The Innovation Problem: The Hidden Cost of Central Clearing
We need to create the conditions for both financial stability and dynamism to protect the U.S. market, or we will have neither.
Everything Was Blowing Up
A world without central clearing is a scary place; you didn’t need to be in the front seat at a cryptocurrency hedge fund to observe the dance-through-a-minefield that occurred in the crypto market from 2022-2023. A major exchange (FTX) and the entire crypto credit market were wiped out (BlockFi, Voyager, Celsius, Genesis). The lack of a central clearing mechanism heavily contributed to the catastrophic deleveraging cycle.
Crypto can be so silly sometimes. You were so right about it all these years, friendly and open-minded Wall Street veteran!
However, let’s not forget that in 2008, the traditional financial system only survived due to government intervention. When Lehman Brothers collapsed, the absence of centralized clearing in several markets exacerbated the panic and liquidity crunch. That credit contagion was much broader and enduring across the broader economy (for the Gen Zers who missed it, the unemployment rate rose above 6% in August 2008 and only dropped below 6% in September 2014, more than six years later). In the aftermath of that carnage, there was a concerted effort to implement central clearing across as many markets as possible to cut off contagion from the start. But at what cost?
Benefits of Central Clearing
Central clearing’s core value lies in its ability to eliminate counterparty risk and increase market stability. By acting as the buyer to every seller and the seller to every buyer, central clearers like the DTCC in the U.S. provide a crucial safety net across their respective markets. Central clearers ensure that even if one party defaults, transactions are completed, maintaining market integrity. This safety net is why central clearing is a cornerstone of many modern financial markets, offering participants confidence that their transactions will be honored even in times of crisis.
There are Tradeoffs, However
While the benefits of central clearing are clear, the economist Thomas Sowell reminds us “there are no solutions; there are only trade-offs.” Central clearers, by their very nature, can also impose costs on the markets they safeguard.
This results from the fact that in several markets they are natural monopolies with concentrated market power. For example, it is in practice, nearly impossible to launch competitors to the NSCC (a subsidiary of the DTCC) in the U.S. equity market (the idea of trying is laughable). Any innovation within the U.S. equity market must effectively work through the DTCC.
That is significant power, and while each market is unique (FICC, another subsidiary of the DTCC, clears government securities, while CLS clears foreign exchange), the issue often boils down to the extent of the monopoly-like power held by the clearer in each respective market. Even in relatively “competitive” clearing markets, establishing and maintaining a central clearer is often prohibitively expensive. Consequently, competition among clearers is typically minimal due to the high costs and substantial barriers-to-entry.
This monopoly-like power affects clearers’ willingness to either innovate or support innovation. In general, clearers have little incentive to adapt for new products or streamline integrations for new entrants. You must integrate or build to them; they will not come to you, and they can be risk-averse given their systemically important positions. They generally have significant power over the future direction of the markets they serve, as they can decide who to partner with and allow into the market on the new product side.
If these core market infrastructures do not choose to innovate, they can impact end-users by negatively affecting the dynamism of the market.
Houston, We Have a Problem
We have a central clearing innovation problem across several markets, whether the market wakes up to it now or in five years. There is no putting the crypto genie back in the bottle. The most fertile period of technical financial product innovation in history has occurred in the crypto space over the last five years, as teams of 3-4 people can launch new products into a global, ultra-competitive marketplace. The freedom from the myriad traditional market constraints and barriers-to-entry (which include the need to integrate into a central clearer) has allowed for unprecedented new product experimentation. Before we can even finish an argument about how “crypto has no inherent value”, a new product iteration cycle across twenty new crypto derivatives have occurred.
Conclusion
The market should serve end users with the best product. Stability and security through central clearing is an important part of that end product. But those are not the only parts. If new products eventually become materially better in other ways (despite lacking stability and security), the market (the sum of end users, with their preferences) will eventually become willing to forgo stability and security to use the new products. If that occurs, the market will develop greater systemic risk as market participants skirt domestic U.S. markets (which generally have the benefits of central clearing) for other markets with less stability and security to access the new products. This is already happening on a small scale. We need to create the conditions for both financial stability and dynamism to protect the U.S. market, or we will have neither.