All about business

Efforts by US regulators to move privately traded derivatives to central clearing houses are unlikely to be a cure-all for the industry, and may increase systemic risk if exposures are dispersed among too many counterparties.

Regulators around the world are pushing for the majority of contracts in the $450 trillion over-the-counter derivatives markets to be cleared through central counterparties, as futures and options contracts have been for years, in order to reduce the systemic risk posed by the web of connections between large financial institutions.

If there are too many clearing houses though, regulators run the risk of increasing the systemic risk posed by OTC derivatives trading, said Darrell Duffie, professor of finance at Stanford University.

“A clearing house through its opportunity to net across many asset classes and dealers can lead to a very substantial reduction in risk and also a very big increase in efficiency,” Duffie said.

“However, that only works if you have very few clearing houses,” he said. “Many clearing houses could be very bad. You would have increased counterparty exposure and excessive use of collateral, with multiple points of failure. This could add systemic risk.”

Clearing the majority of derivatives through one counterparty is advantageous as market participants can offset all contracts in which they owe or are owed money against each other, a process known as netting.

The amount of collateral needed to back their exposures would also be radically reduced in this scenario.

Creating too many clearing houses, however, increases the amount of exposure a participant could have to a failed dealer, as it would be spread across several entities payday cash loans.

There are currently at least five clearing houses in the U.S. and Europe that clear or plan to clear credit default swaps, contracts that are used to insure against a borrower defaulting on their debt.

Other clearing houses clear, or plan to clear, other derivatives, including contracts in the $414 trillion OTC interest rate derivatives market.

REDUCING RISKS

Debate has increased recently over whether central clearing will successfully reduce risk posed by OTC derivatives, as some participants fret that difficulties in determining appropriate capital requirements for certain contracts could make concentrating exposures in clearing houses risky.

To some, CDS contracts are too risky in or outside of central counterparties.

David Einhorn, president of Greenlight Capital, said at a recent investment conference that CDSs cannot be made safer and should be banned, citing the “anti-social” incentives to let companies fail that may motivate protection holders who also own corporate debt.

“The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialized risks by moving the counterparty risk from the private sector to a newly created too-big-to-fail entity,” he said. 

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