The idea of the clearinghouse is fairly simple. A clearinghouse acts as a middle man who will insure a financial transaction between two market parties. This definition may be simple enough, but in reality a clearinghouse is far more complex and, if it were to fail, the results could be disastrous for the economy. For now, though, let’s start at the beginning.
This past week, Chairman Ben Bernanke explained the historical need and creation of the clearinghouse. Clearinghouses were set up to improve and streamline the clearing and settling of checks in the mid 19th century, immediately reducing the number of disputes and mistakes that were being made on transactions between financial institutions. Soon a large portion of the financial services industry was relying on the clearinghouses’ services. Then, later on in the 1920’s, the securities and derivatives markets had emerged and the role of the clearinghouse began to evolve. The markets were faced with growing volumes of trades and they needed a way to not only reduce the number of checks associated with settlements but also to reduce the volume of funds and credit needed to make these transactions, so again clearinghouses were used.
Since then there have been a few bumps in the road that tested the stability of the clearinghouse. There was the “paperwork crisis” of the 1960s, which left backlogs of trading tickets, confirmations and delivery instructions, thus creating a new role. Clearinghouses then created central securities depositories and central counterparties (CCPs) to reduce risk and guarantee trades. A few years later, the financial crises of 1986 hit, which resulted in the development of a CCP for OTC government securities trades. Through these crises the benefits and positive effects of the clearinghouses were realized. They could cut down paperwork and reduce back-office work and the amount of funds and credit needed by its members.
Now we fast forward to 2008: another crisis and another test for the clearinghouse. Though it survived and showed its resilience, it is now apparent that their role must again change and evolve. The new financial reforms being passed will have a direct affect on this role change. While clearinghouses are currently not mandatory, these regulations hope to encourage greater use of them. The OTC derivatives market under the Dodd-Frank Act will now have a mandatory clearing policy for standardized derivatives. In doing this, the dependence on clearinghouses will grow and hopefully reduce the amount of risk associated with derivative trades.
But while Dodd-Frank’s goal is to stabilize the financial markets and make them more transparent, could this new role of the clearinghouse potentially lead to disaster down the line? The increased reliance on clearinghouses will mean that there will be an increased need to ensure the actual safety of the clearinghouse. Clearinghouses will now have to be able to guarantee many more trades than they have in the past, but how? They are taking on a great amount of risk that will all be concentrated in one place; if a clearinghouse were to ever fail the repercussions could be disastrous. Do you think this new role of the clearinghouse is what needs to happen or do you think that Dodd-Frank is setting the financial system up for another failure?