linkedin
twitter
email
rss

  • Home
  • About
  • Market Commentary
  • Speech/Employment
  • Books
  • Media Appearances
  • Magazine Articles
  • Contact



The History of Central Counterparties

November 29, 2012
by Scott E.D. Skyrm
Print Friendly
10 Comments

 

Though Central Counterparties (CCP’s), like LCH.Clearnet and Fixed Income Clearing Corp began to re-emerge 15 years ago, they are not a new invention.  They existed over 150 years ago, during the “National Banking Era” in the U.S. in the 19th century.  At this time, there was no central bank in the U.S., the Federal Reserve was not created until 1913, so there was no government institution to provide supervision, or liquidity and funding to banks during an emergency.  Just like the development of CCP’s for bank and non-bank financial institutions today, bank clearinghouses developed from the void of collective support over a hundred years ago.

The first bank clearinghouse was organized in 1853 as an organization to clear checks.  Back then, there was no email, electronic commerce, fax machines or phones.  As banks received checks written from an account at another bank, at the end of the day they sent a runner to settle the net cash balances between the two banks.  This system was inherently inefficient.  Imagine all the runners criss-crossing all over the city.  A group of banks got together and agreed to have their runners meet in one common location.  As everyone went to the same location and settled accounts between the members together, that single location became organized and eventually known as the “clearinghouse.”

The banks organized clearinghouses as private institutions known as clearinghouse associations.  Each clearinghouse was organized within a region, like New York City, Chicago, and Philadelphia.  The New York Clearinghouse Association (NYCHA) was the largest in the U.S. and represented over $1 billion in deposits at its member banks.

Benefits

Just like the Central Clearing Counterparties of today, the clearinghouse of the past was a common organization to net transactions.  And just like the CCP’s of today, the clearinghouses also performed supervision of its bank members.  The clearinghouse became the era’s ‘bank examiners” and even published its individual members’ finances.  When all the members have joint risk to each other, they want to know each other’s finances.  Netting transactions and supervision are both common in the CCP’s today.  However, there was an additional function performed by the clearinghouse.

The clearinghouse served as a support function for its members in times of crisis and bank panics.  Bank panics were numerous occurrences in the 19th century and were a constant threat to the industry.  A bank panic usually began at the peak of the business cycle and signaled a coming recession.  There was no FDIC deposit insurance, so when a bank went bust a depositor could lose everything. There was no good information as to which banks were actually at risk, so depositors removed a significant amount of deposits from many banks.  Much of the panic was due to perceived risk and not the actual risk of the whole banking system.

Clearinghouse Support

A banking system is by definition illiquid, the assets are long-term loans and the deposits are short term and available upon demand.  The loans cannot be recalled or sold upon like the deposits.  During a banking panic when money is withdrawn from the entire banking system on a massive scale, the banking system becomes technically insolvent.  The support function of the clearinghouse offered liquidity during a crisis.  The clearinghouses offered three forms of support during a banking panic:  First, all members jointly suspended withdrawal of deposits.  Second, clearinghouse ceased publication of bank member’s individual financial information to the public.  That way, the public did not know which banks were strong and which ones had financial difficulties.

Third, the clearinghouse issued money called “clearinghouse loan certificates” to the public in small denominations.  The loan certificates were effectively money that was a joint obligation of all bank members.  Instead of depositors withdrawing their cash from a bank member, they accepted certificates that were treated like money and were a joint obligation of all clearinghouse members.  That way, the Clearinghouse Loan Certificate provided money to be used in the economy for the public and not be withdrawn from the banking system.  The clearinghouse association effectively became the “lender of last resort” to its member banks by mutualizing the risks among all members.

Clearinghouse Loan Certificates have been called “the most important development in American banking during the 19th century.”  They created liquidity during a time of crisis, which occurred often during that era.  They prevented banks which did not have financial problems from forced liquidation.  For example, during the panic of 1893, $100 million of Clearinghouse Loan Certificates were issued nationally.  During the panic of 1907, a total of $500 million Loan Certificates were issued nationally.  These still seem like large numbers now, so consider the relative size over 100 years ago.  To put it in perspective, in 1907, that’s $500 million that would have been withdrawn from the banking system, but was not, due to the success and support of the clearinghouse.

