Streetwise Professor Craig Pirrong, Professor of Finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston, talks with DerivAlert about the evolution of the central clearing and the dangers of placing too much emphasis on clearinghouses.
Q: How will the role of a clearinghouse change with the Dodd-Frank Act?
A: The role of the clearinghouse in terms of its economic function won’t change. But the clearinghouses will be more pervasive, they’ll be more involved in more transactions. The key things that remain to be determined are exactly what products have to be cleared? Who makes that determination? And also, which market participants have to have their transactions cleared. What’s the scope of the end-user exemption going to be? How is the end-user going to be defined? These are the remaining things that will be fleshed out during the rule-making process. The one thing we know – the clearinghouse will be much more pervasive than it is at present.
Q: Will derivatives trades be cleared through the existing clearinghouses or will there be separate clearinghouses for those instruments?
A: That’s going to be a whole issue in terms of the market structure. It’s going to be a competitive business. We already have LCH.Clearnet, CME, ICE Trust and a Nasdaq initiative that are all looking to clear various pieces of the derivatives business in the United States. How the landscape is going to look five years from now or 10 years from now is very difficult to forecast.
Q: How will the clearing market structure evolve with the new regulatory framework?
A: There is a tremendous amount of uncertainty. I think this is one of the things the drafters of Dodd-Frank Act didn’t think through clearly. The analogy that I like to make is the old story about the sorcerer’s apprentice who brings the brooms to life and then can’t control them. We’re in that situation right now. Who knows how this industry is going to evolve. Even Sen. Christopher Dodd will admit that we’re not going to see how this thing works until it goes into effect.
On one hand, from the cost-reduction and efficient risk management perspectives, consolidation into a relatively small number of multi-product clearinghouses will probably be beneficial. But that’s in tension with two other considerations. One is that we might have an oligopolistic industry. And also, the more important tension, considering the fact that the clearing mandate is intended to deal with systemic risk, if we have these huge clearinghouses, which themselves can fail, the failure of these big clearinghouses could be extremely devastating to the financial sector.
There are going to be forces pushing toward consolidation, there are going to be forces pushing toward fragmentation. I’ve heard from people in Europe in particular that exchanges and execution facilities are going to want to have some control over clearing and we’ve seen that evolution going back to the 2006-2007 timeframe. Exchanges are likely to want to have their own clearing silos and once again, from a risk perspective, that’s problematic.
You have all these forces interacting with one another in a very unpredictable way. The French want a clearing house in France and the British want a clearing house in Britain and the U.S. wants a clearing house in the United States. How this is going to play out is anybody’s guess and there are going to be a lot of unintended consequences, many of which will be rather sobering, if not frightening, to those that have been pushing clearing mandates. It’s one of those things – be careful what you wish for.
Q: What consequences is the industry facing?
A: There is a different kind of risk. A lot of advocates of central clearinghouses say, “It eliminates counterparty risk.” That’s not true. It’s just a different way of allocating it and managing it. And it can be better in some respects and it can be worse in other respects. It’s not necessarily clear what the net effect is going to be.
Q: Are we moving toward mandatory central clearing with the passage of Dodd-Frank?
A: We are definitely moving in that direction, but there are many different ways that the mandate can manifest itself in practice. We are going to have a lot of small fragmented single-product clearinghouses and we are going to have a few big multi-product clearinghouses. We can have fragmentation by jurisdiction.
Q: Which regulatory bodies will be charged with maintaining central clearing rules?
A: For securities-based swaps it will be the SEC. For other swaps, it will be CFTC. The Fed will also have prudential oversight over clearinghouses.
Q: What key issues do the industry regulators need to keep in mind when drafting the CCP rules?
