WASHINGTON (MNI) – The following is an excerpt from a paper by
researchers at the Federal Reserve Bank of Cleveland examining the
benefits, as well as some challenges, in reforming the
over-the-counter-derivatives market:

By moving counterparty risk out of the banking system (where it now
resides) and concentrating it in a supervised central counterparty,
mandated clearing of derivatives would centralize information about new
and existing contracts, as well as simplify market monitoring by
eliminating redundant contracts. Clearinghouses could publish pricing
and volume information that would be useful for market participants, and
regulators could require reporting of all contract holders’ net
positions to monitor exposure concentrations within institutions and
systemwide.

And because all transactions would occur through a clearinghouse,
the derivatives exposure reported by an institution would represent its
net exposure (as opposed to a tangle of potentially offsetting
contracts), greatly simplifying the monitoring process.

Recent history illustrates the importance of such monitoring. The
insurer AIG nearly collapsed in 2008 due to a large, unhedged CDS
exposure to mortgage securities. The full extent of AIG’s position was
unknown to investors, counterparties, and regulators at the time of its
rescue by the Federal Reserve through the extension of a massive,
emergency discount window loan. A central counterparty model for the
derivatives market would prevent such information lapses from again
spiraling into systemic events.

What’s more, a central counterparty can use the aggregated
positions of individual counterparties to net out their margin
requirements. For example, if a bank has to post $1 million of margin
for a CDS contract, but another contract the bank has outstanding moves
$1 million in its favor, the clearinghouse can simply cancel the two out
since it is counterparty to all contracts in the market. In this way,
the centralization of trade information lessens the constant (and
expensive) burden of posting capital in the derivatives market,
particularly compared to the current OTC market.

The Exchange

An exchange-trading model for derivatives would maintain the
benefits of central counterparty guarantees and information collection,
but would add a pricing service. Remember that in the clearinghouse
model as outlined, two counterparties agree upon the terms of a contract
and then clear it through a clearinghouse. An exchange, on the other
hand, would actually facilitate the terms of the contract by soliciting
buy and sell offers from participants for standardized contracts.

A dealer bank, for example, might offer to buy a $5 million CDS
contract on our software company for a 200 basis point annual spread
(premium) or to sell a similar contract for 210 basis points. Out of
such price quoting from multiple dealers and risk management end-users,
an active derivatives market would emerge, with centralized,
instantaneous pricing. Gone would be the days of calling up multiple
dealers to search for the best price. Instead, the exchange would supply
a single price for a given standardized contract, and in turn would
allow for more dynamic margin and collateral calls if prices fluctuate
sharply. Mandated exchange-trading of derivatives would therefore
provide even more transparency and standardization than a central
clearinghouse.

An Imperfect Solution

Either a clearinghouse or exchange-trading mandate for derivatives
would go a long way toward removing the problems of opacity and
counterparty risk — including their contribution to systemic risk —
from the market. Because in the past these issues have contributed to
the possibility of contagion (such as through the default of a major
dealer bank), migrating counterparty risk to a central counterparty will
lessen the too-big-to-fail (TBTF) problem as it currently exists.

But as is nearly always the case, the policy change would not be a
free lunch. Rather, central clearing and trading will simply move part
of the TBTF problem out of the banking system and into one or a handful
of clearinghouse or exchange institutions. These new TBTF institutions
would have to be appropriately supervised to ensure the integrity of
their risk management practices and management. In all, though, the
central counterparty model should be seen as partially mitigating TBTF
since it provides clarity in terms of how financial firms and markets
are connected through the derivatives markets — increasing the ability
of markets and financial system supervisors to discipline firms with
excessive exposures to specific types of risk or to other financial
firms.

Another imperfection that central counterparties exhibit relates to
the inefficiencies of standardization. Both clearinghouses and exchanges
would opt to standardize contracts because it would simplify product
offerings (making it easier to use them), improve pricing and market
thickness, and improve institutional risk management for the central
counterparties themselves. For those looking to hedge, some efficiency
may be lost as hedging strategies have to be “shoehorned” into
standardized instruments. But clearinghouses and exchanges will have the
financial incentive — just as they do in existing organizations like
the New York Stock Exchange and the Chicago Mercantile Exchange — to
create instruments that meet the needs of their customers. If
nonstandardized derivatives are still created and traded, they are
likely (and ought) to be costlier and subject to higher capital
standards to compensate for illiquidity. If in the past derivatives have
been subject to lower or less rigorously enforced capital standards than
are now being proposed, it suggests that additional pressures were
externalized to the financial system itself, with tremendous downside
risk and consequences.

Finally, a central counterparty mandate is not a magic bullet as it
does not address the more fundamental regulatory and economic questions
about how much incremental complexity derivatives — especially those
used for speculation as opposed to hedging — contribute to the
distribution of risk in the financial system. Even so, uniformly applied
clearing and trading of derivatives would represent a meaningful
improvement over the current OTC market framework. Such a system would
engender robustness in this useful market by allowing both regulators
and market participants to manage its safe, efficient operation in a
newly transparent environment.

** Market News International Washington Bureau: 202-371-2121 **

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