Former central banker Paul Tucker is the chair of the Systemic Risk Council, a Fellow at the Harvard Kennedy School, and author of Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State. 

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Are Clearing Houses the New Central Banks?

Central banks are in the news all the time, clearing houses only occasionally and, even then, typically in the back pages of the Financial Times and Wall Street Journal. Could it be the other way round in a few decades time; or might clearing houses at least be sharing the attention of markets, media and politicians?

Chicago, Illinois

Paul Tucker, Harvard Kennedy School and Harvard Business School

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Central banks are in the news all the time, clearing houses only occasionally and, even then, typically in the back pages of the Financial Times and Wall Street Journal. Could it be the other way round in a few decades time; or might clearing houses at least be sharing the attention of markets, media and politicians?

If those questions seem not only exaggerated but bizarre, pause for a moment to think about what central banks and central counterparties do, how they evolved, and the State’s role in their functions. I will do just that, before going on to review why this matters now more than ever and the high-level public policy issues it raises.

Comparing central banks and clearing houses

Insurance against financial risk

Central banks provide insurance against liquidity risk to the banking system and wider economy. In the past the only recipients of this insurance were, in the language of the Federal Reserve, their ‘member’ banks. Central counterparty clearing houses (CCPs) also provide insurance to their members: against counterparty credit risk. As time passes, the insurance is being extended to non-clearing-member participants in markets.

Just as central bank liquidity insurance can reduce the incidence of liquidity runs on banks, so clearing- house counterparty insurance reduces the probability of counterparties refusing to deal with an ailing firm, because they know they are protected by the clearing house. This is important: central bank liquidity provision is not enough of itself to stem a ‘counterparty run’ on a trading firm.

Central banks lend money. They protect themselves against risk by taking collateral, with an excess (haircut) over the amount lent. They are, therefore, exposed to tail risk: namely, if their counterparty(ies) fails and the collateral doesn’t cover the debt. Central counterparties enter into securities and derivatives transactions, interposing themselves between buyers and sellers of cleared contracts. Multilateral netting simplifies the network of counterparty credit exposures, leaving the clearing house with a series of contingent exposures to their members. They protect themselves against having to ‘pay out’ on counterparty default by taking collateral (initial margin) from their members. They too, therefore, are exposed to tail risk: if a large member bank or dealer failed and their collateral proved inadequate. And if one large member failed, such might be the market frenzy that others would fail too.