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March 2, 2012

CQ&D Cover Story: For Better Or For Worse

Why The Clearinghouse Solution Could Have Its Own Difficulties

By Gregory Bresiger

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Sometimes the solution to a problem-such as the current dangers inherent in the over-the-counter derivative trade-is as bad as, or worse than, the problem.

The use of the clearinghouse, or central clearing counterparty (CCP) has been anointed by lawmakers as the way to prevent a repeat of the disasters that sprung from OTC derivatives trading in 2008. This market is huge-a few years ago, it was pegged at around $600 trillion in notional value, according to the Bank for International Settlements. But now some regulators and market observers want to examine the supposed solution, the clearinghouse/CCP. And these are institutions, like dealers, that haven't always been 100 percent foolproof-in one instance, one Hong Kong clearinghouse went under during the 1987 crash.

So what is the case for the reform of the OTC derivative trade going through the exchange instead of on a bilateral, dealer-to-dealer basis?

"Clearinghouses are designed to mitigate risk. Day to day, they plan for the worst-case scenario and how it can be managed, all within a highly regulated structure," said Chris Jones, executive director and head of risk management for LCH.Clearnet.

Chris Jones, LCH.Clearnet

Jones adds that clearinghouses are better equipped to handle market shocks than dealers.
His proof? LCH.Clearnet lived through the disasters of 2008.

"We were the first clearinghouse to manage an OTC default when we managed Lehman Brothers' $9 trillion interest rate swap portfolio," Jones said.


Several factors, he said, allow the clearinghouse to weather the worst storms of the market. Among these are the pooled risk feature of the clearinghouse and the open nature of clearing OTC derivative trades through public exchanges.

Left unsaid by Jones: The clearinghouse model is much safer and more transparent than the opaque quality of privately transacting these trades. It is less dangerous than the dealer-to-dealer model. Indeed, this was the language used by lawmakers in the Dodd-Frank Act of 2010.

See Sidebar: See How They Clear

"Clearing more derivatives through well-regulated central counterparties will benefit the public by reducing costs and risks to the American taxpayers, the financial system and market," Dodd-Frank reads. The huge financial reform law, which numbers around a thousand pages and is in the process of being interpreted by various regulators, also calls for "a fair and open access to clearing."