Professor Craig Pirrong Comments on the Prospect of Nationalizing Clearinghouses
Commentary by Bob Zwirb
In an online commentary, University of Houston Finance Professor Craig Pirrong discussed Law Professor Stephen J. Lubben's recent article arguing for the nationalization of failing clearinghouses ("CCPs"). Professor Pirrong agreed with many (though not all) of Professor's Lubben's points, particularly the idea that temporary nationalization, with a preestablished procedure for subsequent privatization, is reasonable and would ensure the continued operations of a CCP. Professor Pirrong went on to argue, however, that it is important not to exaggerate the benefits of nationalization, and described potentially problematic outcomes of certain aspects of it.
In Mr. Pirrong's prior paper, which was published in the Journal of Financial Market Infrastructures in May 2014, he argued that, contrary to the opinion of various clearing advocates, mandating the central clearing of OTC derivatives is no guarantee of reducing systemic risk.
See: "Nationalize the Clearinghouses?" by Craig Pirrong, Streetwise Professor; "A Bill of Goods: CCPs and Systemic Risk," by Craig Pirrong; Interview with Mr. Pirrong on tradersmagazine.com. Related news: Law Professor Stephen J. Lubben Calls for Nationalization in the Event of the Insolvency of a CCP (with Lofchie Comment) (August 8, 2014).
Commentary
In 2010 in an op-ed piece titled "Clearinghouses Are the Answer," then CFTC Chairman Gary Gensler argued that a central lesson of the financial crisis was that some financial institutions had become "too interconnected to fail," and that "[t]his interconnectedness [wa]s a direct result of the unregulated over-the-counter derivatives market where financial institutions are contractually obligated to each other through trillions of dollars of derivatives contracts." Gensler, "Clearinghouses Are the Answer: Complex derivatives should be regulated like commodity futures," Wall Street Journal (Apr. 21, 2010). He proposed central clearing as the solution to this problem.
The value in economist Craig Pirrong's paper is in subjecting this flawed wisdom, which is shared by regulators, to a more holistic economic analysis, and in demonstrating that central clearing offers "dubious protection against systemic risk."
Take, for example, the notion of "interconnectedness." If that is the problem, then mandatory central clearing as envisioned by reformers doesn't solve it, for central clearing creates the mother of all interconnected systems. Moreover, contrary to conventional wisdom, central clearing does not reduce risk, but instead, as Pirrong demonstrates, redistributes it; while mandated clearing may constrict one channel of contagion, it widens others. In addition, central clearing, as Federal Reserve Governor Jerome H. Powell points out, has its own set of risks, including that of "concentrating risk in a central counterparty [that] could create a single point of failure for the entire [financial] system." "OTC Market Infrastructure Reform: Opportunities and Challenges," a speech by Federal Reserve Board Governor Jerome H. Powell at the Clearing House 2013 Annual Meeting, New York, New York (Nov. 21, 2013), available here. Indeed, as Pirrong points out, CCPs are most vulnerable to default precisely at the point in time when their advocates look to them to be the breaks that contain financial firestorms.