Derivatives Regulation 101: Central Clearing of Over-the-Counter Derivatives Deals

Everyone I know is for a “tough” derivatives regulation title in the financial reform bill, but there’s relatively little clarity over what that means. This is particularly confusing because there are two distinct elements of this which sound similar. One has to do with whether standardized derivatives ought to be forced onto exchanges (the way stocks are generally trades on exchanges, rather than sold party-to-party) and the other is whether there ought to be a central clearinghouse that financially intermediates derivatives deals. For about a month, I took it to be the case that these were two phrases for the same idea, but they’re actually distinct and it’s important to see that the clearing issue is much more important.

This IMF paper includes a helpful graphic:

Even if A has no contracts with say, B, if B has a contract with C or D and A has one with C or D, then the failure of B could still affect the ability of C or D to fulfill its contract with A. But when a CCP [i.e., central counterparty] takes all sides in transactions, A’s exposure is only to the central clearinghouse, which nets out all the individual exposure (See Chart 2, right-hand panel). Not only are counterparty risks reduced (although not eliminated because the CCP has risks), so are their operational risks because clearing is done with one counterparty rather than with many.

Basically under the current system, it’s not clear where the risks lie — a blowup anywhere in the system can create problems in surprising new places. Centralizing the transactions in this way doesn’t eliminate risk, but it does at least mean that you know where to look. This is probably the single most important piece in the derivatives reform world.



I should clarify that the bill that passed the Agriculture Committee does well on this score. It also contains various “tough” provisions that have nothing to do with this and are arguably ill-advised. If Lincoln’s bill gets “watered-down” by reducing that other stuff and the clearinghouse language is left in place, then you’ve still got a very good derivatives title.