Experience Shows CCPs Safer than OTC Trading
Experience both before and after the crisis revealed that the system of bilateral OTC derivatives transactions was far more fragile than experience with CCPs. As a result, many people began to advocate a shift to central clearing. And, the G20 leaders agreed.
To see why, we can look at a few episodes from the past 15 years. In the first, we can compare the case of Amaranth Advisors to that of Long-Term Capital Management (LTCM). In September 2006 Amaranth Advisors, a US-based hedge fund specializing in trading energy futures, lost roughly $6 billion of its $9 billion in assets under management and was liquidated. With the exception of its shareholders, most people watched with detachment. By contrast, eight years earlier, the impending collapse of LTCM provoked horror and financiers sprang into action to work out its debt without bankruptcy. One big difference was that Amaranth was engaged in trading natural gas futures contracts on an organized exchange, while LTCM had entered thousands of OTC interest rate swaps. Futures and swaps differ in that futures are standardized and exchange-traded through a clearing house. This distinction explains why Amaranth’s failure provoked a yawn, while LTCM’s threatened a crisis.
Consider a simple model for thinking about the problem posed by LTCM. Imagine a set of three institutions engaged in OTC activities, arranged in a circle. And, assume that each has a long position with the person to their right and a short position in the exact same contract with the person to their left. Everyone in this circle is perfectly hedged with a zero net position. But think of what happens if one goes bankrupt and breaks the circle; each of the other two is now exposed: one long and the other short. Expand the number around the circle to 10 or 20 and the problem does not essentially change.
This example is not hypothetical. It is common to offset a derivative position not by buying back the original contract from the original counterparty, but rather by entering into a new derivative contract for an offsetting payoff with someone else. As a result, any serious deterioration in the creditworthiness of one of the dealers, with the resulting flight to quality by its counterparties, creates a surge of demand for new derivative positions with other counterparties.
This massive counterparty risk can be reduced substantially by moving to centralized clearing, with its combination of collateralization, margin requirements and, especially, multilateral netting. On the latter, multilateral netting can compress gross notional amounts by as much as a factor of 10. So, if LTCM had been forced to clear centrally, they might have had about $150 billion in swaps outstanding, not $1.5 trillion.