Further My Last
| Craig Pirrong |
My previous post on the Acharya et al (AEFLS) assertion of the purported externality in bilateral OTC markets focused on whether there was actually an unpriced “bad.” I judged otherwise based on the fact that credit and counterparty risks are repriced repeatedly (and ruthlessly).
There is another reason to reject their analysis. It should be incumbent on one who justifies the existence of an externality to justify a particular policy to (a) identify the transactions costs that preclude internalization of this externality, and (b) demonstrate that their policy would create a net benefit, by, for instance, reducing transactions costs. AEFLS don’t even try to do this (another symptom of the Nirvana fallacy). And when one examines the particulars, it is highly doubtful that the costs of the purported externality are as large as AEFLS insinuate that they are.
The AEFLS story is that contracts between two counterparties to an OTC derivatives deal impose costs on other market participants, notably, the firms’ other counterparties to earlier derivatives deals, and the counterparties’ counterparties, and on and on. OTC market participants don’t take these costs into account, trade too much, and create too much risk.
Which raises the Coase Question: if these costs are so large, why don’t the affected parties craft a solution that mitigates them? If, as AEFLS argue, a central counterparty would reduce these costs, why don’t the affected parties create one to internalize the externality and enhance their welfare?
In some cases, e.g., the classical one of a factory that spews pollution that harms myriad individuals, it is plausible that coordination costs (arising from, inter alia, free rider problems) preclude private collective action, and that legislation/regulation mitigates these costs. But that hardly seems the case here. The very fact — often cited by the advocates of new, invasive financial regulations–that there are a relatively small number of large institutions that dominate this market means that large numbers-driven coordination problems preclude effective collective action. Indeed, the institutions that account for virtually all of the activity in the OTC market are already members of a formal organization, the International Swaps and Derivatives Association (ISDA). ISDA has long served as a mechanism for coordination among, and providing collective goods to, its members. For instance, ISDA facilitated the standardization of the terms of OTC deals through its standard master agreement.
In brief, the parties that bear the primary burden of this putative externality are relatively small in number; know who each other are; regularly cooperate on a variety of issues of common interest; anticipate interacting with one another well into the future; and have a formal organization to facilitate this coordination. These conditions would tend to favor private collective action to internalize an externality, especially one allegedly as costly as the one asserted by AEFLS.
But they haven’t done so. This is like the dog that didn’t bark. If the danger was there it would have barked. It didn’t, so . . .
Could there be transactions costs that prevent cooperation? Just because the canonical sources of such costs appear absent in this instance doesn’t mean they are altogether absent. One possibility is the kind of problem that Libecap and Wiggins identified in their work on oil field unitization (and that Libecap addressed more generally in his Contracting for Property Rights). Specifically, that it can be prohibitively costly to negotiate agreements that would (but for these transactions costs) enhance wealth when said agreements have profound distributive effects, and there is private information about these effects.
The complete alteration of risk sharing arrangements would certainly have distributive effects (as I’ve noted in work dating back to the ’90s), especially when the affected parties are heterogeneous (as was almost certainly the case before the crisis, and likely even more so today). Consequently, one can’t rule out this possibility.
However, it is also plausibly the case that the adoption of clearing would be wealth reducing. In some sense, then, the heterogeneity-driven coordination cost externality story and the no externality story are observationally equivalent: both predict that market participants would not voluntarily cooperate to create a central counterparty.
To try to untangle the correct explanation of an incontestable fact — that clearing was not adopted voluntarily for the bulk of OTC derivatives transactions — it is necessary to undertake a fact- and context-intensive analysis, rather than play the superficial Pigouvian “I spy an externality” game and stop there, as AEFLS do. And sad to say, by even getting to this point they are miles ahead of most of the advocates of a radical reshaping of financial market institutions, most notably those in the administration and Congress.