Benefit of clearinghouse

(1) It economizes collateral.
(2) A reduction of the "replacement" losses in the event of a default.
the ccp typically has a better picture of each member’s overall position risk than any dealer in a bilateral market possesses.

It is important to note that many of the benefits of clearing are captured by the members of a clearinghouse. The member firms benefit from declines in the amount of collateral they must hold, reductions in replacement costs, and improvements in the terms of trade and reductions in collateral that result from increases in the amount of information available. Thus, the benefits of a clearinghouse are largely private, and profit-motivated firms have an incentive to take them into
account when deciding whether to form a clearinghouse

 

Clearinghouse

A modern futures clearinghouse is a “central counterparty” (CCP). That is, the clearinghouse becomes the buyer to every seller, and the seller to every buyer, through a process sometimes known as “novation.”

Once the details of the contract between S and B are confirmed by the clearinghouse, the clearinghouse creates a contract to buy from S and a contract to sell to B. S still has a contract to sell, and B has a contract to buy, but the clearinghouse is substituted as the counterparty to each contract. With clearing, if B defaults, the CCP bears the loss. It draws on its financial resources to pay S what he is owed.

Clearinghouses almost always have members who are large trading firms, including brokerages and banks.

The clearing members provide the financial resources for the clearinghouse to cover the losses that result from a default of another member.

Require CCP members to post collateral, called margin, with the clearinghouse. The collateral amounts reflect the risk of the members’ trading positions.

Buyers must post more margin when prices decline, to offset the risk that a buyer might walk away from a futures contract in which the agreed-upon price now seems too high; sellers must post more when prices rise to offset the risk that the seller might walk away from an agreed-upon price that now seems too low.

Default risks arise from two sources. The first is the risk of the positions that the trader holds. A default occurs only if the losses on a member’s positions are larger than his capital.

The financial intermediaries who are clearinghouse members invest in other risky assets, and they may default if the losses on the other assets on their balance sheets are sufficiently great to make it impossible for them to cover their obligations to the clearinghouse.

It is often overlooked, but essential to remember, that default risks are also shared in “bilateral” over-the-counter markets.

Over-the-counter market participants often require their counterparties to post collateral. Dealer firms usually adjust their collateral demands to reflect their assessment of both the position and balance sheet risks of their counterparties.

(Indeed, one of the factors that brought the Lehman Brothers crisis to a head was the decision of J.P. Morgan Chase to demand an additional $5 billion in collateral based on its appraisal of Lehman’s deteriorating financial condition; J. P. Morgan’s demand for collateral from Merrill Lynch was reportedly the catalyst for Merrill’s sale to Bank of America.)

It is typically the case that the margining process in over the- counter markets is less mechanically rule driven than at clearinghouses.

A consideration of the nature of credit derivatives and the firms that trade them demonstrates that the potential for information asymmetries is particularly acute for those products.

In particular, it is highly likely that dealer firms have far better information on the risks and values of CDSs than a clearinghouse, and also have better information on the balance sheet risks that they impose on the clearinghouse.

It is difficult to assess the risk of and value credit derivatives because of their complexity. Dealer firms use “rocket science” quantitative models to assess risks and value derivatives. The dealers have a strong incentive to develop accurate models because the models enable the dealers to quantify and manage their market risk more effectively, price their derivatives more accurately and earn trading profits as a result, and evaluate the default risk posed by their customers.

A clearinghouse doesn’t have much incentive to develop a more accurate model. Public good problem. It is true that current models of these firms are flawed, but the question I want to pursue is whether clearinghouse could have a better model.

Given the lack of trading activity in many CDS products, determination of market values for the purpose of updating margins is not a trivial task. Indeed, many products have to be “marked to model” rather than marked to market, because of the lack of market prices.

Information-intensive financial intermediaries have substantially better information about the risks on their balance sheets than outsiders. In particular, they have better information than a CCP could obtain.

This has important implications. Recall that futures CCPs do not explicitly price member balance sheet risks. This reflects the prohibitive information costs that they incur to do so, and the strains that any attempt to discriminate between members would place on a cooperative organization. CCP members do not pay a cost for adding balance sheet risk, which creates an incentive to take on additional amounts of such risk. This creates a potential moral hazard that reduces the benefits of sharing risks.

In contrast, dealers that supply information-intensive intermediation have a comparative advantage in appraising the balance sheet risks of their counterparties. Dealer firms expend considerable effort and money to determine and manage counterparty risk, including that of other dealer firms they trade with. Recall, moreover, that dealers do adjust collateral levels to reflect their estimates of counterparty balance sheet risks.

In sum, complicated products traded by complex, information-intensive intermediaries pose serious challenges to central clearing.

Advocates of cds clearing argue that it is necessary to reduce systemic risk, that is, the risk that the failure of a large dealer will threaten the stability of the wider financial system.

Over-the-counter derivatives dealers are so interconnected, the argument goes, that the failure of one can trigger the failure of many others. Multiple failures would jeopardize the payment system and create economic chaos. The threat to the payment system is an externality, which provides a justification.

If interconnectedness among big financial institutions is the source of a systemic risk problem, creating a central counterparty is an odd way to “solve” it.

“Interconnection” is a synonym for “risk sharing mechanism,” and as noted above, bilateral markets and a ccp are just different ways of sharing that risk.

Indeed, the lack of pricing of balance sheet risks in ccps (in contrast to the fact that such risks are priced in over-the-counter markets) creates a moral hazard that encourages greater risk taking in a cleared market than in a bilateral one. Moreover, reductions in collateral that would likely accompany the formation of a clearinghouse would actually tend to encourage firms to trade more, as with a clearinghouse the netting of positions saves collateral, allowing a larger scale of trading activity for a given amount of liquid capital. Thus, the support for the view that a clearinghouse would reduce systemic risk is shaky, at best.\

Balance sheet risks are a matter of particular concern in evaluating the pros and cons of clearing of credit derivatives.

Severing the derivatives market-making part of dealer firms from their other intermediation activities would sacrifice those scope economies. Compulsory separation of market- making activities from the other forms of intermediation performed by big financial institutions could only be justified by the existence of some externality from joining them together that imposes social costs that exceed the private scope economies.