Just as the Patriot Act, felonious wiretapping and Iraq invasion plans were put in process prior to 9/11 by a handful of Nixonian operatives determined to reshape the United States government and Middle East geopolitical map, one begins to sense that some big financial players have carefully crafted plans to be rolled out as “solutions” to any convenient financial crisis that yields cries for reform.
One such plan that strikes me as worrying is a master plan for reforming global OTC derivatives markets toward a single central counterparty (CCP). The planners are the big institutions that provide leadership to these markets – the New York Fed and its core constituency of top tier derivatives dealers. They have been meeting for some time, at least four occasions that have been disclosed, and are now rolling out their plan for centralised clearing of OTC derivatives.
One doesn’t have to be a conspiracy theorist to see that it is sensible for this small coterie to plan and execute a long term strategy that promotes their collective self-interest. It stands to reason that they would rather be more powerful than less powerful, more profitable than less profitable. It is not unreasonable to suggest that one means of preserving power and profits requires imposing “solutions” to each “crisis” that institutionalise their influence over markets they dominate.
The proposals that have me wondering would initially concentrate clearing of credit default swaps and ultimately see all negotiated transactions centrally cleared and margined. The CCP will use the otherwise defunct Clearing Corporation based in Chicago and be owned by the same handful of banks that dominate 90 percent of trading.
Tim Geithner, president of the New York Fed, is the godfather of this plan. He first outlined it in a BIS report on OTC derivatives clearing and settlement in March 2007. Since then ISDA, the trade body for OTC derivatives dealers, has formalised the plan as a target architecture for OTC derivatives operations. Geithner recently hosted a meeting for the chosen seventeen shareholders of the CCP at the New York Fed to push the plan into realisation, setting a deadline for proposals of July 31st that leaves no scope for opposition or alternatives.
While I am happy to concede that there are real risks that are unaddressed in OTC derivatives markets, I am less happy to embrace a solution which would institutionalise huge power to manipulate these markets in the hands of banks which are themselves core dealers and prime brokers in these markets, accounting for 90 percent of trades.
If these seventeen banks, or a smaller subset of these banks, were to collaborate rather than compete, then they would be in a position to manipulate prices, manipulate credit, manipulate leverage, and manipulate margin calls for every traded commodity and every market counterparty. That would allow them to dictate who gains and who loses over time in these ill-transparent and under-regulated markets. If that manipulation were only exercised periodically and unpredictably, they would have very little risk of ever being challenged, investigated, prosecuted or sanctioned.
Think of the possibilities if such infrastructure were in unscrupulous hands. A target country would find their export commodities devalued until their resources were sold at bargain prices to the “right” multinational owners. A target counterparty would find their credit constrained at just the time when margins were raised or collateral devalued, making them a takeover patsy at a knockdown price and guaranteeing a swift profit to the lucky acquiror.
As in any casino, a team of sharks working together only has to shift the odds from 51-49 favouring the house to 51-49 favouring the sharks to win big money consistently. If they’ve co-opted the floor manager to look the other way, the likelihood of being challenged is massively reduced. If they own the casino, and are themselves the dealers, they can rig the tables to whatever odds they prefer to meet quarterly profit targets. If they co-opt the casino commission, hey baby, no worries. What happens in Vegas stays in Vegas.
The Geithner CCP proposal strikes me as mandating a casino where the seventeen dealers at the seventeen tables own the casino, control credit, control the odds, control the deal and can determine who wins and loses. If your only choice is to go from one rigged dealer-owned table to another rigged dealer-owned table run under common management, that isn’t much of a choice.
Oh, look! Geithner himself will regulate this CCP to give you that warm, cozy confidence that everything is on the level.
I have some other concerns about the proposal as well.
First, the determination to ressurect the defunct and lifeless Clearing Corporation rather than use an existing, proven clearinghouse like the CME or LCH-Clearnet is intriguing. The CME and LCH-Clearnet each have established track records of prudent and conscientious derivatives risk management and margin calculation, and have high standards of independent, objective risk modelling and asset pricing. For a market with as many pitfalls as credit derivatives, one can only wonder at the rationale that would favour an untried, uncapitalised, untransparent alternative. I am not the only one to find the determination of the dealers to shun existing clearinghouses surprising, as it has also raised eyebrows and suspicions in Chicago and London.
