FRB Staff Considers Bilateral versus Central Clearing
Commentary by Bob Zwirb and Steven Lofchie
In a new working paper, staff at the Federal Reserve Board Divisions of Research and Statistics and of Monetary Affairs analyzed "the desirability of central versus bilateral clearing." They concluded that central clearing is not inherently preferable; rather, it "depend[s] on traders' characteristics and the institutional features defining the operation of the CCP." The authors argue that while mandatory clearing is intended to address the lack of transparency in OTC derivatives markets, the consequences "on the incentives of financial market participants to acquire information about each other are not well understood."
The authors stated that central clearing "may weaken [counterparties'] incentives to acquire and reveal information about such risks." As a result, they noted, crucial information about counterparty risk acquired in a bilateral relationship "may be lost when clearing services are transferred to a central counterparty which operates under commonly used loss allocation methods." Staff concluded that, notwithstanding the goal of regulators to reduce systemic risk, mandating clearing comes at a cost.
Commentary
While the authors' paper is highly technical and complex, their point is straightforward, i.e., for more complex products traded by large financial firms, mandating central clearing "may result in an increase in counterparty risk at the CCP." See Paper at 10-11. These are points that have been well developed by economist Craig Pirrong, whom the authors cite and quote in their paper.
Commentary
It is unfortunately unremarkable that while the creators of Dodd-Frank were tasked with considering the potential consequences of their gargantua, they overlooked some potential flaws. Kudos, on the other hand, to Mr. Pirrong and his independent and objective analyses. Here are some additional links to Cabinet news items in which Mr. Pirrong's Cassandra-like views on central clearing were reviewed.