Getting clear on clearing

Gary Cohn, president and COO of Goldman Sachs, weighs in with his doubts about the wisdom of the current regulatory push to move as much as possible of security trading onto clearinghouse platforms.  (See article in FT here, and podcast here.)  Now Moody’s asks for industry feedback on clearinghouse risk, and CFTC Commissioner Bowen reiterates call for “public directors and diverse ownership” of all clearinghouses and exchanges.  The game is clearly afoot, but what is at stake?

Students of American financial history remember the days when a consortium of New York banks, led by JP Morgan, ran the US payments system through its payments clearinghouse.  The crisis of 1907 put an end to that, and gave rise to the Fed, though the private clearinghouse remains.  There is a public interest at stake here, as well as a money interest, and the boundary between the two is in play.

But there is also a deep analytical question at stake.  One way to understand the Dodd-Frank injunction is as an attempt to separate out matched book dealing (which involves a balance sheet that looks like a clearinghouse) and speculative or “proprietary” trading (which involves price risk).  That’s the so-called Volcker Rule.  Formerly both forms of dealing were on the same balance sheet; in future on different balance sheets.  But why?

The justification has usually been about removing public subsidy for private speculation.  In my own understanding, it is about separating ultimate liquidity backstop (which is inevitably public) from solvency backstop (which should be private capital buffer).  The big risk in a matched book dealer is liquidity risk.  The big risk in a speculative dealer is solvency risk.

Last December I posed that question in the final exam I gave to the students in my class “Economics of Money and Banking”.  Here is the question.  Next post I will reveal the answers I proposed.

  1. Balance Sheets and the Dealer Model (15 points).

Please refer to the attached article, “’Too big to fail’ worries reach clearing houses”, with special attention to the highlighted passages:

a) The clearinghouses in this article can be thought of as matched book dealers, that stand in between the ultimate counterparties for derivative contracts during the life of those contracts. Using balance sheets, show the relationship between the CCP, their member banks, investors, and governments.

b) The BIS and IOSCO have proposed four steps that CCPs could take when crises erupt. Explain how each one works, and who takes the loss.

c) Like any dealer, a CCP faces both solvency and liquidity risk, in different degrees. From this perspective, comment on the efficacy of the proposal to require CCPs to hold a minimum “total loss absorbing capacity”.