If you are a politician or a regulator, you had better be responding to the credit crisis right now. Do something – do anything.

Amongst the myriad proposals out there, the one that has gained near global consensus is mandatory, or at least strongly incentivised, clearing of OTC derivatives through a central counterparty (CCP) or clearing house.

Such universal certainty is reassuring to us contrarians. It is always a good signal that the policy is wrong, and this instance is no exception.

The logic of the proposed policy goes as follows. There were serious problems both in bilateral monitoring of counterparty creditworthiness in some OTC derivatives markets during the crisis, and in ensuring that counterparties lived up to their obligations – some important ones did not do so.

In contrast, the infrastructure providing CCP clearing performed well. So the presumed logical step is to require OTC derivatives products to be cleared centrally via a CCP. This should stop future failures and protect systemic stability. No?

No! Even ignoring that OTC derivatives played only a relatively minor role in the credit crisis, and that the appearance of good performance on the part of all CCPs may have masked a few private shaky moments at some of them, there are two key reasons why a regulatory mandate to clear OTC derivative products via a CCP is likely to lead to costly failure.

Not all products should be CCP-cleared

The first concerns the eligibility of contracts for clearing. Eligibility has been used to mean different things, but here it refers to whether a CCP will be able to manage the risks of clearing a particular contract.

Eligibility depends on various factors, including, critically, price transparency and liquidity. When a member of a CCP goes bankrupt, the CCP has to assume the positions of the member, and then liquidate them. In order to do this, there needs to be both pricing transparency of the contracts in question, so the CCP knows what they are worth, and liquidity in the contracts, so the CCP can sell them at a reasonable price. Not all derivatives contracts are eligible to be cleared via a CCP.

Governance is about power. Allowing a CCP the power to choose what contracts to clear is normally optimal, since the CCP has a strong incentive to ensure that any such contracts are eligible to be cleared. If they are not, the CCP and its membership are likely to face significant costs in the event of a member bankruptcy.

In contrast, if a regulator is given the power to decide what contracts should be cleared via a CCP, it is likely to require some contracts to be centrally cleared that are not eligible for clearing.

This is because the regulator will not directly bear the cost of any problems at the CCP arising as a result of the ineligibility of the contracts it clears.

This will lead to problems and, at the extreme, failures at CCPs. The proposal to require CCP clearing of OTC derivatives conveniently ignores the long and fine history of failures at CCPs.

Difficulties with a government guarantee

The second problem with mandated CCP clearing of OTC derivatives is the standard one of moral hazard.

A regulatory mandate to clear OTC derivatives is likely to bring with it an implicit guarantee: an assumption that government will support a CCP clearing such products in times of crisis.

Such a CCP will be less concerned about risk management than it should ideally be – especially if it faces competition.

If government believes that it is not credible not to provide a guarantee, implicit or not, it can of course choose to own and manage the relevant CCPs directly. But public ownership of CCPs is not where most countries are at.

These two arguments do not imply that more CCP clearing of OTC derivatives products is not publicly desirable.

It may well be, particularly in markets that have historically been dominated by a limited group of financial intermediaries who have shunned CCP clearing in order to exploit informational asymmetries and their own relatively high creditworthiness, so as to maximise their profits.

Regulatory intervention or persuasion can be effective in these circumstances.

Of course, centralised clearing of such contracts by a CCP may well give rise to another competition problem – namely that the CCP itself will exploit its likely market power to its own advantage, or at least to the advantage of its owners. But that is another story.

Please Mr Politician and Ms Regulator, continue your search for reasonable crisis-mitigating policies. Don’t believe, however, that mandating centralised clearing of OTC derivatives products is one of them.

Ruben Lee is CEO of Oxford Finance Group and author of ‘The Governance of Financial Market Infrastructure’, which can be downloaded free from www.oxfordfinancegroup.com.