GEORGETOWN LAW

Faculty Publications

Georgetown Law and Economics Research Paper No. 12-032 Georgetown Public Law Research Paper No. 12-124 August 10, 2012

The Tenuous Case for Derivatives Clearinghouses

101 Georgetown Law Journal (forthcoming 2013)

Adam J. Levitin Professor of Law Georgetown University Law Center adam.levitin@law.georgetown.edu

This paper can be downloaded without charge from: SSRN: http://ssrn.com/abstract=2119249 Posted with permission of the authors

THE TENUOUS CASE FOR DERIVATIVES CLEARINGHOUSES ADAM J. LEVITIN ABSTRACT Mandatory use of swaps clearinghouses represent the major regulatory response to the systemic risk from credit derivatives. Scholars are divided on the merits of clearinghouses; some scholars see them as reducing systemic risk, others contend they increase it. The case for swaps clearinghouses comes down to two related propositions: (1) that clearinghouses are better able to manage risk than dealer banks in the over-the-counter derivatives market, and (2) that clearinghouses are better able to absorb risk than dealer banks. Both propositions are heavily dependent on the details of clearinghouse design, the structure of the clearinghouse market, and the manner of clearinghouse regulation. In theory, however, a well-designed clearinghouse boasts one major advantage over dealer-banks: capital. Clearinghouses can have deep capital structures, including callable capital from their members. Clearinghouses thus diffuse losses out across their membership, thereby avoiding catastrophic losses to any single institution. If designed properly, a clearinghouse should be much more resilient to losses than an individual dealer bank. Clearinghouse owners, however, are likely to pursue lower capitalization, leaving it up to regulators to ensure sufficient capitalization. Clearinghouses concentrate risk and also potentially encourage greater risk taking via underpricing and reduced capital to gain market share and increase returns on equity. Therefore, if poorly regulated, they can present a dangerous increase in systemic risk relative to dealer banks. Thus, the case for clearinghouses remains tenuous and ultimately dependent upon the still-to-be-determined particulars of their regulation.
INTRODUCTION ...................................................................................................... 2 I. OTC VS. CENTRAL CLEARING ........................................................................... 5 II. CLEARINGHOUSE AS RISK MANAGER ............................................................... 9

A. Balance Sheet Risk vs. Position Risk ........................................... 10

Visiting Professor of Law, Harvard Law School; Professor of Law, Georgetown

2012, Adam J. Levitin

Electronic copy available at: http://ssrn.com/abstract=2119249

LEVITIN

[8/10/12

B. Risk Management Tools ............................................................... 10 C. Information Fragmentation and Limitations ................................. 13 D. Empty Creditor Problems? ........................................................... 15
III. CLEARINGHOUSE AS LOSS ABSORBER .......................................................... 19 IV. DO CLEARINGHOUSES CREATE SYSTEMIC RISK? ......................................... 20 CONCLUSION........................................................................................................ 23

INTRODUCTION Ever since the financial crisis of 2008, one financial product has been firmly in the regulatory crosshairs: a credit derivative known as the credit default swap or CDS. CDS are a type of financial insurance contract in which one party (the protection seller) sells another party (the protection buyer) credit insurance on a debt instrument that the protection buyer may or may not own. Credit derivatives were heavily implicated in the financial crisis as a major mechanism for the transmission of systemic risk because they served to link major financial institutions.1 Indeed, because of the risks they pose, credit derivatives have been branded by Warren Buffett as financial weapons of mass destruction.2 Post-crisis, there have been numerous calls to regulate or even ban CDS.3 And yet four years later, the CDS market continues merrily along, with over $28 trillion in notional outstandings and more than $1.5 trillion in market gross market value.4 To date, the major regulation of derivatives, including CDS, has been to require swaps contracts to be submitted for central counterparty clearing by clearinghouses (or

1 See, e.g., THE FINANCIAL CRISIS INQUIRY COMMISSION, FINAL REPORT OF THE NATIONAL COMMISSION ON THE CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS IN THE UNITED STATES xxiv (2011). But see Ren M. Stulz, Credit Default Swaps and the Credit Crisis, 24 J. ECON. PERSPECTIVES 73 (2010) (arguing that CDS were not central to the financial crisis). 2 Warren Buffett, Berkshire Hathaway Annual Report 2002. 3 George Soros has called for CDS to be banned. Alan Wheatley, Ban CDS as Instruments of DestructionSoros, REUTERS, June 12, 2009. Others have called for the use of CDS to be limited to when the protection buyer has an insurable interest. See, e.g., Lynn A. Stout, Regulate OTC Derivatives by Deregulating Them, REGULATION 30 (Fall 2009) (arguing for a return to differences contract jurisprudence in which derivatives were unenforceable absent an insurable interest). Yet others have called for central clearing of derivatives. See, e.g., Hal S. Scott, The Reduction of Systemic Risk in the United States Financial System, 33 HARV. J. L. & PUB. POLY 673, 686-705 (2010). 4 Bank of International Settlements, Semiannual Over-The-Counter (OTC) Derivatives Markets Statistics, Table 19, Amounts Outstanding of Over-the-Counter (OTC) Derivatives, Dec. 2011, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.

2
2012, Adam J. Levitin

Electronic copy available at: http://ssrn.com/abstract=2119249

LEVITIN

[8/10/12

derivatives clearing organizations), rather than being cleared bilaterally by dealer banks in the over-the-counter (OTC) market.5 While the clearinghouse requirement was the centerpiece of derivatives market reform under the Dodd-Frank Wall Street Reform and Consumer Protection Act, it has been heavily criticized. Critics have argued that clearinghouses present concentrated nodes of systemic risk, which is worrisome because they are unlikely to manage risk well and may themselves fail;6 that they are likely to underprice risk, thereby creating a moral hazard that will encourage more unwarranted risktaking; 7 that they may result in markets that favor too-big-to-fail financial institutions; 8 and that to the extent clearinghouses are successful, they merely effectuate a risk transfer from creditors inside the clearinghouse to creditors outside the clearinghouse. 9 Even clearinghouse proponents freely admit that they are an imperfect solution.10 As Professor Hal Scott has rightly observed, Clearinghouses can reduce but not eliminate systemic risk.11 So what, then, are we to make of clearinghouses? At core, the case for clearinghouses comes down to two related propositions: (1) Clearinghouses are better able to manage risk than dealer banks, and;

