Derivatives Clearinghouses and Exchanges

Update:  The Lincoln version of the derivatives legislation clears the Senate Agriculture Committee today (which raises another set of issues, different from the ones under discussion below):

Democrats won the support of a senior Republican who voted in a Senate committee Wednesday for a sweeping overhaul of the market for derivatives, the complex financial instruments at the heart of the financial crisis.  The backing from Sen. Charles Grassley (R., Iowa) is the first sign of what Democrats hope will be an eventual wave of Republican support …  The move was also significant because Mr. Grassley said he favored one of the bill’s most controversial elements, a provision that could force Wall Street banks to spin off their derivatives trading desks.   The 13-8 vote in the Senate Agriculture Committee came as Senate lawmakers appeared to be inching closer to a deal on a broader remake of market rules.

The New York Times reported yesterday on negotiations over financial regulation legislation, and included this comment on derivatives regulation and Wall Street:

The derivatives bill, which is expected to be folded into the sweeping overhaul of the nation’s banking system, would also require most derivatives trades to be routed through a third party, known as a clearing agent. That would provide each of the parties a guarantee that they would be paid if the other party defaulted or went out of business. The bill would also require most derivatives to be traded on an open exchange.

Currently, the only way to trade many derivatives is to call up various dealers and ask for the price at which they are willing to buy or sell. The securities dealer profits from the difference between the prices at which it buys from one party and sells to another. Investors rarely, if ever, see details on the other side of the trade. Wall Street has signaled that it can live with a clearinghouse approach, but it is strongly opposed to exchange trading of derivatives, which would introduce price competition and lower the profits.

I think it’s fair to quote those two grafs from the lengthy article, which covers many aspects of the bill negotiations.  Here is my question – and it’s a genuine question, I’m not sure exactly what to think.

I had more or less assumed that Wall Street would be bothered more by a clearinghouse than an exchange, if it were one or the other and not both.  Why?  I assumed Wall Street would be concerned that a clearinghouse serving as a centralized counterparty would be motivated to contain its risk, by limiting margin and generally limiting leverage on the contracts for which it ultimately was responsible to clear.  The exchange seemed much weaker as a regulatory device because it would not have the ability, or at least the same incentives, to limit margin.  The exchange would help matters by making public the prices and counterparties, but not act to clear and, so, have to think about its own risk.  (If you had both, however, you would have the advantages of an entity motivated to limit risk and with public information on prices by which to help the determination of regulatory margin.  But we’re assuming here it is one or the other, although I myself strongly would like to see both.)

So I was surprised to read this passage and see my assumptions turned on their head.  And maybe I should never have been surprised, and this ordering preference should have been obvious.  But it did surprise me.  Which then leads me to the further thought, what is Wall Street’s assumption on the NYT’s description of its ordering preferences?  Wall Street prefers a clearinghouse that takes central counterparty risk but which should then address attendant risks?  Why?  Is it because of an assumption that – in a market that does not publicly post prices for everyone to see – if leverage gets out of control, the central clearinghouse will serve as the clearer of last resort?

In other words, does a clearinghouse without a public posting of exchange prices increase or decrease the likelihood that the central clearinghouse (in practical effect backed by the Federal government, which blessed the system through legislation after all) run the serious risk of serving as the next Wall Street bailout mechanism?  The New Fed-Market Put Option?

I don’t know the answer to this; this reporting surprised me, so I put the proposition to you.  Or have I misconceived Wall Street’s motivations or misunderstood what this ordering preference is all about?  Please stay on topic here and directly address these issues.

(Update 2.  Also see Gary Gensler urging a clearinghouse in the Wall Street Journal today, and Thomas Jackson and David Skeel, also in today’s WSJ, urging that derivatives be treated like other contracts in bankruptcy as a mechanism by which failed parties could have the regular bankruptcy protection against contract enforcement and so avoid cascading risk – and financial firms would not have to put (or give up) their customized derivatives onto exchanges (i.e., make everything into a uniform plain vanilla derivative).)