When the architects of the Dodd-Frank regulatory overhaul flinched from the most effective solution — breaking up the banks so that none would be too big to drag down the financial system — they forced regulators of the derivatives market into a cumbersome and potentially dangerous workaround.
Those regulators are feverishly making lots of important, arcane rulings that are being followed only by insiders. They are replacing an opaque system prone to failures with a new, huge Rube Goldberg-like system that may reduce global financial risk. Or it may not. Nobody knows, not least the regulators themselves.
The Commodity Futures Trading Commission, led by Gary Gensler, last month approved rules that would require derivatives clearinghouses to open their membership to firms that have as little as $50 million in capital. A clearinghouse is a central body through which trades take place. It is supported by its financial firm members. For instance, if JPMorgan Chase enters into a derivatives transaction with Goldman Sachs, their deal would go through a clearinghouse, which is on the hook for the trade if one of those banks fails.
The big banks that dominate derivatives trading resisted letting in smaller firms, arguing that doing so would make the clearinghouses vulnerable. They have a point: A clearinghouse with a bunch of undercapitalized members would be more prone to failure, unable to pony up when one side of a trade defaults, and we would be back where we started.
And who had lobbied for this? One of those smaller brokerage firms, MF Global, then run by Jon S. Corzine. Of course, MF Global went belly up because of its aggressive bets and high leverage.
Oops. That disaster makes it easy to conclude that the Commodity Futures Trading Commission is going about trying to reform the derivatives markets all wrong.
But excluding the small fry is dangerous as well. If clearinghouses restricted their membership to only the biggest and best-capitalized firms, the markets would more or less look like they are today — an oligopoly.
Derivatives trading is dominated by the likes of JPMorgan, Goldman Sachs and Deutsche Bank. We now have a financial system where the failure of one megabank can jeopardize the world financial system, and having clearinghouses run by only the “too big to fail” firms merely replicates that fundamental problem.
“If you want to restrict access to just the larger organizations, you don’t solve the problem that clearinghouses are there to solve,” said Nicholas Dunbar, the author of "The Devil’s Derivatives" (Harvard Business Press), a history of the creation of these markets.
So both options are bad; letting in small guys is dangerous, but so is keeping them out.
Another insoluble problem is that of the One or the Many. If there were only one giant global clearinghouse for all derivatives, it might have enough capital to survive a panic in any one corner of the derivatives market. But if a general financial crisis forced many members to default, then it really would be too big to save. No country, not even the United States, would allow such a gargantuan institution to be domiciled on its home turf.
Instead we have an explosion of clearinghouses. We have clearinghouses for different asset classes. We have competing clearinghouses. We have clearinghouses in the United States, Europe and Asia. Dodd Frank implicitly supports this “let a thousand flowers bloom” approach.
That leads to another concern. Clearinghouses create an impression there’s some underlying capital to protect them, either in the entity itself or among the members. But a multiplicity of small ones is dangerous, according to Frank Partnoy, a professor of law and finance at the University of San Diego. The fragmentation means that safety is likely to be an illusion.
“There is less money” in each tiny clearinghouse, he explained. It virtually guarantees that if there’s a panic in one area of the world, the clearinghouse that backs it won’t have enough capital.
The regulatory changes could make things worse in another way, said David Murphy, principal of the risk management firm Rivast Consulting and a former head of risk at the trade group International Swaps and Derivatives Association. Here, it’s worth knowing a little about how banks minimize risks as they trade derivatives.
The underlying amount of derivatives, called the “notional value,” is in the hundreds of trillions. The biggest dealers, like JPMorgan, have tens of trillions of notional value on their books. What we are worried about is counterparty risk: What happens if one of the banks on either side of a trade fails?
As an example, the investment bank Robbin & Steelin has a portfolio with another investment bank, Engulf & Devour. Robbin goes through an exercise to figure out the following:
If Engulf fails, how much would Engulf owe us and what collateral do we have against that?
And how much would it cost us to replace those positions, to restore our offsetting hedges?
That, with a few steps in between and a lot of fancy math, is how those trillions of “notional” amounts shrink to a much smaller “net” figure, in the billions.
But under the clearinghouse regime, the banks will have to split up those gargantuan portfolios. Let’s say Robbin and Engulf had two trades with each other, a European derivatives trade worth $200 and an American derivatives trade worth $180. It has a net value of $20, with Engulf posting that amount in collateral with Robbin.
Now the trades move to clearinghouses. The European trade goes to a European clearinghouse. The American trade goes to an American clearinghouse. The parties need to post larger amounts of collateral. If, say, the European clearinghouse fails, one bank is exposed and now has a much bigger exposure.
Will that bank have received adequate collateral from the clearinghouse? Maybe, but maybe not.
But the bank may have to go out into the market to offset its exposure — possibly a more disruptive move than it would have been under the previous regime.
It’s possible that the netting effects from other trades with the clearinghouse will serve the same function. But it hasn’t been adequately studied.
One possible result of all of this is that there will be less derivatives trading and more collateral going back and forth. That’s bad for bankers, but good for the rest of us.
Given the weak hand that regulators have, however, it seems more likely that the collateral will just be inadequate. It’s easy to see regulators and trading partners falling for the illusion of safety that clearinghouses provide.
“The scary part,” said Mr. Murphy, the risk expert, “is that I’m pretty certain that clearing is being imposed without anyone actually knowing whether it actually reduces counterparty risk or not.”
One sure thing in this morass of uncertainty: We will find out.