5 Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203, 124 Stat. 1376, 1675-76, 1762-63, July 21, 2010, 723, 763, codified respectively at 7 U.S.C. 2(h) and 15 U.S.C. 78c-3. The SEC and CFTC are empowered to exempt certain types of swaps from the clearing requirement. Id. Derivative market participants are also subject to capital and margin requirements. Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203, 124 Stat. 1376, 1703-12, 1784-96, July 21, 2010, 731, 764, codified respectively at 7 U.S.C. 6s and 15 U.S.C. 78o-8(e). In addition, to bank capital requirements as part of Basel III require additional capital to be held against derivative positions, but the details of this remain to be determined. 6 See, e.g., Mark J. Roe, Post-Crisis Clearinghouse Over-Confidence, working paper, April 30, 2012 (on file with author); Yesha Yadav, The Problematic Case of Clearinghouses in Complex Markets, 101 GEO. L.J. __ (2012); Jeremy C. Kress, Credit Default Swaps, Clearinghouses, and Systemic Risk: Why Centralized Clearing Parties Must Have Access to Central Bank Liquidity, 48 Harv. J. on Legis. 49, 72-73 (2011); Craig Pirrong, The Clearinghouse Cure, REGULATION 44 (Winter 2008-2009); Kirsi Ripatti, Central counterparty clearing: constructing a framework for evaluation of risks and benefits, Bank of Finland Discussion Paper 30/2004 at 21-24 (2004). 7 Pirrong, supra note 6. 8 Michael Greenberger, Diversifying Clearinghouse Ownership in Order to Safeguard Free and Open Access to the Derivatives Clearing Market, 17 FORDHAM J. CORP. & FIN. L. (2012); Rena S. Miller, Conflicts of Interest in Derivatives Clearing, Cong. Research Serv. Mar. 22, 2011. 9 Roe, supra note 6; Pirrong, supra note 6. 10 See, e.g., Scott, supra note 3 at 688; Kent Cherny & Ben R. Craig, Reforming the Overthe-Counter Derivatives Market: Whats to be Gained? Cleveland Fed. Reserve Bank, Economic Commentary, 2010. 11 Scott, supra note 3 at 688.

3
2012, Adam J. Levitin

LEVITIN

[8/10/12

(2) Clearinghouses are better able to absorb losses than dealer banks. An assessment of clearinghouses should then come down to whether they are more likely to incur losses than dealer banks in the current OTC market, and, if they do, whether they are they more likely to fail because of those losses. Professor Yesha Yadavs article, The Problematic Case of Clearinghouses in Complex Markets, focuses on the risk management proposition. In particular, Professor Yadav is concerned that clearinghouses lack the legal rights necessary to properly manage risk. To remedy this situation, she proposes that clearinghouses be given greater information about the risks they assume, tools to discipline members risk-taking, and debt governance rights to shield them from empty creditor problems.12 Whether clearinghouses are superior risk managers to dealer banks is an open question, as neither has an obvious advantage in risk management, and both are subject to dangerous competitive pressures to underprice risk. Nonetheless, I am more sanguine than Professor Yadav about clearinghouses risk management capability. As it stands, they have considerable information about risks and substantial ability to discipline members risk-taking, including the ability to force information about risk-taking. Debt governance rights defeat the whole purpose of using a derivative contract, which is to decouple credit risk from the debtor-creditor relationship. In any case, debt governance rights are unlikely to be worth the costs involved in engaging in a wholly distinct line of business as an asset manager. More importantly, as long as a clearinghouse is wellcapitalizedmeaning it can absorb losses without failing to meet its obligationsits lack of debt governance rights will not be material to its systemic risk profile. Thus, I believe that the risk management proposition is less important than the loss absorption proposition, which Professor Yadav treats as tangential. Even if clearinghouses are more likely to incur losses than dealer banks, what matters is their resilience to the losses. Ultimately, it is capital, not information or legal rights, that will determine the success of clearinghouses. Well-capitalized clearinghouses can absorb and diffuse losses, serving as systemic lightning rods. But without sufficient capital (protected by regulation),
12

Yadav, supra note 6, at [PART IV].

4
2012, Adam J. Levitin

LEVITIN

[8/10/12

clearinghouses present vulnerable points of financial interconnectivity that may incur excessive risk in a race for market share. Clearinghouse resilience depends on their design, the shape of the clearinghouse market, and the manner of clearinghouse regulation. At present, all of these factors are still fluid; while there are CDS clearinghouses operating, we do not know the final shape of this market or its regulation. In theory, a well-designed swaps clearinghouse should be a fortress of capital, with exponentially greater capacity to withstand losses than individual dealer banks, much like the Federal Reserves role as a payments clearinghouse. Whether this sort of swaps clearinghouse will in fact materialize is uncertain and highly dependent upon regulation, and the tenuous case for clearinghouses is entirely dependent upon it. I. OTC VS. CENTRAL CLEARING To understand what centralized clearing through a clearinghouse does and does not accomplish, it is necessary to first understand the world without clearinghouses. The pre-Dodd-Frank Act swaps market was largely an over-the-counter (OTC) market based around large dealer banks. There are approximately a dozen major dealer banks.13 While swaps are bilateral contracts, they are often intermediated by a dealer bank. That is, rather than the two ultimate economic parties to a swap (the end-users), say a hedge fund and an insurance company, swapping directly with each other, they will each swap with a dealer bank. (See Figure 1.) There may be only one dealer bank involved or each end-user could swap with a separate dealer bank, which then swaps with another dealer bank. (See Figure 2.) Alternatively, the dealer bank could itself be the end user in a swap for its proprietary account. Figure 1. OTC Clearing: Single Dealer Bank Intermediary
!"#$%&'() *+,"-'(./(-0) 1'/2'() 3/"4) !"#$%&'() *+,"-'(./(-0)

Figure 2. OTC Clearing: Multiple Dealer Bank Intermediaries

!"#$%&'() *+,"-'(./(-0) 1'/2'() 3/"4) 1'/2'() 3/"4) !"#$%&'() *+,"-'(./(-0)

13

Miller, supra note 8, at summary.

