The History of Central Counterparties

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 19^th 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 19^th 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.