(I wrote this post a while ago, but for some reason I never got around to publishing it. I was reminded of it when I read Felix Salmon's post on derivatives reform from this morning, in which Felix gives a quick-and-dirty explanation of clearing vs. exchange-trading. I was going to write a take-down of Bob Litan's recent Brookings paper on derivatives reform, but it's honestly not even worth my time. Litan makes a compelling case for derivatives reform in a derivatives market that simply does not exist. The number of basic factual errors is overwhelming, and if Litan advocates for a reform you also endorse, it's likely by coincidence. Suffice to say, you rely on it at your own risk.)
Repeat after me: a clearing requirement and an exchange-trading requirement are NOT the same thing. They are very, very different. It is extremely important that people understand the difference between mandatory clearing and mandatory exchange-trading, because there's an incredible amount of confusion about this in the press — even journalists who cover financial reform constantly conflate clearing and exchange-trading.
A clearing requirement is a requirement that all eligible derivatives be cleared on a central clearinghouse (also known as a central counterparty, or CCP). A clearinghouse provides critical counterparty risk mitigation by mutualizing the losses from a clearing member's failure, netting clearing members' trades out every day, and requiring that parties post collateral every day. Clearinghouses also centralize trade reporting, and can provide any level of post-trade transparency to the OTC derivatives markets that your heart desires — same-day trade reporting, including prices, aggregate and counterparty-level position data, etc. Virtually all of the harmful opacity and murkiness of the current OTC derivatives markets can be ended with just a clearing requirement — that is, a clearing requirement is a prerequisite for getting rid of the harmful opacity in OTC derivatives; an exchange-trading requirement is not.
In sum, virtually all of the systemic risk mitigation in derivatives reform — reduced counterparty risk, the huge increase in transparency, the reduced complexity, regulatory access to the necessary data, etc. — comes from the clearing requirement.
An exchange-trading requirement, on the other hand, is simply a requirement that all eligible derivatives use a particular type of trade execution venue: exchanges (also known as "boards of trade"). It is important to remember that an exchange-trading requirement has nothing to do with clearing — they are completely separate issues. People tend to think of exchanges as synonymous with clearinghouses because, at least in the US, the big exchanges own their own "captive clearinghouses," so most exchange-traded derivatives are also cleared through the exchange's clearinghouse. But they are two separate functions entirely.
The exchange is just the trade execution venue (think NYSE vs. Nasdaq). The only thing that an exchange-trading requirement adds to the clearing requirement is "pre-trade price transparency." That's it. As I've explained before, pre-trade price transparency is not always and everywhere a good thing — and if mandated for all cleared derivatives, it would almost certainly be a bad thing on net. Mandating a particular form of trade execution venue (of which there are many, and among which the competition is fierce) for all cleared derivatives is incredibly short-sighted, and just bad policy.
But even if you accept the most optimistic view of the exchange-trading requirement, the benefit we're talking about is reducing the bid-ask spread that hedge funds and bond managers pay on OTC derivatives from 0.8 bps to 0.4 bps, or from 10 bps to 5 bps. This is what progressives are fighting for? Not knowingly, of course, but they've clearly been fooled into believing that the exchange-trading requirement is the same as the clearing requirement (something they actually should fight for). Arguing that exchange-trading would be a better deal for end-users is NOT an argument for why public policy should require exchange-trading; it's just your view on the relative merits of the various trade execution platforms — a view which most other end-users obviously do not share. There's absolutely no reason that we need to settle these disputes by legislation. It's also important to remember that not including an exchange-trading requirement would do nothing to prevent the market from migrating onto exchanges.
The ultimate difference, then, between the clearing requirement and an exchange-trading requirement is this:
- The clearing requirement is what's important, and the fight over the scope of the clearing requirement is where ALL the action is in derivatives reform;
- The exchange-trading requirement, on the other hand, is a pretty terrible idea, which even under the most optimistic assumptions would provide only minimal benefits to financial markets — it is, in other words, an extremely dangerous sideshow.