Clearing House - FOR

Clearing house margin account

Now that the financial reform debate is heating up again, I want to caution people against viewing a wider clearing requirement for OTC derivatives as necessarily better. Clearinghouses are not a panacea by any means, and pushing instruments that aren't mature enough or sufficiently liquid for clearing onto clearinghouses would be a very bad idea.

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.

It seems that a lot of people are pushing for the government to "err on the safe side" by enacting a very wide clearing requirement for OTC derivatives, with exceptions only for truly bespoke deals. The more OTC derivatives that trade through clearinghouses, the safer the system, right? Well, not really — it's not at all clear that this approach would be "erring on the safe side."

In fact, we have a very good example of the potential dangers of this approach: AIGFP. Yes, I'm fully aware that AIG's CDSs weren't centrally cleared. But they were fully collateralized, requiring AIG to post collateral daily based on market prices — the equivalent of a clearinghouse collecting daily variation margin from counterparties to cleared trades.

Most people agree that it was the decision to collateralize their CDSs that ultimately doomed AIG. Since the contracts required AIG to post collateral based on the mark-to-market prices of the underlying CDOs, the decision to collateralize the trades meant that AIG was exposed to short-term fluctuations in the CDO market. AIG was fine with that, because they foolishly believed that the CDO market was deep enough and liquid enough that mark-to-market prices would remain stable.

As everyone knows by now, liquidity in the CDO market vanished, and the market prices of CDOs plunged. Because they had agreed to collateralize their CDSs, AIG was suddenly forced to post billions of dollars in collateral. The effect would've been the same had AIG been required to clear its CDSs through a clearinghouse. The clearinghouse would've required AIG to post daily variation margin based on market prices — this, again, is the primary way that clearinghouses mitigate counterparty risk — which means that AIG would've been forced to post the same amount of collateral when liquidity dried up in the CDO market.

Popular Q&A

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Can I borrow on margin in my brokerage account to come up with 20% house downpayment?

I don't want to sell the stock in my portfolio to come up with cash for 20% downpayment for buying a house. If I can take cash out of brokerage account on margin (collaterized by the stock), will lenders allow me to use that cash towards the 20% down payment?

You should be able to do this. Technically, this is a zero debt, zero credit report impact. The bank will ask you where the money came from. In the end, if you have asset coverage, they should not care provided you have solid credit and income coverage. I just did a refinance on one of my rentals with a bank and they did not even verify income. In fact, they did a drive by appraisal and took my number on the value. Talk to your banker first. Be honest and do not pull the trigger unless you have the bank on the hook for the loan.
All the best,
Gromac

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on the show jersey shore, how much money did tom take from jwoww when he cleared out her house and paypal account?

Jenni "JWOWW" Farley of Jersey Shore fame, never revealed exactly how much money Tom Lippolis stole from her. In addition to stealing money from her Paypal account, he also stole her bed, watch and hard drive. She was able to recover her watch and hard drive with the help of the police a few days later.

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