The Office of Financial Research recently published a working paper on the question of how safe are the derivative clearinghouses that regulators set up in response to the Great Financial Crisis.
Short answer: not very.
I don’t want to say this result was easily predictable, but I observed these central clearinghouses would not increase the safety of the global financial system when they were first proposed and before their inclusion in the 2010 Dodd-Frank Act.
This working paper goes beyond just confirming my statement, it also confirmed my statement about the limits of regulatory stress tests.
We propose a general framework for estimating the likelihood of default by central counterparties (CCP) in derivatives markets. Unlike conventional stress testing approaches, which estimate the ability of a CCP to withstand nonpayment by its two largest counterparties, we study the direct and indirect effects of nonpayment by members and/or their clients through the full network of exposures. We illustrate the approach for the credit default swaps (CDS) market under shocks that are similar in magnitude to the Federal Reserve’s 2015 Comprehensive Capital Analysis and Review trading book shock. The analysis indicates that conventional stress testing approaches may underestimate the potential vulnerability of the main CCP for this market.
What the author discovered was banks don’t just trade derivatives through the clearinghouse, but also trade directly with each other. Financial contagion between banks can therefore spread through the clearinghouse as well as through direct exposure.
This is 2017.
It has taken seven years to acknowledge the central clearinghouses haven’t ended financial contagion. It can spread through these clearinghouses. It has taken seven years to also realize banks trade derivatives with each other that aren’t cleared by a central clearinghouse. Financial contagion can spread through these directly traded derivatives too.
At this pace, it will take seven more years before OFR realizes banks have much more exposure to each other than just derivatives and these exposures are also a source of financial contagion.
Regular readers know the financial system is based on the combination of transparency and caveat emptor. Transparency provides the disclosure so investors can assess the risk of any investment. Caveat emptor provides the incentive for investors to perform this risk assessment and limit their exposure to what they can afford to lose given the risk.
Banks are opaque black boxes. Nobody can assess their risk.
This means investors cannot exert market discipline on bankers to restrict their exposure to other banks to what each bank can afford to lose given the risk of these other banks.
As a result, bankers are free to take on much more exposure than their bank can afford to lose. And given how bankers’ pay is structured, they have an incentive to take on this extra exposure. To no one’s surprise, they do.
To its credit, OFR has stumbled upon the fact central clearinghouses only increase the stability of the financial system in theory. In reality, central clearinghouses actually make the financial system riskier by making it harder to assess how risky the financial system really is.