When the G20 met in Pittsburgh in 2009 and agreed to mandate clearing of many derivative securities, which at that time were being blamed for causing much of the then-ongoing financial crisis, many financial experts thought the problem was being well-addressed.
University of Houston finance Professor Craig Pirrong did not. In a recent paper, entitled A Bill of Goods:CCPs and Systemic Risk, Prof. Pirrong outlined why he thought mandated clearing and the use of a network of central counterparties (CCPs) for clearing likely will not reduce the risk the way the G20 member countries envisioned.
Traders spoke to Prof. Pirrong about his criticism of the CCP method, reducing systemic risk, and the current dispute between regulators in the U.S. and Europe that is roiling the global derivative clearing market.
Traders: In your paper, you argue that we are being sold a bill of goods in effect because the structure of mandated clearing through the use of CCPs will not fix the problem the G20 tried to fix. Why do you say that?
Prof. Pirrong: Overall, I have doubts that clearing itself will reduce systemic risk. In 2009, when the G20 in Pittsburgh decided that all governments would require clearing of OTC derivatives, they changed the way these products were to be cleared. Before that time it was bilateral swaps, which were the old way and just between the two parties, but now they decided we would all use CCPs.
Traders:Are the CCPs themselves the problem?
Prof. Pirrong:Not exactly, but its what they are being asked to do. Right now there are a smaller number of CCPs, each with a different approach but basically doing the same thing for different product classes. Their jobs are basically to set and collect margin for protection against failure; to use multilateral netting, which takes some intermediary players out of the contractual chain; and to handle collateralizing.
Traders:In your paper you are critical of multilateral netting-how does that work?
Prof. Pirrong:Simply put, if Party A sells a derivative security to Party B, who then sells it to C, who sells it to D and so on, to Party E as the final holder, then with multilateral netting, you would just have Party A and Party E with the exposure and the rest would be considered netted out of that contract. So it matters less about those in the middle.
But one of the problems is that regulators focused too much on multilateral netting as a cure-all, saying it makes exposures go away, but instead, it just spreads the risk.
Traders:Are there other problems with the way theyve structured the CCP clearing system?
Prof. Pirrong:Yes, margin risk poses an additional problem. In some cases, the CCPs set their collected margin at a high level, where it protects against about 99.7% of price moves. And now its mandatory to collect margin where before the crisis it was voluntary.
But that means that during a big market movement-like a financial crisis or crash-players may have to pony up cash at precisely the worst time. And this creates more stress on liquidity during a crisis.