Although I have a few reservations about the tone of the article being just slightly conspiratorial, Louise Story’s front page NYT story today on the evolution of derivatives clearinghouses is highly informative and very well done. The graphics showing how the bilateral trades would turn into centralized clearing are quite good and would be useful with a class. On balance, I think the overall shift to centralized clearing is a good move. But I also have a bad, bad feeling about this in the context of Dodd-Frank and future expectations. As I have said in past posts, in a future of financial regulation in which the central question of systemic risk and moral hazard has not been addressed, the result of what is otherwise a sensible move (yes, yes I’m skipping over all the concerns about end-users and Main Street, etc.) could turn out to create not so much a central clearing house but instead ... a central address for depositing unwanted risk.
After all, why should any of these leading market participants believe at this point that the government would allow the central clearinghouse to burn down in a crisis? And if they don’t believe that, then what is their incentive to set terms that will adequately address the risk as a matter of private ordering of fees, margin, whatever form of insurance the central risk-clearer needs? Having a central clearing counterparty is a great idea – if it and the actors that run and control it have the private incentives to make sure it is not a mechanism for accumulating and compounding risks.
Presumably the answer is that government regulators will set those requirements and solve the problem. But the general theory of financial regulation used to be that systems would be monitored for risk-taking, after private parties (with well-structured incentives forcing them to internalize the risks) had already made the first round of risk-decisions. Regulators would be kicking the tires for safety and soundness, as a second line of regulatory defense, not the first. I am an admirer overall of Gensler’s efforts, but he cannot be Batman to Financial Gotham. The peculiarity is that a structure that ought, in principle, to reduce risk might wind up leveraging it. The clearing house might turn out to be the one address market participants need to send their unwanted risks.
ps. Here are a couple of possible unaddressed risk scenarios:
- The clearinghouse turns out to be pretty good at managing fairly predictable, day to day risks.
- The clearinghouse turns out to be okay at managing day to day risks, but is not good at identifying or dealing with risks that arise over a long run of time from relatively minor distortions in the system’s incentives, perhaps arising from conflicts and complexity of those who own and run the clearinghouse and their other activities, perhaps other things. Those distortions over time start out small but turn out to be large and compounding and structurally invisible or discounted until they blow up.
- The clearinghouse’s private managers turn out to be good at managing day to day risk; Mr. Gensler, et al. turn out to be okay at forcing the clearinghouse and its private owner-managers to internalize risks caused by apparently minor distortions as they arise, because the public regulator is pretty good at spotting conflicts, even amidst complexity, and has an institutional mandate to pry apart conflicts of interest, even if it angers the banks.
- The system centralizes tail-risk, radical uncertainty.
If the clearinghouse system could achieve the third as its long term behavior, then I think it is on balance a good move. The fact that the fourth exists is not a reason not to create an otherwise rational scheme of regulation; if it is, nearly by definition, unforeseeable with sufficient specificity to prevent it from happening, that might be a pretty good definition of what the role of institutional and liquidity provider of last resort is supposed to be. One of the peculiarities of financial regulatory reform, after all, is that one can always object to nearly everything on the grounds that there is radical uncertainty and there might be unforeseen and unpredictable consequences ... so better not do that. Or that, or that, or that. But of course not doing anything at all is also doing something with equally radical uncertainty.
I sometimes think that we should all re-take Philosophy 101 in Skepticism and Rationality in embarking on academic discussion of financial regulation and risk. What is the appropriate kind of skepticism about the limits of our rationality in creating regulatory systems for complexity? Sometimes I ask a question about what I think is a fairly concrete, rationally predictable thing in financial regulation – close, in my mind, to asking what the weather is likely to be tomorrow – and get an answer back that sounds a bit too much like, “We cannot say, because after all we have no proof of the existence of the external world. La vida es sueno.”
Hmm, I think, vale. It is a little like what the late philosopher of mind Rogers Albritton referred to as the skeptic’s devious willingness to shift to another existential form of skepticism just when we thought we had answered him on this one, but not quite saying that he had shifted skeptical grounds. (“Shapeshifting skepticism,” one might call it.) We ordinarily wouldn’t worry much about this possibility, obviously – except that many people think we just experienced this radical uncertainty, come to pass, in the financial crisis.
Other people think, of course, that it was imminently foreseeable, if not because of the actual (disputed) causes, then because the procedural combination of complexity, conflicts of interest, and moral hazard driven complacency strongly implied something that could not go on as it was going – a matter of a visibly flawed process, so to speak. If that is one’s view, however, then the lurking question of number four is less whether the tail risk was actually foreseeable and preventible, but instead whether relations of complexity of systems, conflicts of interest, and attendant complacency meant that no one had enough at stake to find it. In which case, the prescription for public regulators in regulation is less to try and find it, than to give all those other, deeply interested, but also potentially deeply conflicted, parties reasons to overcome their complacency and conflicts, and have them dig through the complexity to find it, instead.
(Moreover, the point of providing liquidity as the provider of last resort in number four is in order to allow markets to make an orderly path to price discovery that is not simply a strategically forced run on the banks. It can’t magically remake insolvency into solvency except by fiat – or fiat money.)