Micro Prudence = Macro Danger: Scrutinizing Counterparty Clearinghouses

by: Craig Pirrong

There are a lot of jokes about economists that go something like: “An economist and a physicist are on the top floor of a skyscraper. Someone runs in screaming ‘the building is on fire. The stairways are all blocked.’ The physicist immediately panics, then looks at the economist, who is amazingly calm. The physicist says, ‘How can you be so calm? We’re all gonna die.’ The economist smiles wanly and says, ‘No we’re not. First, assume a 100-story ladder.’”

That genre of joke came to mind when reading this:

Clearinghouses for derivatives can help reduce risk to the financial system, Federal Reserve Governor Daniel Tarullo said in written remarks prepared for House Financial Services Committee testimony tomorrow.

“If properly designed, managed and overseen, central counterparties offer an important tool for managing counterparty credit risk, and thus they can reduce risk to market participants and to the financial system,” Tarullo said.

Translation: “First, assume a properly designed, managed and overseen central counterparty.”

Yes, if we assume all those things are true, our assumed world is wonderful indeed.

But as I have written for the past two-and-a-half years (and I think I can honestly say “you read it here first!”), all that is easier assumed than done.

Reading an article by Samuel G. Hanson, Anil K. Kashyap and Jeremy C. Stein in the most recent issue of the Journal of Economic Perspectives helped crystallize a thought that is implicit in what I’ve written, but which I have not made as explicit as I should.

Specifically: Historically clearinghouses have been microprudential institutions, with the responsibility of ensuring that a particular set of claimants get paid what they are owed, just as bank regulation has been microprudential in its focus on ensuring that depositors get paid. But Dodd-Frank and all of the other initiatives around the world give CCPs huge macroprudential responsibilities.

As Hanson et al show, there can be substantial tensions between microprudential and macroprudential regulation: Some things that are prudent microprudentially are very dangerous from a macro/market-wide/systemic perspective. I do not believe that Frank and Dodd, Geithner, Gensler, the EC, you name it, were or are fully cognizant of the difference. And therein lies the danger.

Here’s the most obvious example. CCPs utilize margins - collateral - to control counterparty exposure. That’s sensible microprudentially. But as I argued beginning in 2008, and as Brunnermeir and Pedersen formalized in 2009, collateralization and rigid mark to market can be systemically destabilizing. I referred to this as the “collateral death spiral.” Prices change a lot, imposing big MTM losses on some parties, who liquidate their positions, exacerbating the price moves, which leads to more liquidations. This positive feedback mechanism is what creates serious systemic risks.

Brunnermeir and Pedersen emphasize that a purely mark-to-market system that bases margin calls only on price moves, and makes no effort to distinguish between fundamentals-based price moves and those that result from mispricings or liquidity effects are the most systemically dangerous. And that’s exactly how CCPs work. They are ruthlessly mechanical. If you talk to people in the futures business, that is a feature, not a bug. I can’t count the number of times I’ve heard about the virtues of the “discipline of a rigorous daily mark-to-market system.” Microprudentially - agreed. Macroprudentially - not true, and more than that, dangerously misleading.

So, there is a fundamental disconnect between Timmy’s and GG's paeans to rigid collateralization and mark-to-market and their assertion that mandatory clearing will eliminate the prospect that derivatives will be a source of systemic risk. Indeed, evaluated properly, the reverse is more likely to be true. In times of market stress, rigid collateralization can be a doomsday machine.

That is a reality that can’t be assumed away - but has been. And don’t count on that ladder saving our collective rear ends when - when, not if - the next financial firestorm occurs.