While this is a very sound argument, I think it is, first, off-base and second, dangerous.
Here’s why it’s off-base. We believe the idea that OTC clearing would be a multi-billion dollar opportunity is overstated. Given that the swaps market, like any other market, will be dominated by a select number of major players, which may or may not be the same large global banks of today, we can expect that these dealers and heavy users will have significant influence over where they trade and how their trades are going to be cleared.
The less expensive the clearing, the greater the incentive will be to migrate clearing to that cost-effective venue – clearing competition. Given that clearing has been traditionally paid for by market participants and will be volume-weighted with the largest participants paying the most to the clearinghouse, the largest participants will have a significant incentive to pressure clearing firms to reduce fees to an “affordable” rate.
While this may mean that total clearing revenues may be measured in the billions, we think that it will most likely be in the low billions, $1 or $2 at most. Given that the ICE made $655 million from clearing CDS in 2009 – and we estimate that this is greater than the revenues from interest rate swap clearing – we believe that the market is currently at most $1 billion.
We also believe that increased competition and a reduction in dealer profitability from an OTC migration to SEF/exchange-traded will not allow the profitability of swaps to be compromised by dramatically increasing the cost of clearing on a macro basis.
At TABB Group, we cannot see this amount increasing dramatically, even with a clearing mandate. Eventually, this cost needs to be paid by the largest users, who are not unsophisticated and will easily see their pockets being picked by a clearing firm, ready to rebel if they feel abused.
The other major problem is risk. Clearinghouses are set up to mutualize risk, which means if one player defaults and their margin and default fund contributions do not cover their loss, the loss must be shared with other clearinghouse members. The larger the participants, the greater positions, the more significant the risk, the greater the margin and the default fund contributions. This is why clearinghouses such as LCH Clearnet and ICE have Tier I capital mandates of $5 billion. That way, if the market tanks and a major dealer goes under, the clearinghouse margin and capital, backstopped by the other dealers, will have the financial wherewithal to withstand the crisis.
Reducing the amount of capital needed to become a member to $50 million from $5 billion means that there will be a larger number of smaller players. Although these players may be financially more stable than the larger banks, they will be by definition smaller. With a greater number of smaller players, there will be more dealers to supervise, regulate and financially monitor to ensure their safety. If these dealers are not adequately capitalized, the larger dealers will be financially guaranteeing the smaller ones, as larger dealers, given that the risk is not concentrated, can bail out smaller dealers. But it would be difficult, if not impossible, for smaller players to bail out the larger dealers.
In addition, now with a mandated Federal Reserve/Central Bank guarantee, clearinghouses will be able to tap central bank liquidity in case of an emergency. If a clearinghouse got into financial trouble, it could go to the central bank for a loan, leaving the government (and taxpayers) as the central guarantor of the clearinghouse.
Putting this all together, the migration from OTC to centrally cleared/SEF (exchange-traded) swaps will reduce the profitability of large dealers who will look to pressure clearing houses to reduce their fees.
Responding to cost pressures, the clearinghouses will open themselves up to a larger number of smaller participants, who may or may not be financially stable, and compete over the lowest fees, margin and default fund contributions.
This will make the clearinghouse less safe and more likely to get into financial trouble. When they do experience trouble, they will have fewer resources (lower margin and default fund contributions) available to bail themselves out. As the default funds are used to offset the loss, the losses must be taken as a financial loss, which could jeopardize the health of the smaller dealers. As these dealers default, it would increase the burden on the remaining dealers who agreed to mutually share the clearing risk.
This could spiral easily until the largest dealers would not need to bail out only the initial defaulters, but the entire market.
Who picks up the bill? The Federal Reserve/Central Bank (taxpayers), who now backstop this whole mess.
Unless we want clearinghouses to become a systematically important risk magnifier, we need to be careful who we let into the clearing club; make sure they are financially healthy; ensure they have the deep pockets to withstand not only a self-created crushing loss, but a systematic (multi-dealer) crushing loss; and make sure that the clearinghouses do not have a mandated Federal Reserve/Central Bank/taxpayer implicit or explicit guarantee.
Otherwise we are creating a race to the bottom that incentivizes firms to take risks, clearinghouses to magnify those risks and governments (taxpayers) to pick up the bill.
In other words, when you are dealing with OTC derivatives turnover measured in the thousands of trillions of dollars (quadrillions), any systemic problem will make the credit crisis look like a walk in the park.