FRB Governor Powell Wants to Expand Central Clearing
Commentary by Steven Lofchie
Board of Governors of the Federal Reserve System ("FRB") Governor Jerome H. Powell reviewed the progress made in central counterparty ("CCP") clearing and offered his thoughts on expanded central clearing for the repurchase markets.
Speaking at the Clearing House Annual Conference, Mr. Powell asserted the benefits of central clearing under the right circumstances, but added that central clearing itself "is not a panacea." As risks accumulate, he said, CCPs must continue to "build up their ability to manage them" and plan for "a world in which large firms will fail and be resolved without government support." Mr. Powell voiced his recognition of the progress being made in this area, such as in major U.S. financial institutions' cooperation with market infrastructures around the world, as well as in over 70 percent of new U.S. interest rate and credit derivatives that are now centrally cleared. However, he also said that the financial community's work is not yet done.
Weighing the bad against the good, Mr. Powell noted that higher regulatory costs forced banks to hold more liquid assets (which he argued "has unquestionably made them safer") but also "raised their balance sheet costs and thereby created incentives to scale back on less profitable business lines." With regard to clearing specifically, Mr. Powell said that the "higher cost of funding for large financial institutions has made these liquidity arrangements substantially more expensive and more difficult to obtain. Given the balance sheet costs involved, financial institutions may also be less willing to hold cash deposits on behalf of their CCP clients."
One area that demands continued efforts to mandate central clearing is the repo market, Mr. Powell maintained. He recommended that clearing be limited to those assets that are highly liquid and are expected to remain so even under severely stressed market conditions. Because any model for expanded repo clearing will have to satisfy stringent regulatory requirements, regulators should be open to emerging clearing solutions that allow such models to provide substantial benefits and to meet these standards. He argued that this may be particularly true for repo trading in government and agency securities, since new regulations require financial institutions to hold such high-quality collateral under the assumption that it can be converted to cash quickly. Therefore, it is important to consider ways to support their continued liquidity whenever possible, he said.
Commentary
Governor Powell argues for expanded clearing even as he observes that banks are cutting down on providing clearing services (which will make it harder for market participants to hedge and exacerbate concentration risks), and that banks don't want to hold cash for customers who clear (a result that does not seem positive).
Mr. Powell's observation that a very large percentage of plain-vanilla swap trades are now centrally cleared is, for purposes of systemic risk, largely unimportant. As Center for Financial Stability Senior Fellow and NYU Professor (and former private market employee) Bruce Tuckman said about the aftermath of the 2008 financial crisis, "because Lehman's [over-the-counter] derivatives books were relatively liquid and balanced, the derivatives' liquidation did not disrupt the financial system. . . . [N]o derivatives counterparty failed because of having lost or having to replace its derivatives contracts with Lehman. In fact, in subsequent regulatory filings, only two of Lehman's major derivatives counterparties even mentioned losses from the termination and replacement of derivatives contracts."
To put this another way: cleared products can be liquidated quite successfully, even if only on a massive scale, but so can uncleared products. Ultimately, the ability to liquidate financial transactions depends on the size and depth of the market for the product. In a deep market, liquidation on a massive scale can go well, but this has nothing to do with whether or not the product is cleared; it has to do with the size of the trading market alone. What makes Professor Tuckman's observation even more trenchant is this: all regulators likely would agree that a system of central clearing is only effective when the underlying product has a deep and liquid market. Clearing is a workable tool in liquidation, but only when used for those types of transactions in which it is completely irrelevant.
In the face of growing acknowledgement that the benefits of central clearing were oversold, and the concentration and liquidity risks caused by it, largely ignored, it is neither logical nor prudent to push for an expansion of the clearing mandate. Still, the regulators continue to push on with mandated central clearing while disregarding the risk/benefit analysis. Perhaps wikiHow can provide some help for regulators' obsession with central clearing - an obsession that has lasted long after the glow should be gone.
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