Fisher Investments Editorial Staff
Politics, Market Risks

Freer + Butter = Better

By, 04/07/2010

Story Highlights:

  • The Federal Housing Finance Agency will likely require Fannie Mae and Freddie Mac use a clearing house for interest rate swaps by year end.
  • Acting as middle man, a central clearing house wouldn't carry much downside risk, while potentially increasing transparency.
  • This is just one of many regulatory proposals floating around Washington—the net effect of which remains to be seen. 


The Federal Housing Finance Agency (FHFA), in charge of regulating housing giants Fannie Mae and Freddie Mac, will likely require the use of a clearing house for interest rate swaps by year end. This is the latest in Washington's crystallizing regulatory response to the financial crisis—but with Greece in the headlines again, it didn't get much play. (Despite increased Greek debt uncertainty and spiking sovereign yields, global markets mostly yawned.)  

As per usual after a crisis, there's been finger pointing, grand standing, and regret shunning galore. Regular readers will have gathered we don't often think much of Washington's "bright" ideas. And they might expect us to recoil at this one too. Certainly, the issue of derivatives regulation is (and will continue to be) cast starkly in black and white—with the industry and a few in the Beltway decrying virtually any new regulation as anti-free markets, while others can't believe that, as responsible adults, we aren't going further.  

For those waiting to catch us agreeing with the feds—or, maybe more like projecting cautious optimism—this is your chance. Almost always, freer is better. But sometimes, a few simple, rational (unchanging) rules of the road can help butter the skids. A central clearing house wouldn't carry much downside risk of roiling markets, while potentially increasing transparency—and more transparency is always good. The same goes more generally for similar regulatory proposals in other markets like credit default swaps. 

First things first. Just what is a clearing house? A middle man for financial transactions. Banks or securities firms sign up as members, and the clearing house handles all trade execution and settlement. Commercial banks have used clearing houses to clear and settle checks from other banks for ages. In fact, in the Panic of 1907, it was the non-clearing house trust companies (like Knickerbocker) that were in the greatest danger of failing. Since then, stocks and certain derivatives have adopted the concept—most dramatically when the late sixties paper crunch overwhelmed Wall Street back offices and forced a slew of systemic changes.  

Not all financial instruments need clearing houses and exchanges. Many are so obscure and thinly traded, the over-the-counter market is perfectly suited for them. But if a market grows as fast as credit derivatives have in recent years, it only makes sense to update the system—the huge interest rate swap market seems to be a good candidate.  

Fannie and Freddie don't make the market, but they are notable forces. The two housing behemoths hedge their massive mortgage portfolios against sudden interest rate changes by swapping variable rates for fixed rates. Currently, most of the deals are done over-the-counter, arranged by big banks like Goldman Sachs or JP Morgan. Setting up a central clearing house and requiring Fannie and Freddie to use it could lure others to sign up, if everything is in working order.  

But a clearing house is not the same as listing on a public exchange. For now, interest rate swaps would still trade over-the-counter (directly between member firms, with the clearing house facilitating). So how would it boost transparency? Currently, trades are disconnected, taking place directly from firm to firm. On a daily basis, no one knows exactly what transactions took place (like so many ships in the night). But with a clearing house winding together all the separate strands, no trade would go unnoticed. So, at the least, the market would have a central repository of trade and pricing data. Further, clearing houses usually require counterparties post collateral on a daily basis—insuring sudden changes in the market don't take the whole system by surprise. (An added benefit of centralization many argue would have prevented some panic during the financial crisis.)   

For the bigger over-the-counter derivatives markets, clearing houses or even public exchanges, could make the financial system more transparent and a little stronger. But just how all this regulation plays out remains to be seen. As you score the debate, try and remember: Sometimes, freer + a little butter = better.  


*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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