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"Streetwise Professor" Craig Pirrong Considers Effects of Central Clearing on Dealer Exposure

In a blog post titled "An Elegant Answer to the Wrong Question (or an Incomplete One)," University of Houston finance professor Craig Pirrong discussed dealer exposure as described in a recent paper published by the Federal Reserve Bank of New York. The paper examined the effect of introducing a central clearing counterparty ("CCP") on the expected net exposures of dealers.

In the paper, authors Rodney Garratt and Peter Zimmerman find that with a variety of network structures, clearing reduces netting efficiency and increases CCP risk exposures. The authors show that when the system relies on relatively few crucial nodes, clearing reduces netting efficiency, which could explain why clearing has not been adopted voluntarily and also raises doubts about the advisability of clearing mandates.

According to Mr. Pirrong, it is not surprising that interventions which lead to dramatic alterations to networks increase CCP risk exposures, since existing networks must be configured to reduce these exposures. However, Mr. Pirrong argued, the paper's focus is too narrow: "to analyze systemic risk, you need to analyze the system, not a piece of it."

Additionally, Mr. Pirrong noted, "shuffling around credit risk is probably not the most important effect of clearing mandates," even though it receives the most attention. In reality, Mr. Pirrong stated, it is the way in which clearing reduces credit risk and thereby increases liquidity risk and liquidity needs that creates the "huge potential systemic risk."

Overall, Mr. Pirrong said, the paper is "very elegant and technically sophisticated," but asks either the wrong question or one that remains incomplete.

See: "An Elegant Answer to the Wrong Question (or an Incomplete One)," by Streetwise Professor Craig Pirrong.
Related news: NY Fed Releases Paper Regarding Central Clearing (with Lofchie Comment) (March 25, 2015).

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