Prof Pirrong of the University of Houston tackles the complexities of clearing by central counterparties…
Since the late-90s, I’ve emphasized in my academic writing the importance of accurate price information in making clearing efficient-or even possible. It is therefore encouraging to see this article in the FT make the same point. It is important to note, though, that although this is an important part of the story, it is not the whole story.
First, good pricing information is a necessary, but not sufficient, condition for clearing to be the most efficient way of organizing a trading market.
To set the right margins and give the right incentives, a central counterparty (”CCP”) not only has to have a good snapshot of the value of an instrument at an instant in time, it has to understand the risks of that instrument. It also has to understand the balance sheet risks of the firms that trade it. It has to understand the interaction between the price and balance sheet risks. Many times, dealers are going to have better information on all of these things, and hence are going to price counterparty risk more accurately. Moreover, CCPs usually have to choose a one-size-fits-all margin, which is problematic when member firms are heterogeneous (as is the case today). In contrast, dealers can price default risk in a discriminating way.
In this regard, it is interesting to note that both the CBOT and the LME resisted adopting clearing for years (adopting it in the end only under intense regulatory pressure) despite the fact that each operated a highly liquid and transparent centralized market. Obviously, price transparency was not the obstacle to clearing in these instances - other factors were also relevant.
Second, although clearinghouses are repeatedly touted as producers of information, they are also consumers of information. True, they can improve transparency about positions and some risks. But to work effectively, they need information on prices that is generated by the actions of other market participants. The ICE tradeable quote mechanism the article mentions is one way of generating this information, but it is necessarily the case that instruments that are traded more frequently in more liquid markets can be valued more precisely than those that trade infrequently. By centralizing price information, a CCP arguably has access to the best information on value. But if there is little information to centralize because trading activity is infrequent, the CCP must operate in the dark.
These considerations direct attention to another issue. Legislators and regulators are moving towards forcing “standardized” derivatives to be cleared, but are stumbling over the definition of “standardized.” The focus on what contractual features constitute a standardized product is a red herring. What is important in determining the costs and benefits of clearing a particular instrument are its price behavior, the riskiness of the firms that trade it, the liquidity of the markets on which it trades, and crucially, information about these factors. These things are inherently heterogeneous; the contractual terms of two instruments (e.g., CDS on two different names) may be very similar, but the relevant economic considerations that determine their suitability for clearing may be quite different indeed.
In sum, the FT is to be praised for focusing attention on the importance of informational considerations in determining the feasibility of clearing. Price information is crucial, but other information is vital as well. Hopefully this article represents the beginning of a trend to move beyond the rah-rah that has surrounded clearing in the aftermath of the financial crisis, and to cast a more critical and discerning eye on the information CCPs need to do their job efficiently.
Craig Pirrong is Professor of Finance, and Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston. He blogs at the Streetwise Professor.
Related links:
Wall Street makes significant concessions on OTC derivatives - FT Alphaville
Central counterparties and CDS risk, a contrarian argument - FT Alphaville
