Tuesday, March 30, 2010

Important Notes about Financial Exchanges/Clearinghouses

I've mentioned a few times that I think that putting standardized off-exchange securities on an exchange would be useful. I still stand by that point.
However, there's a tendency to believe that exchanges are invincible, and thus that putting EVERYTHING on an exchange would be a good thing. 
This is a terrible, terrible idea. Exchanges are just as able to fail as any other institution - it just makes the threshold of failure much higher because you don't have an "individual actors are interconnected" problem. The exchanges can still be left holding the bag and require large bailouts if quoted prices don't reflect the actual prices available for that security at quantity.
Thus, exchanges only work for standardized contracts. There are many types of futures and swaps which have standard terms and could be easily exchange-placed. There are many other kinds of forwards and other derivatives that cannot and should not be exchanged - that just obscures the risk picture and makes participant have to judge the viability of the exchange and all of its partners, instead of just its particular counterparties.
"In order to properly manage counterparty risk, a clearinghouse needs to be able to accurately price the instruments it clears. Clearinghouses manage counterparty exposure by requiring counterparties to post initial margin at the beginning of the trade, and — crucially — daily variation margin. As explained by Robert Bliss and Robert Steigerwald in a Chicago Fed paper:
Margining systems are designed to ensure that in the event that a clearing member fails to meet a margin call, sufficient funds remain readily available to close out the member's positions without loss to the CCP in most market conditions. As a complementary risk-management mechanism, the gains and losses from open positions are posted to a clearing member's margin account on a regular (usually daily) basis and result in calls for variation settlement (or variation margin). The variation settlement reflects periodic mark-to-market fluctuations and is an important mechanism for assuring the collateral held by the CCP is likely to be sufficient to meet the needs of the CCP in the event of a default.
Given the extent to which clearinghouses rely on market prices to mitigate counterparty risk (which is, after all, the main reason we're pushing central clearing in the OTC derivatives space), it's absolutely crucial that the mark-to-market prices be reasonably accurate. Reliable mark-to-market pricing, of course, requires a liquid market."
The article goes on to point out that AIG Financial Products acted as a pseudo-exchange for illiquid securities, and got wrecked.

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