March 11 marked the start of mandatory central clearing for certain kinds of over-the-counter derivatives called swaps. The central clearing requirement, a major component of Dodd-Frank, is purportedly one of the pillars upon which the future stability of our financial system rests. That pillar, however, is not as sturdy as it looks, particularly because regulators-blinded by central-clearing-love-are leaning on it. This pillar could come crashing down with destructive force. Thanks to Dodd-Frank, taxpayers will be there to pick up the pieces.
Once a swap transaction is executed, a central clearinghouse becomes the counterparty to both buyer and seller, thus terminating the relationship between them. That means if the party on one side of the transaction fails to meet its obligations, it will no longer be the other party's headache, but the central clearinghouse's problem. The clearinghouse protects itself by collecting margin from its counterparties when it first enters into transactions with them. Then, as necessary, it collects additional margin throughout the duration of the contract.
Swap dealers and their customers have undertaken a lot of preparatory legal and information technology work to ready themselves for the transition. Only the industry's major players are required to clear at this early stage. Less active market participants have another three to six months before they have to start clearing. Also, only swaps specifically subjected to the mandate by the Commodity Futures Trading Commission have to be cleared.
There is nothing inherently wrong with central clearing. Central clearinghouses play an important role in many markets. Even absent the mandate, there would have been a move by hedge funds and other important swap market participants towards central clearing of certain types of standardized swaps.
The problem is the mandate itself. Regulators are pushing central clearing: the more, the better. They want to be able to report that they have succeeded in moving as high a percentage as possible of the market into clearinghouses. Meanwhile, clearinghouses have an incentive to outrun their rivals to establish themselves as the go-to clearinghouse. The collective push to bulk up clearinghouses comes at a cost-risk management.
Market participants, whose only long-term swaps relationships will be with clearinghouses, will no longer have to monitor their counterparties. It will be left to clearinghouses to watch for risk, and they are not getting much encouragement on that score from regulators.
In a regulatory environment concentrated on getting everything cleared and opening up clearinghouses to as many market participants as possible, there is little time or patience to think about sound risk management. Clearinghouse risk management is a complicated business in the best of times. It is even more difficult in a regulatory environment so intensely focused on shoving swaps into clearinghouses. Relevant considerations include the risks of particular types of swaps; the correlations among swaps, which are not necessarily static; appropriate margin levels; appropriate default fund size; and clearinghouse members' financial health. Regulators aren't paying much attention to how effectively clearinghouses are taking these and other risk considerations into account. A few weeks ago, CFTC Chairman Gary Gensler told the Senate Agriculture Committee that "we're also not doing the examinations that we really should be doing of the clearinghouses ...we do not have staff examining clearinghouses annually for their risk management and we're pushing-statutorily pushing-all sorts of additional transactions into clearinghouses."
And when regulators do turn their attention to clearinghouse risk management, their interest is focused less on quality than on check-the-box considerations. For example, regulators have emphasized the importance of a certain percentage of independent directors on clearinghouse risk committees, which oversee clearinghouse risk management. Independent directors are likely to be drawn from among people who are not familiar with the industry or its risks.
Deficient risk management at a clearinghouse would likely come to light at a time of market turmoil. A clearinghouse's troubles would spill over to the many financial institutions that are heavily exposed to it because of clearing mandates. Dodd-Frank's answer? As Chairman Bernanke explained last year, clearinghouses "could also be given access to emergency credit if private-sector sources are exhausted." In short, Dodd-Frank's answer is government to the rescue.
Dodd-Frank promised us financial stability, but if those promises are premised on regulatory vigilance and taxpayer guarantees, can we rely on them?