The Problem with Senator Lincoln's Mandatory Clearing

The Senate Agricultural Committee passed its Chair Blanche Lincoln's (D-AR) bill to revamp the derivatives market today. It will now take the place of the derivatives section in the Banking Committee's broader reform legislation. Lincoln's bill is the most aggressive attempt to date for reforming the shadowy world of Wall Street's most complex securities. It seeks to cast light in some of those dark corners so that investors and regulators can better understand the derivatives market. The sentiment is sensible, but not all of the ideas contained in the bill are as uncontroversial as they appear. One problematic suggestion: requiring virtually all derivatives to be cleared.

Currently, several clearing houses exist for derivatives. They act as sort of middle men that net out derivative obligations and ensure that all parties eventually get what they're owed, depending on how the derivatives perform. This might sound great, but mandatory clearing will impose a cost on the market.

The problem can be understood through an analogy. A clearing house is kind of like a bookie that takes bets, but doesn't set odds. Let's say Nick wants to bet that the New York Knicks will beat the Miami Heat. But another guy, Heath, thinks the Heat will win. They both contact a bookie named Clarence. If Nick knows Heath, then they could just bet each other, without Clarence's help. But if they make the bets through Clarence, then he will ensure that each party gets its winnings. A clearing house makes a similar promise to both investors in a derivative.

Now a bookie like Clarence probably has ways of dealing with people who don't pay up if they lose. For example, he might work with a thug who can track down a deadbeat gambler to make sure that Clarence gets what he's owed. After all, if the loser doesn't pay up, Clarence will have to pay the winner out of his own pocket.

Mandatory clearing would sort of force all investors to use a bookie for their derivative trades. But unlike Clarence in the example above, a clearing house doesn't have the benefit of a thug to break both of an investor's arms if he can't pay.

While this example might seem silly, it brings up a serious problem. Currently, not just anyone can utilize a clearing house for derivative trades. The parties must have strong credit quality, so that the clearing house has little worry that parties will default and not be able to cover their obligations. Otherwise, the clearing house will lose money and potentially default if the losses are high enough.

If clearing is mandatory, however, not only can anyone use a clearing house for their trades, they will be required to. This puts the creditworthiness of the clearing house in peril, and could jeopardize the stability of all the trades it clears. This problem is also touched on in this post about a separate new policy that would require Fannie Mae and Freddie Mac to clear their interest rate swaps.

There are certain ways clearing houses could attempt to deal with this problem. Perhaps they will require riskier investors to post more collateral to cover potential losses; perhaps they will require risk-based fees for clearing services. Lincoln's legislation doesn't appear to prohibit such possibilities, so the market would likely incorporate such changes if clearing becomes mandatory.

The result would probably be a little less liquidity and a little more expense in trading derivatives. That will likely stengthen big banks/investors and hurt smaller ones. Whether that's a good or bad thing depends on your perspective. But it does illustrate that clearing all derivative trades will come at a cost.