Staring down America's next CDS liability

Startlingly, American clearing houses are operating outside the Dodd-Frank regulations. If their solvency is tested it could shake the world more than Greece and the fiscal cliff put together.

Sleeping deep in the US president’s home town of Chicago is a time bomb that one day could do real damage to American and global economies. And there is another one in Atlanta.

Last night world markets were battling on two fronts – yet another Greek crisis and the substantial US tax rises and expenditure cuts that comprise the so-called fiscal cliff. They are nasty situations but on their own they will not bring the world to its knees, and indeed in late sessions share buyers appeared.

But Gretchen Morgenson, writing in The New York Times, (One Safety Net That Needs to Shrink, November 3) has highlighted the amazing situation of the so-called clearing houses led by the Chicago Mercantile Exchange and the Atlanta based Intercontinental Exchange.

The Chicago Merc clears derivatives contracts with a notional value in the trillions of dollars. I.C.E. clears most of the credit default swaps in the United States – billions of dollars a day, on paper. Both organisations are good operators and know derivatives markets but among the big risk takers in this market are some of the large European banks who on any normal tests have insufficient capital. The derivatives market is high risk.

Yet under the Dodd-Frank laws introduced after the global financial crisis, clearing houses were granted the right to tap the Federal Reserve for funding when the next crisis hits – in other words they were declared too big or important to fail. But in a strange twist the clearing houses can avoid the Dodd-Frank complex regulations that aim to avoid another Lehman style situation where the collapse of a financial organisation brings the world to its knees.

The risks being taken in the derivatives are hidden from regulators. In Australia local councils were able to gain a court judgment against the rating agency S&P because S&P gave triple-A ratings status to a complex set of derivatives. In essence the rating agency did not understand the risks that were being taken in those disastrous derivatives packages.

Local councils are wiser now but if anything the derivatives market has become more complex and the risks being taken are greater.

If we have a major collapse it will be multiplied many times if the derivatives markets go into a tail spin. The solvency of the clearing houses would be tested. But now that the Dodd Frank laws have brought them under the "too big to fail” umbrella it means that the American government will have to stand as an effective guarantor for large chunks of the global derivatives system and European banks.

As The New York Times points out these clearing houses, which could bring the US to its knees, operate outside the main regulatory areas. I guess we must keep our fingers crossed.

Related Articles