Considerations On A Credit Default Swaps Clearinghouse

The Clearinghouse Cure. By Craig Pirrong
Regulation, Vol. 31, No. 4, Winter 2008-2009

Credit Default Swaps (CDSs) are casting an enormous shadow over the world’s crisis-plagued financial markets — as in $50 trillion-plus enormous (although the exact meaning of this oft-quoted figure is somewhat contentious). CDSs were not the source of the ongoing financial crisis (that dubious honor largely goes to complex collateralized debt obligations backed by home mortgages, especially subprime mortgages), but financial markets are filled with fear that a default by a large CDS trader would rip through the financial system, causing a cascade of defaults by other firms. The Federal Reserve and the Treasury Department have responded by bailing out big, financially troubled swaps dealers, including Bear Stearns and AIG, that had large CDS positions, and regret their decision not to bail out another large dealer, Lehman Brothers.

The dread prospect that massive defaults on CDSs could crater the world financial system has led to numerous calls for CDS market reform and regulation. Regulators on both sides of the Atlantic and many market participants have seized on the idea of a clearinghouse for these contracts as the way to make the market more secure and protect the broader banking and capital markets from the prospect of CDS contagion.

The Federal Reserve Bank of New York has held numerous meetings with major market participants and has put substantial pressure on them to create a CDS clearinghouse. Five exchanges have presented proposals to this effect. In Europe, European commissioner for the Internal Market Charlie McCreevy has publicly called for the formation of a clearinghouse to mitigate risks in the CDS market.

Advocates of clearing of “over-the-counter” derivatives (that is, derivatives that are not listed on exchanges) like CDS contracts have pointed out many virtues of central clearing and pointed to the longstanding importance of clearinghouses in organized futures markets. Those advantages cannot be gainsaid, but the testimonials beg an important question: If the benefits of centralized clearing are so great, why haven’t CDS market participants embraced the concept before now, and then only under regulatory pressure? Consideration of this question, and a serious analysis of the economics of clearing as applied to CDSs and other exotic products, demonstrate that these products and, perhaps more importantly, the kind of firms that trade them pose grave challenges to centralized clearing. As a result, clearing CDS products is likely far costlier than clearing “vanilla” instruments such as exchangetraded futures contracts. The additional costs can make it uneconomic to utilize central clearing.

Put differently, clearing is not a one-size-fits-all proposition, because not all derivatives are alike. In particular, an institution that works well for standardized products traded on liquid markets by relatively simple financial intermediaries works much less well for more heterogeneous products traded in relatively illiquid markets by complex financial firms.

This conclusion follows from a consideration of the economics of risk sharing and insurance. Central clearing is essentially a risk-sharing — an insurance — arrangement. The members of the clearinghouse share the costs when another member defaults on its obligations. Sharing risks is often economically efficient, but the costs and benefits of risk sharing depend crucially on informational considerations. To ensure an efficient allocation of risks, and to ensure that the insured face proper incentives to control risks, it is essential to price the insurance correctly. Incorrect pricing can induce the insured to take on too much (or too little) risk.

Pricing insurance properly depends crucially on information. In particular, pricing is particularly difficult when information about risks is asymmetric, especially when the insured have better information that the insurer. This can lead to adverse selection and moral hazard problems. Those problems create real costs that reduce the benefits of risk sharing. Moreover, if those problems are not appropriately addressed in pricing, the insurance mechanism can create perverse incentives that can lead to financial disasters; the savings-and-loan crisis of the 1970s and 1980s was in large part caused by inefficient pricing of deposit insurance.

The complexity of CDS contracts and the financial firms that trade them give rise to potentially severe asymmetric information problems, problems that are more severe than for standardized futures products. Participants in the CDS market and other over-the-counter derivatives markets recognize those problems and have taken measures to mitigate them in their bilateral dealings. A comparative analysis suggests that those measures may well be more efficient than sharing default risks through a clearinghouse. Hence, it is certainly plausible that the absence of a CDS clearinghouse heretofore reflects an efficient market outcome, and that a hasty imposition of a clearinghouse could actually be inefficient.

Moreover, it is by no means clear that the formation of a clearinghouse will internalize externalities that are the source of systemic risks. Systemic risks plausibly arise because large financial firms do not take into account the effect that their failure has on the stability of the financial markets and the efficient operation of the payments system. A clearinghouse does not internalize that externality.

The nature of this analysis is inherently qualitative. It is difficult for anyone, be they academics, market participants, or regulators, to determine definitively whether a clearinghouse would improve the efficiency of the CDS market. I certainly do not claim to possess such definitive knowledge. It is troubling, however, that basic considerations relating to the economics of risk sharing and information have been almost completely absent in the public discourse over CDS clearinghouses. It is also troubling that the potential pitfalls have not been fully aired. Nor has there been an extensive comparative analysis of alternative risk-sharing mechanisms. Therefore, at the very least, this article aims to raise the quality of the debate by identifying crucial issues that have been largely ignored until now, and to challenge a consensus that threatens to engineer a fundamental transformation of the financial markets without proper regard for fundamental economic issues. Moreover, the considerations identified herein should be kept in mind when designing a CDS clearinghouse to ensure that information problems do not make this prescription worse than the disease it is intended to cure.

Full text at Cato's site

Craig Pirrong is professor of finance in the Bauer College of Business at the Universityof Houston.