The benefits of the “speculation in sovereign debt” brouhaha

Well, screaming good and loud about manipulation and speculation in derivatives may actually have some advantages afterall — even when the accusations are groundless.  Don’t know many people who believe in the regulation of finance that will complain about this outcome.

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What is a clearinghouse?

The discussion of clearinghouses appears to be missing some crucial elements.  From the latest Squam Lake Working Paper:

[There are] two important advantages of clearinghouses. First, by allowing an institution with offsetting position values to net their exposures, clearinghouses reduce levels of risk and the demand for collateral, a precious resource, especially during a financial crisis. Second, by standing between counterparties and requiring each of them to post appropriate collateral, a well capitalized clearinghouse prevents counterparty defaults from propagating into the financial system. Because of these advantages, the U.S. Treasury Department has announced that in the future all credit default swaps that are sufficiently standard must be cleared.

Clearinghouses, however, are not panaceas. In the fight for market share, they may compete by lowering their operating standards, demanding less collateral from their customers, and requiring less capital From their members. To ensure that clearinghouses reduce rather than magnify systemic risk, regulatory approval requires strong operational controls, appropriate collateral requirements, and sufficient capital. Clearinghouses should be subject to ongoing regulatory oversight that is appropriate for highly systemic institutions.

It strikes me as utopian to think that regulatory oversight could possibly ensure the solvency of a clearinghouse — especially of a clearinghouse for financial contracts that are subject to sudden changes in value like credit default swaps.  The reason that clearinghouses, like the New York Clearing House founded in 1853, were financially stable is because the clearinghouse liabilities were guaranteed jointly by the full faith and credit of every member of the clearinghouse.  In other words, if a firm wants to use a clearinghouse, it has to be willing to stand behind the liabilities of the clearinghouse.

Pushing derivatives onto clearinghouses without insisting on member liability for clearinghouse debt seems foolhardy.  When firms like Goldman Sachs and JP Morgan Chase are willing to put their shareholders on the line, regulators can be confident that clearinghouse policies are well designed.  Without such a seal of approval from the major derivatives dealers, how could regulators ever be sure that sufficient safeguards are in place for the clearinghouse?

And if the response is that the banks are unwilling to support a clearinghouse with member liability, that would imply that there is no way to design a sound clearinghouse for the derivatives under consideration.  This in turn has implications for the inherent stability of the derivatives market — and would immediately raise the possibility that the appropriate action for regulators is simply to shut the market down.