5
2012, Adam J. Levitin

LEVITIN

[8/10/12

Working through the dealer bank helps end-users limit search costs for finding swap counterparties, and also means that the end-users assume the default risk of the dealer banka regulated, major financial institution with a strong reputationrather than each other. By intermediating between the end-users, neither of which knows the identity of the other or the terms of its swap with the dealer bank, the dealer bank can make a spread on the matched transactions.14 The dealer bank, however, has assumed the credit risk of both end-users, and, to the extent it does not match the swaps perfectly, it also assumes the risk on the swap itself. Because the dealer bank has assumed the credit risk of its counterparties (end-users or other dealer banks) it will take precautions: it will price for risk; it may require its counterparty to post margin (collateral) upfront or to be adjusted throughout the duration of the swap; it may limit its total exposures to any single swap counterparty. The dealer will also have setoff and netting rights under the standard agreement governing most OTC swaps.15 Moreover, if a dealer bank finds risk rising too fast during the contract, it may attempt to limit its risk through a novation. A novation is the assignment of a position to another party in exchange for entering a matched swap with the assignee. Typically the novation would be to another dealer bank thereby substituting the counterparty risk of the assignee dealer bank for that of the original counterparty.16 All in all, the OTC dealer market represents a risk-sharing arrangement in which dealer banks assume significant credit risk on both end-users and one another, as well as potential exposure on the derivatives themselves if they do not hedge the exposure through matched swaps. This raises the concern that dealer banks may not manage these risks well, and may fail as a result. The failure of a dealer bank presents a serious risk to the entire financial system because dealer banks are central nodes in the system, highly interconnected with each other and many other financial institutions in a multitude of ways.17 The interconnectedness of dealer
14 The private dealer benefits from opacity in the OTC market may answer Professor Craig Pirrongs question of why centralized clearing did not emerge on its own for credit derivatives; dealers did not want to give up the spread. See Pirrong, supra note 6, at 44 (If the benefits of centralized clearing are so great, why havent CDS market participants embraced the concept before now, and then only under regulatory pressure?). 15 International Swaps and Derivatives Association Master Agreement. 16 Darrell Duffie, The Failure Mechanics of Dealer Banks, 24 J. ECON. PERSPECTIVES 51, __ (2010). 17 Id.

6
2012, Adam J. Levitin

LEVITIN

[8/10/12

banks means that the failure of one could easily cascade into the failure of others and thus transmit distress throughout the financial system. Indeed, in 2008, the dealer bank system showed itself to be exceedingly vulnerable, as shown from the most acute phase of the crisis following the failure of Lehman Brothers. Centralized clearing through a clearinghouse presents an alternative risk sharing arrangement. There are numerous possible ways to design a clearinghouses risk-sharing structure. The details of the design in terms of capital structure and risk management techniques are what will determine clearinghouses success in mitigating systemic risk, not whether clearinghouses are given expanded risk management tools, as Professor Yadav urges. While the precise ownership of clearinghouses varies, they typically have features of mutual insurance via a common guaranty fund to which all members contribute pro rata, and sometimes also the ability to levy assessments (essentially callable capital) on their members. Thus, clearinghouse members have liability for each other, even if the clearinghouse itself is not a mutual company.18 Clearinghouses use their mutual insurance features to diffuse losses out across their membership on a pro rata basis, thereby avoiding catastrophic losses to any single institution and preventing cascades of failure. 19 The loss spreading enabled by clearinghouses is perhaps their single most important feature in terms of reducing systemic risk. Clearinghouse members are usually large financial institutions more or less the existing dealer banks. Other parties access the clearinghouse through customer accounts with the clearinghouse members, with the clearinghouse serving as a central counterparty to all swaps. Technically this happens through a novation, which replaces the swap with two separate swaps, each with the clearinghouse.20 Thus, in a clearinghouse, the end-user directs its agent, the clearinghouse member, to enter into a swap with another end-user, which also has a
See Yadav, supra note 6, at ___. [Discussion of clearinghouse ownership.] EUR. CENT. BANK: EUROSYSTEM, CREDIT DEFAULT SWAPS AND COUNTERPARTY RISK 53 (Aug. 2009) available at http://www.ecb.int/pub/pdf/other/creditdefaultswapsandcounterpartyrisk2009en.pdf (noting that a clearinghouse default fund effectively mutualises the residual loss from a members default, sharing it out across clearing members, rather than having losses concentrated in one non-defaulting member). 20 See, e.g., LCH.Clearnet Ltd. Rulebook, June 20, 2012, Rule 3(a) (Upon registration of an original contract by the Clearing House, such contract shall be replaced by novation by two open contracts, one between the seller and the Clearing House as buyer, as principals to such contract, and one between the buyer and the Clearing House as seller, as principals to such contract.).
19 18

7
2012, Adam J. Levitin

LEVITIN

[8/10/12

clearinghouse member as its agent. The two clearinghouse members take their swap to the clearinghouse, which through novation places itself in the middle of the swap. The result is that the clearinghouse members both swap with the clearinghouse, rather than with each other directly. (See Figure 3.) Figure 3. Clearinghouse as Central Counterparty21
2/,&%&'%(#%,3401%(# !"#$%&'%(# !)%*(+,-./01%# !56#

Unlike dealer banks, clearinghouses make only perfectly matched swaps between their members.22 If a clearinghouse member defaults, the clearinghouse will make good the payment on the matched swap to the other member. Thus, all counterparty risk falls on the clearinghouse. The clearinghouse, however, does not assume the risk on the swap itself other than through counterparty risk. Because clearinghouses do only matched swaps, they typically charge a flat, per transaction fee or a transaction size-based fee. Clearinghouses adjust for risk based on collateral requirements rather than fees. This means that it is impossible for dealers to make an invisible spread on cleared transactions. Instead, they have to price their execution of the transaction upfront to their end-user clients. Clearinghouses make dealer spreads transparent, and this price transparency should result in a more efficiently priced swaps market.

See EUR. CENT. BANK, supra note 19, at 52. The swaps are only necessarily matched for the clearinghouse, not for its members, as a clearinghouse member can also be the end-user, holding some or all of the non-counterparty risk on the swap.
22

21

8
2012, Adam J. Levitin

LEVITIN

[8/10/12

The benefits from this pricing transparency are primarily private benefits for swaps end-users.23 The main appeal of clearinghouses, as a policy mandate, is through their potential to reduce systemic risk. By separating counterparty risk from position risk in swaps transactions, the clearinghouse serves as a systemic risk circuit breaker; as long as the clearinghouse remains solvent, the failure of one clearinghouse member does not infect other clearinghouse members through the derivatives channel.24 The effectiveness of a clearinghouse as a circuit breaker depends on its ability to remain solvent. That depends on how likely it is to incur losses and how well it can absorb those losses. If a clearinghouse is more likely to remain solvent than dealer banks, it is an improvement from a systemic risk perspective, provided that its systemic risk reduction benefits are not offset by generation of increased systemic risk. The following sections consider whether clearinghouses are better able to manage risk than dealer banks, whether they are better able to absorb losses than dealer banks, and whether any systemic risk reduction benefits from clearinghouses are likely offset by increases in systemic risk. II. CLEARINGHOUSE AS RISK MANAGER The ability of clearinghouses to manage risk is critical to their success in mitigating systemic risk. If clearinghouses underprice risk, they can fuel moral hazard that encourages greater and riskier use of swaps. Clearinghouses may or may not price for risk correctly. While we should strive to give them the tools necessary to do so, what matters most immediately is whether clearinghouses will price risk better than the dealer bank that is the worst risk manager. Whether clearinghouses are better risk managers than dealer banks is not a testable, falsifiable proposition. It heavily depends on the details of clearinghouse and dealer bank risk management. As the following discussion explains, however, as a generic matter, clearinghouses and dealer banks have substantially similar tools and information for risk management, therefore making it unlikely that there would be substantial differences in performance.

