBSIDIES HAMPER OPPORTUNITIES
FOR OTHER FIRMS TO SERVICE GROWING
TRADING VOLUME IN FORWARD INSTRUMENTS
SUCH AS CREDIT DEFAULT SWAPS
• Entry of new market makers would be facilitated by
clearinghouse regulation of margins and trading halts
and by supervision of participating brokers’ condition,
expertise, and behavior
• Costs of exiting positions can be reduced by central
clearing
• Safety-net costs are likely to be reduced by giving
regulators access to either centralized-registry or
clearinghouse information of positions taken (alignment
of interests for clearinghouse at least vis-à-vis “fails”)
6
THE KEY POLICY PROBLEM IN FORWARD
MARKETS IS RECOGNIZING, MEASURING,
AND MANAGING THE IMPLICIT SAFETY-NET
BENEFITS THAT TDFU MARKET-MAKERS
AND COUNTERPARTIES EXTRACT
• In Credit Default Swaps (CDS), safety-net subsidies
greatly retarded the natural evolution of customized
deals traded in over-the-counter (OTC) markets to
standardized instruments traded on an exchange or
registered or cleared on a central platform
• As long as the principal market-makers had the size,
clout, and complexity to be perceived as too difficult for
authorities to fail and unwind (TDFU), potential netbenefits from introducing centralized clearing and
clearinghouse guarantees required a crisis to
demonstrate.
7
TDFU MARKET-MAKING INVITES TROUBLE, BUT
MANY ORGANIZATIONAL ALTERNATIVES TO
MARKET-MAKING BY TDFU INSTITUTIONS
DESERVE TO BE CONSIDERED
•
•
•
Central Registry for Trades that would be administered
either by -- or on behalf of -- Safety-Net Managers
1. Government Agency or a “College of Agencies”
might undertake this monitoring role and add expert
analysis
2. Regulators might Outsource the Monitoring
Function Instead [e.g., to a proposed NIF]
Centralized Clearing Platforms [Fungibility Encourages
STANDARDIZATION]
Clearinghouse tiering of Broker and Clearinghouse
Performance Guarantees
1. With Clearinghouse organized as a Partnership
2. With Clearinghouse organized as an LLC
8