The 2012 Nobel prize in economics was awarded today to Alvin Roth and Lloyd Shapley for their research on how markets are best designed.
Although neither has applied their research to derivatives markets, their winning ideas seem to undermine the case for designing derivatives markets around a central clearinghouse, which is precisely what the Dodd-Frank Act of 2010 and other reforms around the world seek to do.
In a 2008 article, Roth noted that well-functioning centralized markets should:
provide thickness, i.e. they need to attract a large enough proportion of the potential participants in the market...and they need to make it safe and sufficiently simple to participate in the market, as opposed to transacting outside of the market, or having to engage in costly and risky strategic behavior.
But when it comes to derivatives markets, there's a major problem: many types of derivatives markets will never be thick enough to function well if centralized clearing is required.
Take credit default swaps (CDSs), the notorious type of derivatives contract that motivated Dodd-Frank's central clearing requirement. Even with the contract standardization and other operational improvements that have taken place in recent years, the market for CDSs that use clearinghouses is very thin.
For example, of the 1000 most active single-name CDSs, there are over 900 that reference corporations. However, the largest CDS clearinghouse (the Intercontinental Exchange) only clears 253 single-name corporate CDSs, or about 28 percent of the most active CDSs. In fact, the value of the currently outstanding CDSs on the Intercontinental Exchange's clearinghouses ($1.5 trillion in open interest) constitutes only 5 percent of the total value of CDSs ($28 trillion in notional value as of year end 2011).
These statistics show that using clearinghouses is a market design that doesn't appeal to a lot of CDS market participants--that it lacks Roth's "thickness" standard.
Roth also notes that well-functioning markets must be safe, which in finance means systemically stable. Although many aspects of derivatives regulation and practice are still evolving, designing the market around clearinghouses reduces safety in a way that may ultimately impede the market from functioning.
In a 2012 article, I noted the risks that the clearinghouse model will introduce, including clearinghouses becoming undercapitalized due to technical risk-management failures or because a clearinghouse reduces its standards to attract business. In addition, clearinghouses may create moral hazard by removing the direct incentive for CDS counterparties to consider counterparty risk upon entering a trade since that risk is shifted to the clearinghouse.
The beauty of Roth and Shapely's research is its practical orientation. Unfortunately, when applied to how derivatives markets are effectively being redesigned by global regulation, it's hard to conclude that the result will be the most functional.