23 Indeed, to the extent that dealers make smaller profits, it is likely to increase systemic risk by making dealers less well capitalized and by increasing the volume of swaps as transaction costs are lower for end-users. 24 Given the multiplicity of dealings dealer banks have with each other, there are other possible contagion channels. Clearinghouses are designed as a solution to only one such channel; other channels are addressed by other regulatory devices.

9
2012, Adam J. Levitin

LEVITIN

[8/10/12

A. Balance Sheet Risk vs. Position Risk

Dealers and clearinghouses both assume credit risk in their intermediation, but this risk comes from two distinct sources. First, there is a risk that their counterparties will default on their swap obligations based on losses on the swaps. As long as the counterparties have sufficient capital to make good these losses, there is no problem, but if the losses are large enough, the counterparty could be rendered insolvent. This type of risk is what Professor Craig Pirrong has termed position risk.25 Second, there is the risk that counterparties will default on their swap obligations because they are rendered insolvent from losses from other transactions. This is what Professor Pirrong has termed balance sheet risk.26

B. Risk Management Tools

Clearinghouses and dealers have the same basic toolkit for responding to risk. First, both clearinghouses and dealers can decide whether they want to deal with a counterparty at all. Clearinghouses has membership requirements that including minimum capital standards.27 Counterparty screening provides an important risk management tool. Dealers can simply refuse to deal. Second, both clearinghouses and dealers can price risk. Pricing can come in a number of forms. For clearinghouses, there are clearing fees, while for dealer banks, pricing is in the form of the spread required on the swap. For both clearinghouses and dealers, pricing can also come in the form of collateral (also known as margin or performance bonds). Clearinghouses and dealers can require upfront collateral postings (initial collateral) and also subsequent adjustments to it (maintenance collateral).28 Both clearinghouses and dealers can specify what types of collateral are acceptable.29 Clearinghouse margin requirements work differently than the typical OTC arrangement. The typical OTC CDS is governed by the International Swaps and Derivatives Association (ISDA) Master
Pirrong, supra note 6, at 46. Id. 27 See, e.g., LCH.Clearnet, Ltd., Clearing House: General Regulations, Reg. 1.2 (membership), 1.8-1.9 (capital requirements); CME Group, CME Rulebook Rule 8H04 (capital requirements for CDS clearing members). 28 See, e.g., LCH.Clearnet, Ltd., Clearing House Procedures, 2.C.8 (initial margin), 2.C.9 (intraday margin); CME Group, CME Clearing Financial Safeguards 7-8, at http://www.cmegroup.com/clearing/files/financialsafeguards.pdf. See also CME Group, CME Rulebook, Rules 8H824 (additional performance bond requirements). 29 See, e.g., CME Group, Acceptable Performance Bond Collateral for CDS, at http://www.cmegroup.com/clearing/files/acceptable-collateral-cds.pdf.
26 25

10
2012, Adam J. Levitin

LEVITIN

[8/10/12

Agreement. Almost all CDS are collateralized.30 Collateralized swaps using ISDA documentation use the Credit Support Annex (CSA) to the ISDA Master Agreement to specify collateral terms.31 The specific terms for the collateral are customized by the swap counterparties. Collateral can is marked-to-market on whatever frequency the parties agree,32 but often CDS provide for margin calls only upon the ratings downgrade of a counterparty or a significant increase in the credit exposure of the in-themoney party.33 The result is that margin calls are infrequent, but when they occur, they are often large, a phenomenon similar to the jump-todefault problem in CDS.34 Moreover, because these margin calls are linked to a counterpartys credit rating, they are likely to occur simultaneously for numerous swaps. 35 The result can be an acute liquidity crisis for the party faced with the margin call.36 In contrast, clearinghouses typically evaluate margin twice daily. 37 This means that clearinghouse margin calls are more incremental, giving the party facing the margin calls more time to find a solution to its financial travails. While collateral postings are usually set based on the size of positions, clearinghouses and dealers can also require general collateral. For clearinghouses, this can be in the form of a lien on the clearinghouse membership or account itself,38 or a required contribution
ISDA, Market Review of OTC Derivative Bilateral Collateralization Practices, Release 2.0, Mar. 1, 2010, at http://www.isda.org/c_and_a/pdf/Collateral-Market-Review.pdf at 6. 31 There are distinct New York and London versions of the CSA. The most important distinction is that the New York CSA permits rehypothecation of the collateral, whereas the London CSA does not. Id. at 16, 18. 32 Id. at 11. 33 Risk Management Consulting Services, Inc., Review of CME Groups Credit Default Swap Margin Model and Financial Safeguards for CDS Clearing 4 at http://www.cmegroup.com/trading/cds/files/cds-review.pdf. 34 Jump-to-default is the phenomenon in which protection sellers CDS payout liability occurs suddenly through triggers such as payment defaults or bankruptcy filings, rather than incrementally. The effect is to make the liquidity demands on CDS protection sellers more volatile. 35 Risk Management Consulting Services, Inc., supra note 33. 36 Id. 37 Id. 38 See, e.g., CME Group, CME Rulebook, Rule 8H08 (Each CDS Clearing Member hereby grants to the Clearing House a first priority and unencumbered lien to secure all obligations of such CDS Clearing Member to the Clearing House against any property and collateral deposited with the Clearing House by the CDS Clearing Member.); CME Group, CME Rulebook, Rule 133, at http://www.cmegroup.com/rulebook/CME/I/1/33.html (CME clearing membership is sold upon a default, with recourse if the sale is insufficient to cover the debt); Federal Reserve Banks, Operating Circular 1 Account Relationships, Effective Sept. 1, 2011, 5.3, at http://www.frbservices.org/files/regulations/pdf/operating_circular_1_090111.pdf (providing Federal Reserve with security interest in clearinghouse account); Federal Reserve Banks, Operating Circular 10 Lending, Effective Oct. 15, 2006, 12 at http://www.frbservices.org/files/regulations/pdf/operating_circular_10.pdf, (providing Federal Reserve with security interest in clearinghouse account).
30

