A highly quantitative staff report of the Federal Reserve Bank of New York suggests that clearinghouses may not mitigate risks as effectively as bilateral transactions in all circumstances. In particular, says the study, “[w]hen a small number of dealers trade in a relatively large number of asset classes, central clearing … may lead to increased counterparty risk and higher margin needs.” According to the staff study, clearinghouses are most effective in reducing risk when the number of asset classes is small relative to the number of dealers, or if there are a larger number of assets, the number of dealers also increases.

My View: I cannot say that I understand fully the advanced math that supports this staff report. However, the fundamental questioning in this report of the appropriateness of central clearing under all circumstances raises significant red flags. At a minimum, as this study seems to argue, an optimal clearinghouse requires many clearing members to help mutualize risk most effectively. Unfortunately, in fact, the number of clearing members is decreasing, and is likely to decrease further as a result of inconsistent public policy that, on the one hand, promotes central clearing, but on the other hand, penalizes firms that offer central clearing through capital charges.