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October 29, 2013

Craig Pirrong looks at the moral hazard problem in a clearing environment

Craig Pirrong (aka the Streetwise Professor) looks at the moral hazard problem firms face when considering if they want to clear or keep their derivatives trades bilateral.

The post is a worthwhile read as it takes the reader away from the more mundane "how do I comply with my regulatory requirements" towards the more in-depth thinking of why someone would decide to not clear.

Basically this is about the higher cost of clearing, especially for such firms that are cash-constrained and need to borrow with banks to fund their margin requirements.

A few highlights:

"I can show formally that if the firm already has debt outstanding, under standard pro rata/pari passu default loss allocation mechanisms, holding everything equal,  the bank’s default losses if it extends credit to the firm to fund margin almost always exceed, and never are smaller than*, the default losses that it would incur if it had entered an uncleared bilateral trade with the firm.  This, in turn, will make the cleared transaction more expensive for the cash-constrained firm, and it will prefer to trade the OTC product."

"This analysis implies that this cash constrained firm will choose to trade OTC rather than cleared products with defaulter pays margins funded with loans.  The bank is indifferent, because it will price the product or the loan to cover its costs, but the firm is always better off  with the bilateral trade because it has to pay the bank less if it trades OTC than if it borrows to fund margin." Craig also says that based on his analysis it makes sense to exempt such firms (e.g. corporate end users) from the clearing mandate. There, of course, are already regulatory standards out there exempting certain derivatives users or at least postponing their mandated participation in the clearing market (e.g. pension funds in Europe).

This train of thought by Craig, i.e. looking beyond the mere compliance to derivatives regulation, is mirrored in talks I have with industry participants, who are looking now at better risk management and cost effectiveness in the new normal of derivatives trading.


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