11
2012, Adam J. Levitin

LEVITIN

[8/10/12

to a guaranty fund, 39 or liability for assessments. 40 This type of collateral is can be used not only to offset losses on a members default, like deal-specific collateral, but also to offset losses from other members defaults if necessary. This collateral is essentially a form of capital for the clearinghouse. For dealers, more general collateral may come in the form of required maintenance of a brokerage or deposit account or other assets with the dealer that can then be used to offset swap losses. Similarly, both clearinghouses and dealers can obtain guarantees from third-parties.41 These types of general collateral are closely related to a third risk management tool, setoff. Setoff (combined with the netting of multiple transactions) permits the clearinghouse or dealer to offset obligations it owes the defaulted counterparty against the debt owed by the counterparty. 42 Thus, if the defaulted counterparty owes the clearinghouse or dealer $100 million, and the clearinghouse or dealer owes the defaulted counterparty $120 million on other transactions, the clearinghouse or dealer need only pay the defaulted counterparty $20 million. Transaction-specific collateral, more general forms of collateral, and setoff all function like deductibles, which help reduce moral hazard in swap clearing by forcing a defaulting party to internalize its losses. A fourth tool for risk management is position limits. Both clearinghouses and dealer can limit the size of their counterparties positions.43 Clearinghouses are likely to have formal exposure limits,
39

See, e.g., CME Group, CME Rulebook, Rule 8H07 (guaranty fund contribution See, e.g., CME Group, CME Rulebook, Rule 8H07 (liability for guaranty fund

required).

40

assessment).

41 See, e.g., CME Group, CME Rulebook Rule 901 (requiring guarantee from control parties of CME Clearing Members). 42 See, e.g., CME Group, CME Rulebook Rule 8H802.B.3 (netting and setoff); Federal Reserve Banks, Operating Circular 1 Account Relationships, Effective Sept. 1, 2011, 5.3, at http://www.frbservices.org/files/regulations/pdf/operating_circular_1_090111.pdf (providing Federal Reserve with right of setoff); Federal Reserve Banks, Operating Circular 10 Lending, Effective Oct. 15, 2006, 12 at http://www.frbservices.org/files/regulations/pdf/operating_circular_10.pdf, (providing Federal Reserve with right of setoff). Most OTC CDS use the International Swaps and Derivatives Association (ISDA) Master Agreement, which provides for bilateral netting between counterparties various transactions, and setoff in the event of default. 43 See, e.g., CME Group, CME Rulebook, Rule 5559 (position limits). The Federal Reserve operates an automated clearing house (ACH) and a wire transfer service (FedWire). The Federal Reserve has position limits in the form of daylight overdraft limits, restricting how much a party can owe the Federal Reserve at any point. See Federal Reserve Policy on Payment System Risk, Mar. 24, 2011, at http://www.federalreserve.gov/paymentsystems/files/psr_policy.pdf. The Federal Reserve both caps the overdraft amount, id. at 22-27, and charges a 50 basis point fee for uncollateralized daylight overdrafts. Id. at 21. CHIPS, a private wire transfer clearinghouse operated by The Clearing House, does not permit any daylight overdrafts,

12
2012, Adam J. Levitin

LEVITIN

[8/10/12

while dealer banks are more likely to impose ad hoc limits, but the tool is the same. Clearinghouses and dealers operate with the same basic set of risk management tools. While they may have different pricing or margin requirements or position limits, they tools are functionally the same. The question, then, is how they will be deployed, which depends on the identification and evaluation of risk.

C. Information Fragmentation and Limitations

The ability of dealers and clearinghouses to manage position and balance sheet risk is heavily dependent upon the information they possess. In the presence of complete and accurate information and good modeling of risks, both dealers and clearinghouses should be able to take sufficient precautions to limit risk. Whether they will be so incentivized is a separate topic, discussed below. Dealers and clearinghouses have access to different types of information. Dealers and clearinghouses both have good basic information about position risk. They know the extent of their counterparties maximum exposure with them, and can compare the potential and likely losses on those positions with the counterparties overall financial wherewithal. How dealers and clearinghouses calculate the likely value at risk is a matter of modeling. It is not clear that dealer banks risk modeling will necessarily be superior to clearinghouses. Dealer banks may have an informational advantage regarding modeling of position risk. To the extent that dealer banks are also active the market underlying the swap, dealer banks will have a modeling advantage, but that is no guarantee of their modeling success. For example, a dealer bank that arranges mortgage securitizations should have a better understanding than a clearinghouse of the risks involved in a credit default swap on mortgagebacked securities (MBS), but this assumes that the securitization desk at the dealer is in close communication with the swaps desk. The experience of the dealer banks incurring large losses on MBS in 2008 suggests that this may not always be the case. Moreover, dealer banks, as active proprietary trading participants in the market, can also affect

http://www.chips.org/financials/033779.php, and limits positions to twice that of pre-funded balances, http://www.chips.org/about/pages/000702.php.

13
2012, Adam J. Levitin

LEVITIN

[8/10/12

risk, particularly if they stake out large positions, like the infamous London Whale of JPMorgan Chase.44 Dealers and clearinghouses have largely similar information regarding balance sheet risk. Most of the information a dealer bank will have is the same is available to a clearinghouse: quarterly public information about its counterparties, credit ratings, secondary market and credit derivative pricing on their counterparties, and anecdote.45 Dealer banks will have a slight informational edge if they can supplement this information with whatever they glean from their own non-swap dealings with their counterparties (such as loans or brokerage services). Dealers have necessarily incomplete information, however, as a dealer bank can never know how much of a counterpartys business it is seeing. Indeed, dealer banks cannot know the extent of a counterpartys total position, either in swaps or in general because of the fragmented nature of the dealer market. Goldman Sachs might know that AIG has $10 billion in long positions on CDS with it, but Goldman doesnt know if AIG has hedged this with another dealer or if AIG has long positions with other dealers. The same holds true for AIGs nonswap exposures. Goldman cannot know the full extent of AIGs liabilities, much less the details of their structuring, such as the existence of affiliate guarantees, etc. Dealer banks lack real-time, birds eye views of their counterparties balance sheets. In contrast, depending on the number of clearinghouses and whether they share information, clearinghouses may be able to see their members total swap exposure. If there is only a single clearinghouse, then it will know the full extent of all of its members swap exposures. If there are multiple clearinghouses, this information advantage is lost; information will be fragmented as it is for dealer banks, unless clearinghouses share information. Clearinghouses might be more willing to share data than dealer banks, as they typically make money on per transaction fees, rather than on spreads between matched transactions. This means clearinghouses are less likely to view exposure data as proprietary in the same way a dealer would view bids and asks. The clearinghouses profits do not depend on informational opacity, but transparency.
44

Daniel Schfer & Ajay Makan, JPMorgans whale causes a splash, FIN. TIMES, May

11, 2012.

CME Group, Financial Safeguards, supra note 28, at 12 (financial surveillance). Mandatory clearing gives clearinghouses a great deal of leverage to force information from counterparties. This may help clearinghouses address balance sheet risk, although, competition among clearinghouses may erode this leverage, however, as discussed below.

