Received wisdom instructs us to resist the urge to meddle. “If it ain’t broke, don’t fix it,” the saying goes. It’s a questionable idea, really. The technology sector and many other industries are based on the idea of “fixing” things that aren’t really broken. The original iPhone worked pretty well, but the iPhone 4 works better, right? The more interesting admonition, perhaps, is that we should sometimes resist the urge to “fix” things that truly are broken. Such caution seems to be at work as financial regulators get ready to impose new requirements on the clearing and settlement of the derivatives industry, which was at the center of the financial crisis.
There’s no question that the market is broken: derivatives were central to the collapse of Lehman Brothers and the liquidity crisis at AIG, which led to a $182.5 billion government bailout.
The urge to fix this mess is central to the Dodd-Frank financial reform act, passed last year. In three months, it will start to impose central clearing on derivatives trades. Big banks that account of the bulk of the industry will be required to form clearing houses that will make prices public and transparent.
In the event that one of the members suffers a loss, it will be borne equally by members of the clearing house, creating a form of self-insurance against financial catastrophe. That is supposed to reduce the risk that the government, supported by the taxpayers, will need to step in with a bailout.
The beauty of this fix — a similar rule are scheduled to be implemented next year in Europe — is that it should shift the risk of financial failure from the public sector to the private sector, leading to less recklessness and more fairness. As appealing as this idea may be, there are an increasing number of academics, economists and public officials who say the law is fraught with new risks, and may not work as well as people think.
“Any thoughts that the policy of mandating central clearing is the silver bullet to stop future financial crises are simply wrong,” says Ruben Lee, founder and CEO of Oxford Finance Group, a consulting firm in London. Lee, a former fellow at Nuffield College at Oxford University, has just laid out his theory in a new book, Running the World’s Markets, published this year by Princeton University Press.
Lee doesn’t reject the idea of central clearing out of hand, but he warns that government efforts to impose its central clearing in cases where they don’t make economic sense could make the odds of a future government bailout higher, not lower.
“It is true that more central clearing in the OTC derivatives markets is to be encouraged — but only where it makes economic sense. Centralized clearing does not, however, always make sense, for example if a clearing house is not able to manage the risks of a default due to a potential lack of transparency or liquidity in the relevant contracts at a time of crisis.” he says.
When the next major default occurs in the derivatives market, clearing houses may complain “that they were forced to clear such contracts by regulation, and accordingly that the public, i.e. the government, should bear the cost of such failures.”
The argument in favor of central clearing won support from the institutions that would benefit from it — the exchanges that were poised to enter the clearing business, and regulators, such as the U.S. Commodity Futures Trading Commission, that would oversee it, Lee says.
Lee isn’t the only skeptic. Some policymakers are wondering whether it makes sense to impose clearing across the board. Even as the law was being written, regulators and policymakers had to grapple with the fact that many derivatives are unique contracts between two parties. That makes them difficult to price, difficult to clear, and subject to a lack of liquidity in the event of a crisis.
As the Wall Street Journal noted on April 23, Fed Chairman Ben Bernanke, who supported the idea of the new clearing rules, sounds a bit more cautious now. In a speech in Atlanta, he warned that the clearing mandate could lead to “concentration of substantial financial and operational risk in a small number of organizations, a development with potentially important systemic implications.” He warned that strong risk management within these new clearinghouses is “essential” and that the government will have to exercise careful oversight of these institutions, as well as their member banks.
The Wall Street Journal noted that clearing houses have failed in France, Kuala Lumpur and Hong Kong, and that none of them had tasks “as complicated as those mandated by Dodd-Frank.”
Representative (R-Texas) Jeb Hensarling famously declared last year after the White House and lawmakers reached agreement on the 2,000-page-long Dodd Frank bill that “My guess is there are three unintended consequences on every page of this bill.”
Can anyone say how many pages of the bill were devoted to derivatives clearing?
