Who Could Have Possibly Predicted That Clearing Mandates Aren’t A Silver Bullet?

Oh, yeah.

The WSJ seized on Ben Bernanke’s “Puddin’head Wilson” speech about the need to be especially vigilant about the risks inherent in huge CCPs, including those engendered or expanded by Frank-n-Dodd mandates (h/t Carl E and Mark B):

One by one, financial regulators who supported the Dodd-Frank law in 2010 are beginning to deny paternity, especially for the bouncing bundle of new derivatives rules. Perhaps they now realize the law created more systemic risk than it eliminated. Witness Federal Reserve Chairman Ben Bernanke speaking in Atlanta recently and warning about the consequences of forcing much of the derivatives market into central clearinghouses.

Mr. Bernanke specifically warned of this “concentration of substantial financial and operational risk in a small number of organizations, a development with potentially important systemic implications.” He went on to say that “strong risk management at these organizations as well as effective prudential oversight is essential.”

It sure is, and the federal regulators who failed to oversee the big banks will now have to oversee both the banks and the new entities housing their derivatives trades. As we’ve noted before, clearinghouses have succeeded in managing risk and enabling efficient markets in many areas of trading over many years. They are especially useful when they develop organically to meet a market need. [Emphasis added.]

Uhm, where have I heard the phrase about CCPs “develop[ing] organically to meet a market need”?  Sounds verrryyy familiar.

Perhaps the WSJ is too aggressive in stating affirmatively that Frank-n-Dood “created more systemic risk than it eliminated.”  But it would not be aggressive at all to state that (a) that is a very real risk, (b) that risk depends in large part on the decisions that regulators make going forward, and (c) that risk received virtually zero attention from legislators and policymakers at Treasury (a very guilty party), the CFTC (similarly guilty), the Fed, or Congress.

The WSJ is on very firm ground in excoriating those who have now found their voices on CCP risks, but who remained conspicuously silent when weighing in on the issue could have slowed down the stampede to clearing:

Add it all up and you have a disturbing number of financial eminences suddenly rushing to get clearinghouse warnings into the public record. Do they know something that the taxpayer doesn’t? It’s hard to tell, because even as the Beltway crowd scrambles to draft clearinghouse warning memos for posterity—and for their posteriors—regulators are also promoting “independent director” rules that will discourage people with knowledge and experience from overseeing these institutions. This is the last thing regulators should be doing if they now understand the risks.

When we started warning against forcing this market into clearinghouses in 2008, the regulators who agreed could have held meetings inside a phone booth, if we still had phone booths. Last May, our story about Senator Chris Dodd’s effort to give clearinghouses access to the Fed’s discount window—and therefore to a taxpayer rescue—attracted scarcely more support. Dodd-Frank was the law of the land by July, with taxpayers officially backing Wall Street derivatives trading for the first time.

Now taxpayers get to watch regulators who did nothing to stop this policy, when their opposition might have made a difference, suddenly offering insightful critiques when it doesn’t.

I share the WSJ’s anger and dismay at the Johnny-come-latelies who now sound alarms.  NOW they tell us.  I wonder if it’s not just CYA, as the Journal would have it, but also another way to assert power and authority, and to expand bureaucratic turf.

The Economics of Contempt is, er, contemptuous of the WSJ stand:

The WSJ says that it’s “not aware of any governments that have ever asked clearinghouses to manage risks as complicated as those mandated by Dodd-Frank.”

That’s funny, because we still don’t know what financial instruments will be subject to Dodd-Frank’s clearing requirement yet! So how does the WSJ know how complicated the risks that clearinghouses will be asked to manage are? They don’t. The CFTC and the SEC don’t even know yet. The WSJ is just making things up.

This is like the people who make the fairly simple and widely-understood point that clearinghouses don’t work well for illiquid or bespoke instruments, and then claim that because of this, Dodd-Frank’s clearing requirement was a bad idea. They apparently don’t have the patience to wait to see which instruments the CFTC and the SEC decide have to be cleared — they want to demagogue the clearing requirement, and they want to demagogue it now, dammit!

FWIW, EOC is a pretty strong Dodd-Frank booster.

IMO, EOC is far too contemptuous of the Journal piece.  Yes, many of the implementation details of Frank-n-Dodd remain to be determined, notable among them just what products will be cleared, and more importantly the process by which that decision will be made.  Yet it is abundantly clear that the intent of the authors of Frank-n-Dodd, the Treasury, and Gensler in particular at the CFTC is to push as many derivatives as possible onto CCPs.  This can be done directly through mandating that particular products be cleared, or indirectly, by imposing punitive margin and capital requirements on non-cleared trades.  We don’t know exactly what they will do, but we know what they want to do–they’ve told us over and over again.  The WSJ editorial is quite fair in speaking to the risks that CCPs could pose if these people get their way.

But even if EOC is right, then we have two alternatives: either clearing mandates and much of Frank-n-Dodd was sound and fury, signifying nothing, or it runs the kinds of risks that the WSJ and, uhm, others identify.  And the sound and fury is not without its costs.  It has created huge uncertainty, and led to the commitment of innumerable resources to trying to understand, shape, plan for, etc., the regulatory changes.

Regardless, the WSJ is spot on in calling out those currently speaking out on their failure to do so when it mattered.

But that’s water over the dam now.  What’s needed is for these newly vocal regulators to put their supposedly new revelations into practice.  Two very practical issues on which they can do so are taking a duly humble approach to the process of determining what gets cleared and what doesn’t (the issue that EOC focuses on), and on CCP membership and governance standards.

Not that I’m holding my breath.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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