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Clearinghouse Over-Confidence

CAMBRIDGE – To reduce the chance that a financial meltdown like that of 2007-2008 will recur, regulators are now seeking to buttress institutions for the longer-run – at least when they can turn their attention from immediate crises like those of Greece’s debt, America’s ceiling on governmental borrowing, and the potential eurozone contagion from sovereign debt to bank debt. Central to their effort has been to bolster clearinghouses for derivatives – instruments that exacerbated the implosion at AIG and others in the last financial crisis. But a clearinghouse is no panacea, and its limits, although easy to miss, are far-reaching.

When a company seeks to protect itself from currency fluctuation, it can reduce its exposure to the target currency with a derivative (for example, it promises to pay its trading partner if the euro rises, but gets paid if it falls). Although the company using the derivative reduces its exposure to the risk of a failing euro, the derivative comes packaged with a new risk – counterparty risk. The company risks that if its trading partner fails – as AIG, Bear Stearns, and Lehman did – it won’t be paid if the euro falls.

Worse, as we saw in the financial crisis, if many financial institutions have many such contracts, a rumor of insolvency can induce all of one institution’s derivative counterparties to demand collateral or payment simultaneously, triggering a run that resembles a classic bank run, which could then spread to other firms.

To reduce the risk of runs in derivatives markets, regulators around the world are poised to require that derivatives trades be carried out through clearinghouses or exchanges. The clearinghouses will have many advantages, but not as many as regulators might think.