FX Clearing Houses: Exacerbating Systematic Risk

In his megalomaniacal effort to use the financial crisis as a Trojan horse to advance his campaign “on every front to increase the role of government,” Barney Frank is hellbent on fixing things that demonstrably didn’t break. Even under the extreme stresses of the crisis. Case in point: he wants to require clearing of foreign exchange derivatives transactions:

If it didn’t break, why fix it?

That is the question being asked by foreign exchange bankers after Barney Frank, chairman of the House Financial Services committee, announced currency derivatives would not, after all, get an exemption from proposed US rules that would require all derivatives trades to be processed through a centralised clearing system.

Mr Frank’s move came as policymakers are debating the detail of legislative proposals designed to increase transparency and reduce risk in the vast over-the-counter derivatives market. While the proposals are not final, the U-turn on his previous stance has stunned the FX market.

Get used to it, guys. Barney’s all about the u-turns, pace his volte face on clearing and exchange trading in his obviously thoughtfully considered OTC regulation bill.

The FX folks point out some things I mentioned months ago, such as the fact that clearinghouses can concentrate risk, and therefore exacerbate systemic risks:

Bankers have also warned that clearing in FX could create new concentration dangers which they fear could create fresh systemic risk, given the size and significance of the FX market. The market is already concentrated among a handful of top international banks.

But it is Barbara Matthews that brings out the key point:

Barbara Matthews, managing director of BCM International Regulatory Analytics, believes there is a general issue to be considered about concentrating so many markets on to clearing platforms. She warned that policymakers must be aware that clearing houses could create new “choke points” in the system – not unlike the risk created now by any large bank – which must be considered carefully. “Its perfectly natural in a time of uncertainty to look towards some kind of central arrangement,” she said. “But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.”

That last bit bears repeating:

But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.

Exactly right. Those who have advocated clearing mandates–Geithner, Gensler, and Frank most prominently–commonly assert that clearing eliminates counterparty risk.

Wrong. It doesn’t. It reallocates it.

The only question is whether they know better and are lying, or are ignorant. Either way, they're selling a bill of goods, and as Barbara Matthews says, are laying the groundwork for the next nasty financial surprise.