On Interconnectedness: That's His Story and He's Sticking to It

Includes: IYF, KBE
by: Craig Pirrong

He being Gary Gensler, and his story being that mandated clearing will improve the stability of the financial system by eliminating interconnectedness:

“Over-the-counter derivatives are meant to lower risk on our economy, and to some extent they do,” Mr. Gensler says. “But they have concentrated risk in a few big banks…through their interconnectedness.” He says forcing them onto clearinghouses would shift the risk from any single institution to the clearinghouse. It can more easily offset, for instance, bets that interest rates will rise with bets that they will fall. That would make it possible to allow a big financial firm that is floundering to fail, restoring market discipline.

Repeating the same BS over and over doesn’t turn it into gold. Clearinghouses are interconnected. And they will almost certainly be too big to fail–and they can fail, a point that Gensler has never acknowledge. Even the New York Times sort of gets it (although I disagree with a lot of what they say in this editorial). ”Interconnection” is just about the worst argument to make in support of clearing mandates.

Gensler has company in Europe. Gertrude Tempell-Gugerel of the European Central Bank supports central clearing mandates, for equally inane reasons. She starts out with a non sequitur (since Lehman and AIG failed, clearing must be better–wrong), and goes downhill from there:

Therefore central clearing has become part of the G20’s agenda and mandatory clearing is seen as a tool to address the risks in OTC derivatives trading. Should a counterparty involved in OTC trading go bankrupt under central clearing, it would not create the chain reaction that the default of Lehman Brothers triggered. A central counterparty (CCP) would allow an institution with offsetting positions to net their exposures and substantially reduce counterparty risk.

In addition, a CCP would need to comply with high risk management standards and require counterparties to post appropriate collateral. Moreover, mandatory reporting of contracts to trade repositories would significantly enhance information on OTC derivatives exposures, to the benefit of authorities and market participants alike.

No chain reaction is possible when there is a clearinghouse? Really? What is the color of the sky on the planet where that is true? Netting already takes place to a considerable extent. Indeed, clearing done badly can actually REDUCE the amount of netting, if clearing is fragmented by product and even within products (e.g., multiple competing interest rate swap or CDS CCPs). And for the billionth time (perhaps I exaggerate), netting like this is a private benefit: if the benefit is as great as Gert (and many other regulators) say, why haven’t private parties fallen all over themselves to exploit it? Mightn’t there be some costs that more than offset this putative benefit? “High risk management standards”–why not impose them on banks? And what about the information disadvantage that CCPs are likely to suffer vis a vis dealer banks? That goes unmentioned. Collateral can be the trigger for a systemic crisis. Moreover, Tempel-Gugerel overlooks the likely equilibrium responses to a clearing mandate. Rather than extending credit implicitly in derivatives transactions (as is often the case now) big banks are likely to extend credit to their customers to permit them to post margins, leaving the overall amount of leverage in the system pretty much unchanged. Since it’s leverage that is ultimately the source of systemic risk, this obsession with collateral is likely to provide a false sense of security. The information benefits can be achieved by mandatory trade reporting to a repository (which I’ve advocated for well over 7 years) without requiring mutualized counterparty risk sharing, or centralized risk pricing (in the face of severe information disadvantages).

The advocates of clearing mandates have had almost two years to come up with credible arguments, and to attempt to rebut counter arguments. They’ve done neither. They keep recycling the same old BS, and don’t even acknowledge, let alone address, the myriad arguments that have been raised against clearing mandates.

Policies built on willful ignorance do not end well.