Arnold Kling  

Clarity on Clearing Houses

Bet on Euro... Race Against the Machine

Mark Roe writes,

as many trades move from the banks to the clearinghouse, the clearinghouse itself will become a systemically vital institution. It will be too big to fail.

Thanks to Mark Thoma for the pointer. Often I do not agree with the pieces to which he links, but this is an exception. I have been saying for a long time that a clearinghouse is not a panacea for derivatives markets. The article makes some good points. I would add that a clearing house has to use generic products, and financial institutions have specific assets and liabilities to hedge. The use of generic derivatives to hedge specific assets creates basis risk. If you force banks to use a clearing house, then you force them to take basis risk. Odds are that the next big failure would involve basis risk.

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COMMENTS (4 to date)
Richard writes:

What's basis risk?

Joe Teicher writes:

Oh come on. Has a major clearing house ever failed? Has one ever been bailed out? I don't think so.

A clearinghouse can effectively eliminate the incentive to sell small out of the money options. They can just require enough margin to make that a low-return business. If CDSes had been cleared products AIG would probably never have gotten into the business of selling them, and how much of the financial crisis would that have prevented? I think quite a lot.

The push against clearing houses is a lot like the propaganda against high frequency traders. The big banks want to keep their opaque, high margin OTC trading where they have less competition. They don't have edge in transparent, exchange-traded and centrally cleared markets. So they have their PR machine out there now working to vilify the exchange traders and poke theoretical holes in clearing houses.

Its propaganda from an industry that doesn't want to lose their cash cow to a more efficient way of doing business. Don't feed into it. Don't be a shill for the banks.

JP Koning writes:

Richard, I think what Arnold means by basis risk is something like the following.

A farmer in Idaho can hedge his wheat production come harvest using CBOT wheat futures. But CBOT wheat futures are priced according to wheat delivered at Chicago. The farmer in Idaho delivers wheat to a nearby elevator in Idaho, not Chicago. As such, the price the farmer receives in Idaho could be significantly different from that in Chicago. So protecting yourself by selling Chicago wheat forward when you are actually producing an entirely different product - Idaho wheat - represents an imperfect hedge. This difference between wheat prices in Chicago and Idaho represent your basis risk. This can be significant! Imagine a drought hitting Illinois while Idaho has a bumper crop, the price differential could be rather large.

The Idaho farmer could significantly cut down on basis risk by negotiating OTC with someone do buy Idaho wheat forward. This would be costly for the farmer due to the effort spent in verifying the credit quality of the counterparty... in the end it could be easier to just transact on CBOT and accept basis risk, since the CBOT is a trusted counterparty.

It would be nice if migration from OTC to organized exchanges happened naturally rather than by force.

Patrick R. Sullivan writes:

Would we even be talking about derivatives if the home loans from which all these securities derived their value had been made on pre 1993 underwriting standards?

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