A: The objective is to try to reduce systemic risk. Regulators shouldn’t operate under the assumption that forcing more things onto clearinghouses will reduce systemic risk. One thing they have to keep in mind is that the more risk you put on clearinghouses, the more difficult and illiquid products that you put on clearinghouses, the more vulnerable clearinghouses will be to various kinds of problems and potential disruptions and that can be its own systemic risk. One thing that concerns me is that there’s been such an evangelical zeal toward pushing clearinghouses, particularly from the CFTC and Chairman Gary Gensler, that I’m concerned there are unrealistic expectations.
Q: Is there a time frame that regulators have to accomplish this by?
A: They have 360 days from the passing of Dodd-Frank and they’re sweating bullets.
Q: Is that doable?
A: Will they get it done? Yes. Will they do it well? That’s more problematic. I’ve heard the people from the CFTC talk and they admit it’s a daunting task but they say, “We have our orders and we have to fulfill them and we don’t want to go back to Congress and ask for more time.” I think that they’re going to do something but there’s the old expression – marry in haste, repent at leisure.
Q: In general, was Dodd-Frank a good move for the OTC derivatives industry?
A: Well, there are two questions. Is it a bad move for OTC derivatives industry? I think it’s definitely going to impose additional costs, which is likely bad for the industry. But then the broader question – Is it good for financial markets and the economy at large? I am skeptical that clearing mandates will do that and I think they’re likely to make the markets less efficient and, at the same time, not generate the benefits in terms of reducing systemic risk that its advocates believe.
Hal Scott, Nomura Professor and Director of The Program on International Financial Systems at Harvard Law School and Director of the Committee on Capital Markets Regulation, talked to DerivAlert about the conflict of interest in clearinghouse ownership and what affect this issue has on market risk ahead of the CFTC open meeting on proposed rules under Dodd-Frank that took place on October 1st.
Q: Recently, you participated in a CFTC-SEC public roundtable on governance and conflicts of interest in the clearing and listing of swaps. Can you talk about the main conflicts of interest discussed at the roundtable?
A: The asserted conflict of interest is where the major dealer banks either own or control the clearinghouses. It is argued that since they make more money clearing these trades bilaterally they would not have an interest in bringing trades on to the clearinghouse. The banks would argue that this is not true. They would say they also benefit from having more trades in central clearing. That’s the basic conflict of interest.
Q: Why is it important to eliminate these conflicts of interest?
A: It’s important to try to maximize the number of trades that are brought to central clearing on the theory that this is good for the financial system as a whole because it reduces systemic risk.
Q: With the upcoming regulatory changes, would bilateral clearing be allowed in the new rules framework?
A: The Dodd-Frank Act will mandate central clearing for liquid standardized contracts. There’s the concern that because some members might have an interest in not having central clearing, they would now enter into contracts that were not standardized to avoid central clearing. It will be up to the regulators to make sure they’re not doing this.
Q: How can the industry go about mitigating these conflicts of interest?
A: Let me say what I think should not be done. I don’t think we should restrict the ownership of clearinghouses. I think ownership restrictions are not the way to go to deal with the conflicts of interest.
First, I think that it’s imperative to have a governance structure that ensures parties other than the major dealer banks have a say in how the clearinghouse works. That can be done by the concept of fair representation, which comes from the Securities Acts and applies to the stock exchanges. The stock exchanges were once controlled by their members. There were duties of fair representation for different user groups to be represented at the governance structure of the exchanges, and you can do the same thing in respect to the clearinghouses. Making sure that not just the dealer banks have a say in how the clearinghouses operate would be one way to deal with the conflict.
The second way would be to have the regulators ensure that things weren’t being done in these clearinghouses to evade the mandate of central clearing and that certain firms were not being excluded from being participants in the clearinghouse. The regulators would be in the background; they shouldn’t promulgate specific rules about these matters. They should be there to monitor that the clearinghouse adopts its rules.
Q: Are the regulators currently considering doing this? Is the ball in their court now?