Second, it isn’t clear that a CCP will be any less prone to undue influence or flawed models than the rating agencies, monolines or other industry infrastructure which were involved in promoting the financial Ponzi schemes of the past decade. As the measurement of value and risk for credit derivatives will presumably use some variant of the flawed, opaque and error-riddled models that banks have used themselves, the scope for either accidental mis-pricing or deliberate manipulation is rather larger than for transparently traded and transparently priced exchange contracts in physical commodities or liquid financial indices.
Third, the move to a CCP seems to be without rationale or support in the context of the evolution of the OTC markets as negotiated markets for players able to judge and manage their own interests. At present the negotiated derivatives industry is largely ill transparent, operationally inefficient, difficult to regulate, prone to poor risk management, under capitalised and under margined. All of that contributes to a deservedly bad press and a lot of well merited concern about the scale of exposures and risk of systemic contagion. But reforms and industry efforts aimed at improving all aspects of derivatives trading, pricing, operations and supervision have to date respected the essential nature of the industry as bilaterally negotiated.
It is some leap to go from the current distributed, negotiated market mess to mandating a central counterparty clearing system. It is a leap further to suggest that there be only one CCP, with no choice or competition in CCP services from existing providers of complex derivatives clearing and margin operations and no invitation to them to develop appropriate services. It is a leap further still to suggest that the CCP be owned by seventeen for-profit dealers and prime brokers who are all facing a crisis in capital and profitability. To put it mildly, one might have some concerns about the independence of CCP governance and oversight. With the New York Fed as the principal cheerleader and proposed regulator for the CCP, it begins to look more CCCP than CCP.
Many of the objectives of risk identification, pricing improvement, liquidity improvement and counterparty risk management could be just as well addressed using distributed solutions and methods developed organically from the existing workings of the derivatives industry. This has been the traditional focus of ISDA efforts, leading the way in open standards for derivatives confirmations and distributed technologies for bilateral derivatives pricing, valuation, reconciliation, risk management and margining. Recent advances in secure financial networks and interoperability have put distributed solutions within cost-effective reach of even second and third-tier market counterparties.
Instead of a casino owned by the seventeen dealers who run seventeen tables, imagine instead a huge poker tournament where everyone is free to play with everyone else, forming tables and choosing dealers by whatever means they prefer. Any player can demand a new pack be dealt at any time. Any player can leave a table and take a seat at another table at any time. Any player can form a new table with themselves as dealer. Any player can ask any dealer or any other player for credit. Any player can propose an amendment to the rules, which if popular, will be adopted by other players at other tables.
In OTC derivatives today, if counterparties don’t agree on exposure valuations or collateral valuations, they margin on the basis of the least agreed amount and reconcile to figure out why there’s a difference. Counterparties can negotiate on what will be acceptable for margin, when it has to be delivered, whether there are large or small haircuts, and other operational matters. If one counterparty has a problem in its own operations or with an agent (and just about everyone uses agents in making payments or delivering collateral), then there is a custom of forebearance and tolerance while problems get sorted out. The danger of a CCP is inflexibility – no arguments, no negotiations, no slack. If a member doesn’t deliver exactly what is demanded exactly on time, the member is put into instantaneous default and is out of business. That’s fine when that’s what you’ve agreed to by trading on an exchange, and that’s what you’ve built your systems for, but maybe isn’t appropriate to every transaction in the negotiated off-exchange markets.
The difference between the negotiated margin and CCP is important. With the distributed model it is much harder to rig the odds or the outcomes to favour a handful of dealers over the great majority of punters in a way that will be sustainable over time.
For the wired crowd out there, one could frame it as the contest between Linux open standards and Windows proprietary standards. It’s as if Geithner is saying that open standards haven’t led to consistent adoption and applications, so there is a need to create and mandate Microsoft.
If you trust Geithner and his chosen seventeen banks to act in the best interests of all the millions of global economic and financial actors of the world who are affected by and deal in the global OTC derivatives markets, go ahead and back the CCP. If you have reservations about whether to trust them now or in future, you might want to consider looking around for an open, distributed solution that achieves the same fundamental objectives of improving OTC derivatives market transparency and risk management without the risks of a rigged casino.
You have until July 31st. Good luck.