This comment was posted as a response to "The Streetwise Professor" — Craig Pirrong — who wrote a critique of a New York Times article by Louise Story on the lack of transparency in the OTC derivatives market.

The comment seems to have been held for moderation or something, so it is reproduced here. The comment includes some typos. I'm posting it as submitted @ "The Streetwise Professor", without edits.

Whose capital is really at risk in OTC deriv mkts, CCP members' or the public's? Obviously, in a minor loss scenario, it is members' capital that takes the first loss. But CCP's are the epitome of systemically important TBTF institutions. How do we quantify, given the fact that "crises" do happen, the degree to which members are bearing CCP risk vs the degree to which the public is bearing CCP risk? And how should that affect our decisions regarding control of the institutions?

Obviously, CCPs are regulated institutions, partially in deference to the fact that the public does provide economic capital in the form of risk-bearing, and therefore is entitled to some degree of supervision. But if that's the case, is not a public preference for transparency in the arrangement of financial markets a legitimate object of regulation?

It may or may not be true that OTC derivative dealers operate an anti-competitive cartel and extract economic rents from participants, just as they may or may not be true in the wireless telephony arena, or many other areas in the economy. As you say, ordinarily we give industries the benefit of the doubt and rely on even oligopolist competition to serve as a sufficient check on misbehavior. But ordinarily is not always, and giving industries the benefit of the doubt is not always optimal. Is it too much, given the public's reasonable skepticism of large financial market participants after recent past events, and given that taxpayers ultimately bear all CCP risk beyond the capital set aside by members, for the public to insist on a high level of transparency with respect competition in the centrally cleared OTC derivatives market?

Your point about high apparent profitability in fact being compensation for the risk of infrequent but severe losses is very well taken. However, if that's right, doesn't that imply that those profits must substantially be retained as capital by the CCPs, that in fact against apparent profits financial institutions ought really ought to be establishing loss reserve accounts? If apparent supernormal profits aren't profits at all, but are compensations for occasional risk, then any disbursements of such profits, to bank shareholders or to their managers or employees as bonuses, is illegitimate, no? In fact, the "supernormal" part of those profits must really be accessible to the CCPs as loss-bearing capital.

Booking "paper profits" up front, paying them out, and then finding oneself undercapitalized in a bad state of the world doesn't sound like a far-fetched scenario, given recent history. So maybe public demands for clearer and more transparent accounting of OTC derivative pricing and profitability make sense. Perhaps the public has a right to understand the degree to which apparent high profits serve the public interest by increasing the risk-bearing capacity of CCPs, and the degree to which apparent profits are treated as fully earned and disbursed to bank employees and shareholders.

If they are to be disbursed, if we have a world where capital requirements substantially cover the obligations of CCP members, and where any profits net of the opportunity cost of supplying that capital are "free and clear", then we cannot explain abnormal profit as compensation for risk of bearing sporadic losses. In which case we should view apparent abnormal profit with puzzlement from a competitive perspective.

I don't mean to prejudge these issues. I could be happy with a world where gross profits on OTC derivative dealings are high, but where these are "not vested" and retained by the CCP for a period of several years. This could be accounted for with loss reserve accounts explicitly, or merely by requiring a retained earnings whose size is substantially all the apparent abnormal profitability of the trades for a 5 to 10 year period. Alternatively, we could live with the simplicity of standard capitalization requirements and let profits be paid out, in which case we should expect a competitive market with little pricing power and thin margins among dealers.

CCPs cannot be purely private operations. Given network effects and their de facto systemic importance, the public will bear a very substantial portion risk of their operations, both in narrow financial terms (ie.g. via bailouts) and in broader terms (a CCP failure would have severe negative externalitest) . I think a high degree of transparency and a clear set of arrangements that we have understood and agreed to be legitimate is the least the public should ask for. And those transparency requirements should be much higher than we impose on Dan Singer's home heating oil company.

— Steve Waldman