Central Clearing and Systemic Risk

[Jefferson23]

Written by James Kwak
August 30, 2010 at 7:30 am



This guest post is by Ilya Podolyako, member of the Yale Law School Class of 2009 and a friend of mine. Ilya led the Progressive Economic Policy reading group with me and served as an adjunct professor of law at DePaul University this past spring.

One of the key provisions of the Dodd-Frank Act is Title VII, which requires all non-exempt derivatives transactions to go through a central clearinghouse (this report provides a good summary). As James and Simon have explained, the Dodd-Frank Act uses the term “swap” as a big basket that captures most financial products that we would normally call derivatives: options, repos, credit default swaps, currency swaps, interest rate swaps, etc.

Prior to the passage of the Act, most of these products were sold over-the-counter by certain large institutions. That is, in form, a transaction where you wanted to buy a credit default swap triggered by some event (say, the bankruptcy of Ford Automotive) resembled a trip to the car dealership. The dealer had inventory on the lot; this inventory was split into several different models / types of product; individual instances of a given model were relatively homogenous and varied mostly by color and minor adornments (spoilers, leather seats, etc.). If you were looking for a car of a given make and model that had certain extra features, a dealer might be able to get one custom-built for you at the factory, but you’d have to wait for the item and pay extra. Of course, the salesperson would not be able to accommodate all requests – if you show up to your average Chevy dealership and ask to buy a jet-powered car, you are likely to leave empty-handed no matter how much money you have, even though a few other individuals have been able to procure said exotic item.

From a structural perspective, an important characteristic of the new car market and other OTC markets is the absence of publicly available information about other transactions. Thus, when you show up to the dealership, you see only the sticker price, which is unlikely to be what prior customers actually paid to take drive the car off the lot. A related and notable feature of OTC markets is the ad hoc nature of customer-retailer pairings within them. That is, such markets usually have multiple parties independently striking their own deals for the same product; the coupling depends on chance, networks, and amenability to agreement. Predictably, in this environment, the final terms could differ quite drastically from one transaction to the other – prices could vary, some parties could be excused from performance in circumstances where others aren’t, warranties may apply to some sales but not others, etc.


remainder: http://baselinescenario.com/2010/08/30/central-clearing-and-systemic-risk/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+BaselineScenario+%28The+Baseline+Scenario%29