STANDARDIZATION AND CLEARINGHOUSES AS TOOLS FOR LESSENING SYSTEMIC RISK IN FORWARD TRANSACTIONS

1. Federal Reserve Bank of Atlanta Financial Markets Conference May 12, 2009 STANDARDIZATION AND CLEARINGHOUSES AS TOOLS FOR LESSENING SYSTEMIC RISK IN FORWARD TRANSACTIONS Edward J. Kane Boston College

2. IN MARKETS WHERE IT EXISTS, SYSTEMIC RISK ARISES AS AN EXTERNAL OR SOCIAL COST GENERATED BY PRIVATE TRADERS THREE CATEGORIES OF PRIVATE COSTS • Explicit Transactions Costs 1) Entry Costs 2) Exit Costs • Costs of Ameliorating Counterparty Risk (i.e., reducing the probability of “fails”) 1) Predeal data gathering, assessment, and pricing 2) Postdeal monitoring and contract enforcement • Costs of Aligning contract terms with idiosyncratic portfolio goals

3. EFFECT OF SAFETY NET • COSTS INCURRED BY SAFETY-NET MANAGERS SUBSTITUTE for Costs of private amelioration and increase with the leverage imbedded in positions traded and in the volatility of returns on underlying instruments • Costs of Systemic Risk Measurement and Analysis • Costs of Designing and Executing Out-of-Crisis Mitigation Programs • Costs of Planning and Implementing Schemes for rescuing over-extended traders or mitigating the losses their counterparties might suffer

4. WHAT IS THE PUBLIC-POLICY PROBLEM? • It is not devising policies to minimize private trading costs over time. (Counterparties have strong incentives to do this by Bonding, Transparency, and Deterrency) • In forward markets, systemic risk develops from incentives for managers of difficult-to-fail financial institutions to devise new and hard-to-monitor ways of extracting implicit subsidies from the safety net: Taxpayer is viewed with little empathy as a sucker who does not deserve an even break. • Private benefits from any financial innovation have an efficiency component and a regulatory component (its safety-net implications). • Under the current regime, the implicit value of safety-net benefits do not begin to become explicit until authorities undertake to rescue distressed (i.e., overextended or insolvent) firms (such as GSEs or AIG) or to “liquify” the markets for troubled instruments.

5. SAFETY-NET SUBSIDIES TO CDS DEALERS • In an OTC swap market: each dealer bonds its promise to perform its side of a swap with its reputation, its alleged expertise, its enterprise-contributed capital, and explicit and implicit guarantees from its government. Whenever (as now) authorities treat major CDS dealers as too difficult to fail and unwind (TDFU) and (2) liquidity in this market as important to sustain, TDFU dealers will enjoy substantial safety-net subsidies. Moreover, these subsidies will grow when either enterprise-contributed capital or reputations falter. This is and the monopoly rents the subsidies support explain why members of ISDA, though willing to make concessions with respect to clearing, are fighting hard to keep control of trading rules. • In a traditional exchange: the safety net is better insulated: • Brokers screen traders and guarantee the performance of trades they are allowed to book on the exchange; • The exchange monitors and disciplines brokers and sets trading rules; clearing members jointly and severally guarantee performance to back up broker guarantees; • The exchange may or may not itself be TDFU.

6. TDFU SUBSIDIES HAMPER OPPORTUNITIES FOR OTHER FIRMS TO SERVICE GROWING TRADING VOLUME IN FORWARD INSTRUMENTS SUCH AS CREDIT DEFAULT SWAPS • Entry of new market makers would be facilitated by clearinghouse regulation of margins and trading halts and by supervision of participating brokers’ condition, expertise, and behavior • Costs of exiting positions can be reduced by central clearing • Safety-net costs are likely to be reduced by giving regulators access to either centralized-registry or clearinghouse information of positions taken (alignment of interests for clearinghouse at least vis-à-vis “fails”)

7. THE KEY POLICY PROBLEM IN FORWARD MARKETS IS RECOGNIZING, MEASURING, AND MANAGING THE IMPLICIT SAFETY-NET BENEFITS THAT TDFU MARKET-MAKERS AND COUNTERPARTIES EXTRACT • In Credit Default Swaps (CDS), safety-net subsidies greatly retarded the natural evolution of customized deals traded in over-the-counter (OTC) markets to standardized instruments traded on an exchange or registered or cleared on a central platform • As long as the principal market-makers had the size, clout, and complexity to be perceived as too difficult for authorities to fail and unwind (TDFU), potential net-benefits from introducing centralized clearing and clearinghouse guarantees required a crisis to demonstrate.

8. TDFU MARKET-MAKING INVITES TROUBLE, BUT MANY ORGANIZATIONAL ALTERNATIVES TO MARKET-MAKING BY TDFU INSTITUTIONS DESERVE TO BE CONSIDERED • Central Registry for Trades that would be administered either by -- or on behalf of -- Safety-Net Managers • Government Agency or a “College of Agencies” might undertake this monitoring role and add expert analysis • Regulators might Outsource the Monitoring Function Instead [e.g., to a proposed NIF] • Centralized Clearing Platforms [Fungibility Encourages STANDARDIZATION] • Clearinghouse tiering of Broker and Clearinghouse Performance Guarantees • With Clearinghouse organized as a Partnership • With Clearinghouse organized as an LLC