Gary Gensler. Clearinghouses, and Interconnections

I recently ran across a Wall Street Journal op-ed article by CFTC Chairman Gary Gensler headlined "Clearinghouses Are the Answer" (subscription required).  In the article, Mr. Gensler argues that OTC derivatives cause financial institutions to be dangerously interconnected.  As examples, he points to Long-Term Capital Management, which he dealt with as a Treasury Under Secretary in the Clinton Administration, and to the more recent problems at AIG.

While it is no doubt true that both LTCM and AIG highlighted the risk of a domino effect if a firm is allowed to fail abruptly, Gensler's assertion that clearinghouses would address this, without making any effort to outline why, is surprising.  Derivatives clearinghouses entail the mutualization of risk; if a large clearing member cannot make good on its financial obligations, then this impacts the other members. This is interconnectedness.

While no futures clearinghouse has ever failed in the United States, it is of course possible.  If a large, systemically important clearinghouse were on the brink of failure, the federal government would no doubt find a way to prevent the failure from happening.

There are pros and cons to mandating that most derivatives be submitted to a clearinghouse.  A clearinghouse that is well-run and has effective margin requirements arguably makes the financial system safer and makes regulators' job of spotting problems easier.  But if something goes wrong and the clearinghouse has to draw on the resources of its members to cover others in a large way, there is the potential for a disastrous situation.

In other words, clearinghouses concentrate risk.  While their rules may make it impossible for firms to take the large risks that some have in the past, clearinghouses, by their very nature, entail interconnectedness.

It is puzzling why Gensler wrote this article the way he did.  He could have made a perfectly reasonable case for clearinghouses without saying that they reduce interconnectedness.  The article probably had little effect on the legislation in any case, and Gensler has been able to obtain for the CFTC much of the authority he wanted.