A: This roundtable was for the regulators to get various points of view on what to do. Obviously they’re considering it. Whatever rules we adopt for these clearinghouses could have a major impact on market risk. For instance, there was one person at the roundtable who seemed to suggest that virtually every swap trader be a member of the clearinghouse, even if they’re a small firm. This could add a lot of risk. Clearinghouses have capital requirements for members. A clearinghouse is just an association, so it’s only as strong as the member firms. If you were hell-bent on fairness, and opened this thing to everybody, that would increase the risk to the clearinghouse.
I made the point that there was one regulator who should be at this table that was not there, which is the Federal Reserve. Although they were in the room, they should’ve been at the discussion table. They are the dominant systemic risk regulator. They have supervisory control over the major dealer banks. The Fed also has the power to extend discount window privileges to the clearinghouses; if a clearinghouse got into trouble, it could draw on the Fed’s liquidity. Without that, I don’t think the clearinghouse is very viable. The Federal Reserve also has a specifically created role to object to any rules that the SEC and CFTC promulgate that it feels are going to increase systemic risk. A prime participant in the conflict rules needs to be the Fed, because these rules can affect systemic risk and the Fed has a big role in that.
Q: As the Director of the Committee on Capital Markets Regulation, do you think the Dodd-Frank Act will benefit or hurt the OTC derivatives community?
A: Our goal is to have intelligent and empirically based capital market regulation. We have authored a very detailed letter on what to do with derivatives during the Dodd-Frank process.
Going forward, our committee is going to want to make our views known on what the right approach to regulation should be in the key areas, including derivatives.
Q: Do you think the Dodd-Frank Act will benefit or hurt the OTC derivatives community?
A: It’s too early to tell. In general, the framework that Dodd-Frank established for OTC derivatives is good. We needed more regulation. We needed to worry about the clearinghouses. Many of the issues the act touched on are good. But the real impact of Dodd-Frank will be reflected in the regulations that are adopted. We need to wait to see what those regulations are. I think as a general matter, the Dodd-Frank approach to derivatives, is good.
Q: When do regulators start to sit down and draft the rules?
A: There are some rules required by Dodd-Frank for which a specific time table is given. There are other rules for which there are no time tables. I think in general, for the complete implementation of Dodd-Frank, we’re looking at two to three years, which of course creates enormous uncertainty in the industry, which in turn can have a negative effect on economic growth. Many of these rules should require a cost-benefit analysis. This isn’t going to happen quickly. It is going to be a time-consuming process.
CFTC Chairman Gary Gensler traveled to Brussels the week September 27 to discuss various rules that will affect the OTC derivatives markets on both sides of the pond with European Commissioner Michel Barnier. After their meeting, the two released a joint statement solidifying the transatlantic intent to cooperate closely in strengthening the global financial system.
According to the joint statement, Commissioner Barnier and Chairman Gensler discussed several issues pertaining to enhancing oversight and reducing risk in the OTC derivatives market including:
- Comprehensive regulating of derivatives dealers for capital and margin, recordkeeping and reporting and business conduct standards
- Requiring standardized OTC derivatives to be cleared by central counterparties, imposing stringent prudential and organization rules for central counterparties and imposing risk mitigation standards for non-standardized contracts that are not centrally cleared
- Increasing transparency of the OTC derivatives market
Read the full joint statement here.
Tradeweb has issued a statement in response to the CFTC draft rules that were announced today:
"We are entirely supportive of the regulators' efforts to modernize the derivatives market, but the new rules need to encourage the growth of a competitive marketplace. Investment in trading and clearing venues by market participants has provided the seed capital leading to the creation of solutions that support the transparency and systemic risk reduction the Dodd-Frank Act seeks to achieve. Competition between clearing organizations, in particular, is best stimulated by rules that ensure open and equal access to DCO's for all SEFs and market participants. Failure to achieve a level playing field for DCO's runs the danger of forming a combined execution and clearing monopoly, stifling innovation and competition."
In reference to governance:
"Tradeweb is in favor of independent directors, but at this stage it is unclear what their role will be. For outside board members to be effective, their interests need to be aligned with investors and other stakeholders."