The Basics of Clearinghouse Efficiency: Fact or Fiction (Part 1)

Like the concept of energy conservation, I am of the belief that risk (as in the concept) cannot be created or eliminated.  It is always present in varying quantities and more importantly, interpretations.  There's risk in everything you do - relationships, career ventures, planned activities...you name it, there's inherent risk.  While it cannot be eliminated, there is the belief it can be mitigated and transferred.  This is where the clearinghouse concept becomes substantially more important - as a risk mitigator, not eliminator (you thought I was going to talk about risk in the framework of something scintillating!?  Like my love life, or more accurately, the current lack thereof?  Ha!).

Introduction:

The fairly opaque and esoteric concept of central clearing has taken a front seat post-financial crisis. Regulators find themselves at the front door of these clearinghouses ("CCPs" or "central counterparties") trying, with varying levels of success, to fully understand how these CCPs can fulfill their collective claim to eliminate bilateral risk through an actual crisis type environment. Future legislation, likely requiring central clearing of all OTC contracts, depends on this understanding. When and if this rule becomes mandatory, the collective risk of the financial industry will presumably sit at these CCPs. Across the industry, in anticipation of this legislation, increasing amounts of activity has been shifted to these clearinghouses, making them increasingly important to the dealers - and clients of these dealers - alike.

To the less informed, maybe I should introduce the concept of clearing in its most basic form. The way I understand it, and perhaps an intuitive way to sell it is:

-You have a buyer and seller of a contract. Think of a standard exchange-traded futures contract.

-Usually the risk is that the terms of the contract are not met on either the buyer or seller's behalf. Therefore, the risk to the buyer is to the seller (and vice versa). This is commonly known as bilateral risk, or the risk that the other buyer will not deliver on the obligations set forth in the futures contract.

-The idea of clearing is that there is a third-party or intermediary to the trade that "steps in" and effectively becomes the buyer to the seller and the seller to the buyer. This is what the clearinghouse does, and this action guarantees that the terms of trade will be met upon settlement or expiry (options). Therefore, the aforementioned bilateral risk shifts from being bilateral in nature to clearinghouse-facing.

-The ability of the clearinghouse to guarantee the risk of any given trade depends on the adequacy of its margining methodology, which is usually stress and back-tested to determine coverage of the contract's value to at least the 99% confidence interval.

With the very basics of how a clearinghouse operates explained, my question to you, fellow monkeys, is simple. How does the concept of central clearing do anything more than concentrate risk even more? To me, and maybe I'm thinking of it too simply, is that the concept of "too big to fail" shifts from the AIGs of the world to the DTCCs (a notable monopoly in the types of clearing services it provides). Ultimately, we have to depend that the clearinghouses are margining correctly, they are transparent enough, and that they can actually navigate through a situation where there are multiple contract (think in the thousands) defaults.

If napalm can be thought of as a more efficient way to blow things up (when compared to straight up gasoline), can we think of the clearinghouse as the financial equivalent of napalm? Is it a more sophisticated way of housing the same risk that caused the system to collapse to begin with?

Part 2 will explore the infrastructure of a clearinghouse (e.g. how a clearinghouse is owned, how the clearinghouse incentivizes its constituency (members) to not bring extreme amounts of risk into the system [because not ANYONE can become a clearing member], and the concept of risk mutualization)