Not surprisingly, the clearinghouse was the model and framework for the Federal Reserve when it was created in 1913.  Look at the initial set up of the Federal Reserve.  It was set up as 12 regional banks, including New York, Chicago, Philadelphia, etc.  It performed bank supervision and provided liquidity to the banks in times of crisis.  One hundred years later, the Fed still supports the banking system.  But the banking system has changed.  The Fed is geared toward support for only banks.  Other financial institutions, like the non-bank financial institutions, do not have liquidity support from the Fed.  In times of crisis, non-bank financial institutions must go to money-center banks for their liquidity, and those banks have no requirement to provide funding.  In order to provide support for bank and non-bank financial institutions, the Central Counterparties re-emerged in the marketplace, providing joint clearing and supervision just like the bank clearinghouses did over a hundred years ago.

Join the free Market Commentary distribution list

* indicates required
Scott E.D. Skyrm
About the Author
I am one of the leading figures in the repo and securities finance markets today and regularly quoted in The Wall Street Journal, The Financial Times, Bloomberg News Service, Reuters, Market News, and Dow Jones. I am the author of the books "The Money Noose - Jon Corzine and the Collapse of MF Global" and "Rogue Traders"

© 2019, Scott Skyrm, LLC, All Rights Reserved

Disclaimer: The information and data in these reports were obtained from sources considered reliable. Opinions, market data, and recommendations are subject to change at any time without notice. Their accuracy and completeness are not guaranteed and nothing herein shall be deemed an offer or solicitation on our part with respect to the purchase or sale of any financial products. Contributors may, in the normal course of business, have position(s) which may or may not agree with the opinions expressed herein.
  • http://www.squaresquared.com Michael Bud

    Lorem ipsum dolor sit amet, consectetur adipiscing elit. Etiam euismod auctor eros, eu dictum libero molestie eu.

  • Ismael Armero

    Not sure if the statement than “bank runs happens in peak and signal….” is an always statement.
    Calling a banking system illliquid by definition is attractive but there are many caveat: reserve requirements, term maturity of loanables…
    Why did LCH appeared 15 years ago.

  • http://www.scottskyrm.com Scott ED Skyrm

    I think if you take out deposit insurance (FDIC in the US) and take out government liquidity support, you can see how a bank run could easily happen.
    LCH.Clearnet emerged following FICC in the US, you can see my article in Futures Magazine and I think that will explain it.
    Thanks for the comment.

  • Pingback: Dubby()

  • Pingback: Scott E.D. Skyrm » Repo Reform And Shadow-Banking()

  • csissoko

    “During a banking panic when money is withdrawn from the entire banking system on a massive scale, the banking system becomes technically insolvent.”

    I disagree. I think the reason clearinghouses functioned historically was precisely because the banking system was not insolvent, but only a few individual banks, and that is why the clearinghouse was able to allay the panic.

    • http://www.facebook.com/profile.php?id=100003438505909 Maghna

      I’m still delivering IT Portfolio Management soultions worldwide. If you think I can help by answering your questions, or providing consulting support please contact me. Cheers,Rob Donnellan401-595-2530

  • Pingback: Repo Reform And Shadow-Banking()

  • Pingback: Scott E.D. Skyrm » Let’s Overhaul The Financial System()

  • http://www.facebook.com/profile.php?id=100003438476547 Rachel

    BrentonJanuary 12, 2012Check out the Fed’s Beige Book, just released yarsetdey. A pretty dry read as well but might offer you a few hints to the true direction of the U.S. economy. I recommend looking up a few stats related to retail sales, consumer credit, and household spending over the last few months and use them to draw further implications from the reports in the Beige Book. Also, try to identify regional trends and trends in economic development on a basic scale in order to identify indicators of how the U.S. economy has evolved (or not) since 2008. If you do get around to reading even just a little then come talk to me and I can guarantee you a very interesting discussion!-B

Social Share
  • google-share
Available in hardcover or on Kindle


Available in paperback or on Kindle

Recent Posts

Flights-To-Quality
Oct 23, 2014
The Assault On Liquidation Rights
Oct 16, 2014
Repo Roundup: September (Quarter-End, Fails, Regulation)
Sep 30, 2014
Fixed-Rate Reverse-Repo: One Year Later
Sep 23, 2014
The Velocity of Collateral
Sep 09, 2014

Popular Posts

Two Bankruptcies That Created The Modern Repo Market
Apr 03, 2013
14 Comments
Repo Roundup: Collateral Shortage, 10 Year Fails, Tri-Party Reform, Q-End
Apr 16, 2013
11 Comments
The History of Central Counterparties
Nov 29, 2012
10 Comments
Tweets by @ScottSkyrm

Tag Cloud

Dodd-Frank Fed FTT futures Jon Corzine MF Global Repo Tri-Party

Copyright © 2014 Scott Skyrm, LLC, All Rights Reserved
Website by Square Squared