45

14
2012, Adam J. Levitin

LEVITIN

[8/10/12

Mandatory clearing gives clearinghouses a great deal of leverage to force information from counterparties. This may help clearinghouses address balance sheet risk, although, competition among clearinghouses may erode this leverage, however, as discussed below. Professor Pirrong has observed that futures clearinghouses only attempt to price position risk, not balance sheet risk.46 To the extent this holds true for swaps clearinghouses, they are unlikely to manage risk better than dealer banks. But there is no reason that this must be the case for derivatives clearinghouses, especially those that clear credit derivatives. Indeed, the Dodd-Frank Act places systemically important financial market utilities (SIFMUs), including swaps clearinghouses under federal regulatory authority. 47 Federal regulators (SEC for securities-based swaps, like CDS on MBS or corporate bonds; CFTC for everything else, like CDS on loans) are required to promulgate risk management standards for SIFMUs. 48 These standards may include collateral and margin requirements and capital requirements among other things. 49 SIFMUs are also subject to annual examination by their regulators,50 and gain access to Federal Reserve liquidity facilities.51 SIFMU regulations have not yet been promulgated as of the writing of this article (and indeed, the SIFMU designation process is ongoing), but one hopes that swap clearinghouses will have to consider their members overall balance sheets and require members to provide them with sufficient real-time information in order to evaluate balance sheet risk.

D. Empty Creditor Problems?

Professor Yadav argues that clearinghouses ability to manage risk is compromised by derivatives separation of legal rights from
Pirrong, supra note 6, at 47. Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the DoddFrank Wall Street Reform & Consumer Protection Act of 2010), P.L. 111-203, 124 Stat. 1376, 18021822, July 21, 2012, 801-814, codified at 12 U.S.C. 5461-72. 48 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the DoddFrank Wall Street Reform & Consumer Protection Act of 2010), P.L. 111-203, 124 Stat. 1376, 181011, July 21, 2012, 805(a), codified at 12 U.S.C. 5464(a). 49 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the DoddFrank Wall Street Reform & Consumer Protection Act of 2010), P.L. 111-203, 124 Stat. 1376, 181011, July 21, 2012, 805(c), codified at 12 U.S.C. 5464(c). 50 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the DoddFrank Wall Street Reform & Consumer Protection Act of 2010), P.L. 111-203, 124 Stat. 1376, 1814, July 21, 2012, 807, codified at 12 U.S.C. 5466. 51 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the DoddFrank Wall Street Reform & Consumer Protection Act of 2010), P.L. 111-203, 124 Stat. 1376, 181114, July 21, 2012, 806, codified at 12 U.S.C. 5465.
47 46

15
2012, Adam J. Levitin

LEVITIN

[8/10/12

economic risk poses serious risk to clearinghouses. She worries that clearinghouses will find themselves dealing with empty creditors nominal creditors with no economic interest in a loan.52 The implication of Professor Yadavs argument is that risk management is the key to clearinghouse success. I disagree. While an empty creditor problem can exist, I believe it is a red herring in the debate over clearinghouses, and that they key is capital, not risk management. While risk management helps protect capital, clearinghouses relative advantage over OTC clearing is capital, not risk management. To be sure, risk management is intimately related to capital; without good risk management, capital is quickly squandered. Nonetheless, I believe that clearinghouse design needs to start with capital standards, not risk management techniques. Professor Yadav sketches out a scenario in which A has bought credit default swap protection from B on C, to whom A has made a loan.53 The CDS makes A indifferent to Cs default and to the losses incurred in the default. Therefore A will not take steps to mitigate the losses on the loan to C, which could in turn increase the amount that B has to pay out on CDS contract with A. Moreover, A might even act to produce a credit event for C, such as a bankruptcy filing that triggers the CDS payout in order to ensure its own losses from C are covered by the CDS insurance. Professor Yadav worries that without the ability to protect itself against the empty creditor problem, clearinghouses will assume risks they cannot manage properly, which is particularly concerning given the concentration of risk in clearinghouses due to their role as nodes of financial interconnectivity. The scenario Professor Yadav presents is standard empty creditor theory applied to clearinghouses, but it is not in any way specific to clearinghouses. 54 It applies equally to OTC derivatives. Given that the empty creditor problem is not unique to clearinghouses, it is hard to see why it is a particular concern in the clearinghouse context any more so than in the dealer bank context.

Yadav, supra note 6, at ___. [section III.A.2.] Id. at ___. 54 See Henry T.C. Hu & Bernard Black, Debt, Equity and Hybrid Decoupling: Governance and Systemic Risk Implications, 14 EUR. FIN. MGMT. 663 (2008); Henry T.C. Hu & Bernard Black, Equity and Debt Decoupling and Empty Voting II: Importance and Extensions, 156 U. PA. L. REV. 625 (2008); Henry T.C. Hu & Bernard Black, Hedge Funds, Insiders, and the Decoupling of Economic and Voting Ownership: Empty Voting and Hidden (Morphable) Ownership, 13 J. CORP. FIN. 343 (2007).
53

52

16
2012, Adam J. Levitin

LEVITIN

[8/10/12

In any case, it is not apparent why any of this particularly matters for a clearinghouse that stands between A and B. As failure to mitigate its loss on the underlying asset will increase Bs obligation to the clearinghouse, and thus the clearinghouses obligation to A. This only affects the clearinghouse if B is insolvent. Otherwise, the clearinghouse is just a pass-through entity. Even if B is insolvent, the empty creditor problem still does affect systemic risk unless the clearinghouse also lacks sufficient capital to pay A. Put another way, the critical question is whether the clearinghouse is sufficiently capitalized, not whether it has debt governance rights or any other risk management tool. If the clearinghouse is sufficiently capitalized, then the empty creditor problem is not material from a systemic risk standpoint.55 Even if the empty creditor problem did pose a major threat to clearinghouses, Professor Yadavs solutions seem impractical. Professor Yadav would attempt to mitigate the empty creditor problem by providing clearinghouses with more information about market conditions, greater tools to discipline their members, and perhaps most importantly, debt governance rights.56 I have no objection to ensuring that clearinghouses have more information or disciplinary tools. It is not apparent, however, that they are lacking for information or disciplinary tools. Clearinghouses are able to demand information from their members57 and purchase data on the open market from vendors, just like financial institutions and regulators. They also already engage in information sharing with regulators.58 As for disciplinary tools, this is simply a matter of clearinghouse rules. Clearinghouses are free to give themselves whatever disciplinary tools they choose. If clearinghouse rules are too draconian, of course, it may be hard to recruit members. Indeed, there is a very real possibility of clearinghouse competition for membership and transaction volume based on rules, including margin requirements and position limits and member liability. If this sort of competition occurs, there will likely be adverse selection, as the riskiest swaps will go to the clearinghouse with the
Theoretically, the empty creditor problem could affect the sufficiency of capital at the margin. But a truly well-capitalized clearinghouse should not be vulnerable to failure based on an empty-credit problem. 56 Yadav, supra note 6, at ____. [PART IV]. 57 See, e.g., LCH.Clearnet, Ltd., Clearing House: General Regulations, Reg. 1.10 (reporting requirements). 58 See, e.g, CME Group, Financial Safeguards, supra note 28, at 12.
55

