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Clearing is Centralized, and Concentrates Risk

Monday, February 13, 2017 6:33
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One of the things blockchain might be able to do better is clearing.  Clearing of swaps especially.  Under Dodd-Frank, the government mandated a lot of swaps clearing.  Logically, this made sense.  I was initially in favor of moving plain vanilla generic swaps into clearinghouses.  There are a number of those.

The swap market is massive though.  It’s measured in the trillions of dollars.  Unlike what a lot of people say, it’s not a Ponzi scheme.  It’s a way for big industrial customers to diversify the risk they take while they are engaged in business.  The Swaps market makes goods and services cheaper and more accessible to more people.

Professor Craig Pirrong is an expert on clearing.  He wrote about the recent developments in swap clearing here.  The one common thread I saw with the whole Obama administration solution to any problem was government centralization and a bureaucratic solution that caused private markets to shutter.  The solutions also caused the big mega corporations in a market silo to merge or get bigger.  Healthcare, Insurance, Banking, Agriculture, Energy, and Media.  It didn’t matter.  Here is what Craig writes about clearing.

So swaps clearing is now hyper-concentrated, and dominated by a handful of systemically important banks (e.g., Citi, Goldman). It is more concentrated that the bilateral swaps dealer market was. Trouble at one of these dominant swaps clearers would create serious risks for CCPs that they clear for (which, by the way, are all interconnected because the same clearing members dominate all the major CCPs). Moreover, concentration dramatically reduces the benefits of mutualizing risk: because of the small number of clearers, the risk of a big CM failure will be borne by a small number of firms. This isn’t insurance in any meaningful way, and does not achieve the benefits of risk pooling even if only in the first instance only a single big clearing member runs into trouble due to a shock idiosyncratic to it.

The other thing to keep in the back of your mind is there is a link between what goes on in the swaps market and the underlying futures market.  Because of Dodd-Frank, there is an “in an emergency break glass” feature where Futures clearing houses can borrow at the Fed Window.  Taxpayers are de facto on the hook if a clearing house defaults.

Because blockchain technology is inherently decentralized, I suspect that we will see private blockchains which are tested out to clear certain products.  In ten years, the underlying clearing mechanism in finance might be a series of linked blockchains.


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