Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Liquidation efficiency of CCPs (clearing corporations)

Earlier this week, I wrote a blog post applying the Gorton-Metrick idea of contractual liquidation efficiency to CCPs or clearing corporations. After that, I came across an interesting paper by Richard Squire (December 2012) arguing that the only real benefit of a clearing house is speed and certainty of liquidation and that this benefit obtains even if the clearing house itself is insolvent.

Squire accepts the arguments of Pirrong and others that the risk reduction benefits of central clearing are dubious (risk reduction in one part of the system comes at the cost of greater risk elsewhere in the system). Yet CCPs are valuable because they speed up the bankruptcy process and give greater certainty to all creditors (even those who are outside the clearing house).

It is clear that Squire has a point. The worst part of the Lehman bankruptcy was that counter parties had their money trapped in the bankruptcy court for years without either liquidity or certainty.

Four years after Lehman filed for protection under Chapter 11, the Lehman estate still held $14.3 billion in restricted cash, which included $10.9 billion in a reserve fund for paying out unsecured claims. (Page 37)

Squire points out how the normal bankruptcy process is designed to be extremely slow:

To distribute assets among creditors, a bankruptcy trustee must do two things. First, she must determine what the assets are worth, which she can do through financial valuation methods or with an auction that converts the assets to cash. Second, she must determine the amount of the debtor’s liabilities, which requires her to collect all creditor proofs of claim and resolve challenges to their enforceability and amounts. Given these requirements, it is difficult to think of a slower rule for distributing debtor assets than the pro rata rule. Under that rule, each creditor is paid according to the ratio between the amount of his claim and the debtor’s total liabilities. It follows that all liabilities must be confirmed and valuated before any creditor can be paid. (Page 36)

The clearing house speeds up this process enormously and provides greater liquidity and certainty. More importantly, this is not at the cost of other creditors of the bankrupt entity:

Unlike netting’s purely redistributive consequences, its payout-acceleration benefit is not zero-sum. Thus, the faster payouts for the clearinghouse members are not the result of slower payouts for the outside creditors. To the contrary, netting simplifies the work of the failed member’s bankruptcy trustee, which might permit the outside creditors also to be paid more quickly than they would otherwise. … And while the arithmetical amounts of their payouts will be reduced by netting’s redistributive effect, the loss may partly be neutralized by the fact that the smaller scope of the bankruptcy estate may save on administrative costs and hence leave more value left over for creditors. Netting therefore is clearly a source of value creation. (Page 38)

The most important part of the paper is the argument that the benefits of netting would remain even if the clearing house itself is bankrupt.

Whereas creditors typically insist on being paid in cash, they are generally willing to accept cancellation of their own debts as payment for their own claims. And netting within the clearinghouse increases the opportunities for this to occur. … Because of netting, Firm A is, in effect, able to take [an IOU from Firm C] and force Firm B to accept it in satisfaction of Firm A’s debt to Firm B. And Firm B, in turn, can take the same IOU and use it to repay its $100 debt to Firm C. Since the IOU is now back in the hands of its issuer, it is cancelled. No cash has changed hands, and therefore none been paid into a bankruptcy estate. And because each transfer of the IOU occurs through setoff rights, the transfers can occur even if the clearinghouse is bankrupt. This capacity for a clearinghouse to transform a debt obligation into a medium of exchange as good as cash is of obvious social value during a liquidity shortage. (Page 42)

I am now even more convinced that CCPs (clearing houses) must be designed to fail gracefully. Many of them have done so through loss allocation rules for each segment that effectively cap the liability of the CCP and make it less likely that it goes bust. We must extend the scope of these mechanisms to make it almost impossible for a CCP to become bankrupt just as securitization waterfalls make it almost impossible for an SPV to become bankrupt. Such rules are the only way to prevent the need for bailing out the CCP and engendering moral hazard through the process.

If we see CCPs not as a magic bullet to eliminate risk, but as a legal mechanism to achieve fast bankruptcy with high legal certainty for payouts, then the CCP becomes more and more like a CDO than an over regulated financial infrastructure. This would be a great achievement because it solves the dilemma that forces regulators to either regulate CCPs as utilities and forgo the benefits of competition or allow free competition and see a race to the bottom in risk management. By pushing the risks of CCP failure back to the users of the CCP, a mandatory loss allocation mechanism (like a CDO waterfall clause), allows competition to work its usual magic without creating systemic risk or moral hazard. The world should then be able to withstand a credit event at even the largest CCPs like LCH.Clearnet, CME Clearing or Eurex Clearing. Similarly, India should then be able to withstand a credit event at its largest CCPs like CCIL or NSCCL.

Post crisis, regulators have expended much energy on resolution mechanisms to eliminate the “too big to fail” problem. I think resolution mechanisms need to draw upon lessons learnt from securitization and CDOs about how to make this work. I often say that the key purpose of resolution is not to ensure that firms do not die, but to ensure that when they do die, there are no stinking corpses. CDOs and securitization SPVs have shown how this can be done effectively – these methods have proven themselves on the ground and have stood the test of time. Instead of designing resolution mechanisms on a clean slate, regulators should take these proven methods and extend their scope and application to cover large swathes of the financial sector.

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