17
2012, Adam J. Levitin

LEVITIN

[8/10/12

laxest rules. Thus, there may be a governmental role in mandating minimum rules and ensuring that they are enforced. The power to control membership, pricing, and position limits should give a clearinghouse sufficient disciplinary tools, but only if the clearinghouse is motivated to use them.59 Debt governance rights, however, are more problematic. First, the clearinghouses rights will, by necessity, be limited to those of its swap counterparty. That swap counterparty may not have or want debt governance rights; the whole point of a naked CDS, for example, is to assume credit risk without having to engage in actual lending operations. Indeed, there will necessarily be an empty creditor when CDS are used for a naked wager, rather than a hedge, meaning in the above scenario that A lacks an insurable interest in C. If the protection buyer lacks an insurable interest, it has no ability to mitigate losses, but this is part of the nature of credit derivatives; they are not financing relationships. To illustrate, a small hedge fund might want to assume the credit risk on General Motors, for example, but would never consider trying to manage a loan with GM. Hence a CDS is a perfect match. Similarly a party that wants to short an illiquid bond, such as a mortgage-backed security, needs to use CDS to go short.60 The goal in such a transaction is to have a short position, not control over the reference asset. The ability to do these sort of transactions is a large part of the appeal of CDS. Equally important, debt governance rights are only valuable if a party wishes to engage in debt governance. Its hard to believe that any clearinghouse would be interested. Clearinghouses are in the payment guarantee business, not the asset management business. They are not designed to hold and manage assets like loans and bonds, much less on a vast scale, and it is not apparent that the costs and risks involved with debt governance would offset the losses a clearinghouse might incur because of an empty creditor problem. Instead, there is a solution to empty creditor problems and anything else that increases default risk for clearinghouses: capital. As long as a clearinghouse is a bastion of capital, it can shrug off losses without producing a systemic crisis.
59 See, e.g., LCH.Clearnet, Ltd., Clearing House Procedures, 8.4 (providing for fines, suspension, public censure, and termination among other remedies for violation of clearinghouse rules); CME Group, CME Rulebook Rule 402.B. (providing for range of sanctions, including fines, suspension, position limits, additional capital requirements, and expulsion). 60 Adam J. Levitin & Susan M. Wachter, Explaining the Housing Bubble, 100 GEO. L.J. 1177, 1242-43 (2012).

18
2012, Adam J. Levitin

LEVITIN

[8/10/12

III. CLEARINGHOUSE AS LOSS ABSORBER The major potential advantage clearinghouses have over dealer banks is in their ability to absorb risk, rather than manage it. Clearinghouses are essentially highly layered capital structures. While the details of a clearinghouses capital structure are (but need not be) set by private ordering, the structures of one the clearinghouses currently clearing corporate CDS, the Chicago Mercantile Exchanges CME Clearing, is as follows.61 First, any losses from a default by a customer of a clearinghouse member are reduced by collateral, netting, and setoff against the customers account. 62 Second, if the members customer is unable to make good its obligation via collateral and setoff, then the clearinghouse may engage in setoff and seize collateral from the clearinghouse members proprietary account and its contribution to the clearinghouses guaranty fund.63 Third, the clearinghouse itself will kick in some of its own funds.64 Fourth, other clearinghouse members contributions to the guaranty fund are applied against the default. 65 And finally, if these outer layers of defense are insufficient, the clearinghouse may make a capital call (up to a limited amount) on its members.66 And, if the

61 LCH.Clearnet, Ltd., has a similar structure with losses allocated first to the defaulting customer, then to the member clearing that customer from its guaranty fund contribution and proprietary accounts, then to the clearinghouse (capped at paltry 20 million), then outside insurance, then to non-defaulting members guaranty fund contributions, and then the clearing house itself again. LCH.Clearnet, Ltd., Default Fund Rules May 2012, 16. 62 CME Group, CME Rule 8H802A.d.2 (A CDS Loss arising in the defaulted CDS Clearing Members proprietary account class shall be satisfied from the CDS Collateral. A CDS Loss arising in the defaulted CDS Clearing Members customer account class shall be satisfied by application of performance bond, excess performance bond and settlement variation gains (collectively, the CDS Customer Collateral) held in the customer account class in which the CDS Loss is generated and by any excess CDS Collateral remaining after finalizing the CDS Loss of the defaulted CDS Clearing Members proprietary account...). 63 Id. 64 CME Group, CME Rule 8H802B.1 (If the CDS Collateral, the CDS Customer Collateral, and any excess assets from other product classes made available to cover CDS Losses, as described in Rule 8H802.A, is insufficient to cover the CDS Loss produced by the default, the Clearing House shall cover, or reduce the size of, such CDS Loss by applying the following funds to such losses in the order of priority as follows: First, the corporate contribution of CME for CDS Products (the CME CDS Contribution), which shall be equal to the greater of (x) $50 million and (y) 5% of the CDS Guaranty Fund, up to a maximum of $100 million). 65 CME Group, CME Rule 8H802B.1 (Second, the CDS Guaranty Fund (excluding the contribution of the defaulted CDS Clearing Member), which shall be applied pro rata to each nondefaulted CDS Clearing Members deposit to the CDS Guaranty Fund in accordance with Rule 8H07). 66 CME Group, CME Rule 8H802B.1 (Third, CDS Assessments against all CDS Clearing Members (excluding any previously defaulted CDS Clearing Members), which shall be assessed against each CDS Clearing Member pro rata in proportion to their required deposit to the CDS Guaranty Fund). In theory, nothing prevents unlimited liability for clearinghouse members.

19
2012, Adam J. Levitin

LEVITIN

[8/10/12

clearinghouse is a SIFMU, it will be able to access emergency Federal Reserve liquidity facilities.67 This capital structure places losses first on the defaulted part (netting, setoff, collateral) and then disperses excess losses among the clearinghouses members, thereby lessening the impact on any one of them. The different layers of capital and sources of liquidity make clearinghouses resilient to losses, and the diffusion of losses among members makes no single members share of losses catastrophic. Thus, the feared domino chain of failures is broken. This is not to say that a clearinghouse could not fail, either because of illiquidity or insolvency, and the details of the capital structure clearly matter; it is certainly possible for a clearinghouse to be undercapitalized. In theory, though, the financial strength of a clearinghouse could be the sum total of its members, making it stronger than any single dealer bank. Ultimately, ex post loss resilience, rather than ex ante risk management, is more important from a systemic risk standpoint. If clearinghouses can accomplish that, then they will serve as systemic risk circuit breakers in the swaps space. Yet it is also quite possible that clearinghouses will not be well-designed and will neither be resilient to losses nor good risk managers. In particular, clearinghouse owners may have incentives adverse to good risk management and capitalization. As the next section discusses, clearinghouses could potentially increase systemic risk. IV. DO CLEARINGHOUSES CREATE SYSTEMIC RISK? Clearinghouses might create systemic risk in three ways. First, they concentrate risk. Clearinghouses become centralized risk nodes within the system. Accordingly, the failure of a clearinghouse would have systemic consequences that would be far worse than a dealer banks failure. Not only would CDS counterparties lose the insurance function of the clearinghouse, but the market would also be in disarray if a clearinghouse failed. Concentration of risk on clearinghouses does have a benefitit should focus systemic risk regulation on clearinghouse regulation. Systemic risk regulation may be easier when risk is not dispersed. Moreover, if a clearinghouse were to fail, it would be far easier to bailout
67 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the DoddFrank Wall Street Reform & Consumer Protection Act of 2010), P.L. 111-203, 124 Stat. 1376, 181114, July 21, 2012, 806, codified at 12 U.S.C. 5465.

20
2012, Adam J. Levitin

LEVITIN

[8/10/12

than a dealer bank both in terms of bailout execution and as a political matter. The direct rescue of a privately owned financial institution is politically much more different than bailing out a utility used by the entire market. 68 Second, clearinghouses may create systemic risk by underpricing risk on CDS in order to gain market share. This underpricing could take the form of lower margin requirements, lower capital and membership requirements, or lower information production requirements. Clearinghouses are volume businesses, so expanding transaction volume increases revenue. If volume is increased without a concomitant increase in equity, a clearinghouse has increased its leverage and hence its return on equity. Market share is thus critical to clearinghouse profitability, and, indeed, there may be network effects in the industry that make it especially critical to establish market share. Thus, there will be a strong temptation for clearinghouses to underprice risk without increasing their capital in order to gain market share and thus increase returns on equity.69 Underpricing for market share is analogous to an insurance rate war. If this occurs the results are predictable: all the parties in the rate war are left undercapitalized for the risks they have incurred. Indeed, underpricing risk is also likely to encourage more CDS transactions by lowering transaction costs, further increasing the risk assumed by the undercapitalized clearinghouse. And there is likely to be adverse selection, as the riskiest swaps are moved to the clearinghouses with the laxest risk management (including lowest capital requirements in terms of margin and other collateral). The standard insurance regulation responses to this problem are rate-regulation or public provision of insurance. It seems unlikely, however, that the SEC and CFTC would impose rate regulation on clearing utilities to limit risk-taking, and although the Federal Reserve runs a payments clearinghouse, there seems to be little interest in a public swaps clearinghouse. All of this points to the market structure for clearinghouses being critical to their success. If there are too many clearinghouses, their membership and their capital will be shallower; they will not be able to disperse losses as effectively. There is also the potential for a destructive
See Adam J. Levitin, In Defense of Bailouts, 99 GEO. L.J. 435 (2011). Underpricing is also a potential problem for dealer banks, but because they make money on the opaque spread, rather than simply on volume, market share is less critical than for clearinghouses.
69 68

21
2012, Adam J. Levitin

LEVITIN

[8/10/12

rate war. Yet competition may also encourage innovation and efficiency in clearing. Thus we are faced with a tradeoff between innovation and efficiency and prevention of systemic risk. Given that clearinghouses raison dtre is systemic risk reduction, it would seem that innovation and efficiency would be secondary concerns, but again it seems unlikely that regulators would limit the number of clearinghouses or impose mandatory risk management requirements, rather than looser standards upon them. The third way clearinghouses may affect system risk is by shifting it outside the clearinghouse. Professor Mark Roe has argued that clearinghouses reduce risk for cleared transactions at the expense of creditors in transactions not handled by the clearinghouse.70 In particular, clearinghouses are secured creditors, which transfers risk to members unsecured creditors by limiting the assets available to them in the event of a members bankruptcy. Clearinghouses use of setoff and netting also functions similarly to secured credit, benefitting the clearinghouse at the expense of other creditors of its members by giving the clearinghouse priority in some of its members assets. (So too, one might add, does callable clearinghouse capital.) Professor Roe observes that this transfer of risk from inside to outside the clearinghouse could be systemically damaging if the risk is transferred to systemically important parties. The risk transfer effectuated by clearinghouses may well harm other systemically important parties. Yet the problem the Professor Roe identifies is one of systemic risk transfer, not generation. Unless we believe that parties outside the clearinghouses are more systemically important than those in the clearinghouses, it is hard to see this transfer as deleterious. To the extent that systemic risk thrives on nodes of financial interconnectivity, it is hard to think of institutions more important than dealer banks. Clearinghouses are merely a device to reduce the risk that stems from a dealer bank failure. They are not general systemic risk panaceas. They do not even cover all of the risks from dealer banks, as Professor Roe notes, given that dealer banks have other non-swap dealings with each other outside of clearinghouses (and which may be made riskier by clearinghouses).71 Instead, clearinghouses are one piece in a much larger systemic stability infrastructure of oversight, capital, and resolution mechanisms that is being slowly assembled. This systemic stability infrastructure is
70 71

Roe, supra note 6. Id. at __.

22
2012, Adam J. Levitin

LEVITIN

[8/10/12

far from perfect, and the Dodd-Frank Act provides only a general blueprint, with many crucial details to be determined. All that we can hope for from clearinghouses is a stabilization of the swaps market. Yet we should be asking how clearinghouses will combine with other measures to affect the general equilibrium of systemic risk. Are we merely engaged in a risk shifting game or are we actually managing to reduce risk? Can institutional framework design actually reduce systemic risk? CONCLUSION The debate over clearinghouses mirrors the larger policy debate over how to address systemic risk. Is it best addressed by limiting risk itself, through ex-ante regulation and commitment to ex-post resolution regimes that allocate losses predictably? Or is it best addressed by ensuring that financial institutions are more resilient to losses by mandating greater capital and liquidity? Of course, these need not be either-or approaches. Hopefully clearinghouses will be a belt-and-suspenders approach that results in better risk management and more resilience to losses. But on both counts, the devil lies in the details, which are ultimately in control of federal regulators, and it is still too early for clarity on clearinghouses.

23
2012, Adam J. Levitin