Alexandra G. Balmer - Regulating Financial Derivatives - Clearing and Central Counterparties (2018)

© Alexandra G.
Balmer 2018
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Contents
Foreword vi
Acknowledgements viii
List of abbreviations ix
1 Introduction 1
2 Derivatives 13
3 Clearing 38
4 Pre-crisis regulation of derivatives and clearing 65
5 Current regulation and implementation 88
6 Reforming the reform 124
7 Regulatory analysis 152
8 Summary of findings and outlook 197
Bibliography 208
Index 223
v
Foreword
August 2017 is the 10 year anniversary of the beginning of the global
credit crisis which began on 10 August 2007 when BNP Paribas
announced huge losses and the closure of three of its largest structured
investment funds. This led to the announcement of similar unprecedented
losses by other banks, such as UBS AG and Citigroup, and to a freeze in
lending between financial institutions. As the crisis intensified in late
2007 and 2008, governments provided direct and indirect taxpayer
support to financial institutions, in the form of credit and liquidity
guarantees, direct capital investment and in some cases nationalisation.
Clearly, financial institutions – especially those in Europe and the United
States – had catastrophically mismanaged their credit, market and
liquidity risks. As the crisis unfolded, it became apparent that regulators
had failed to understand the systemic risks in the securitisation and the
bilateral (over-the-counter or ‘OTC’) derivatives markets. The OTC
derivatives markets constituted a complex web of financial contracts
between financial institutions in which they had speculated and hedged
against trillions of dollars of liabilities and assets. As the bankruptcy of
Lehman Brothers investment bank in September 2008 demonstrated,
these risks were not well understood by the banks and institutions which
traded them, nor by the regulators whose responsibility it was to protect
society against the system-wide consequences of such risks.
Dr Alexandra Balmer’s important book, Regulating Financial Deriva-
tives: Clearing and Central Counterparties, provides an in-depth analysis
of the rationale and reform of international financial regulation following
the financial crisis of 2007–2008 to address systemic risks in the OTC
derivatives market. Indeed, financial market derivatives have attracted
much attention in the regulatory reform debate. This book critically
analyses the post-crisis regulatory reforms that require most OTC deriva-
tives contracts to be standardised and centrally cleared by third-party
clearing houses or central counterparties. These regulatory reforms are
analysed from a doctrinal and policy perspective and suggest, among
other things, that these reforms may only be shifting risks to central
counterparties without having adequate regulatory and market discipline
safeguards in place to manage these risks efficiently. The book addresses
vi
Foreword vii
an important area of the regulatory reform debate and is well-researched

and clearly written. It explains a difficult and complex area of financial
regulation from a comparative and international perspective. It draws on
a vast amount of research in both primary and secondary government
documents, including EU and US legal and regulatory materials, industry
and trade association reports, and academic studies to analyse the
evolution of regulation of the derivatives markets in general and the OTC
derivatives markets in particular. The analyses of the international
regulatory developments following the crisis are informative and identify
important weaknesses in the new regulatory framework for central
clearing of OTC derivatives and the operation of central counter parties
and derivative clearing houses.
Policymakers have observed that it would be a mistake to ‘waste’ the
financial crisis by failing to learn the lessons of regulatory reform that are
necessary to prevent or mitigate a future crisis. This book takes us a step
closer to understanding how systemic risks in the OTC derivatives
markets toppled the financial system in 2008, but also sheds light on how
certain post-crisis regulatory reforms can potentially introduce new risks
to the financial markets that threaten financial stability. The book also
sets forth some interesting regulatory reform proposals for the OTC
derivatives market. I have no doubt that the book will make an important
contribution to the literature and a reference for both academics and
practitioners.
Professor Kern Alexander

Chair for Banking and Financial Market Regulation
University of Zurich
Acknowledgements
Financial regulation has never been as complex and encompassing as it is
today. Derivatives were identified as core contributors and catalysts to the
last financial crisis and, as a result, they have been subject to a plethora
of regulation, which has reshaped the way derivatives are considered, but
not diminished their usage.
The core objective of the regulatory change was to ensure safe and
stable financial markets, where no future State-funded bailout would be
necessary. Yet, the risk to financial stability was not eliminated, but
simply shifted to the central counterparty (CCP), and the likelihood of an
intervention increased as each CCP represents an entity which is consid-
ered to be too-big-to-fail. As such, the reader must be asking right now:
‘Well, have we made the financial markets safer, at the very least?’ This
is the question at the heart of the following discourse. It is my desire to
give the reader all the information to answer this question for him- or
herself. I have made my own decision.
The completion of this book has been enabled through the support of
many. Particular gratitude belongs to Professor Kern Alexander, Professor
Aline Darbellay, Professor Seraina Grünewald, Dr Francesco De Pascalis
and MLaw Samir Ainouz. My sincere gratitude also belongs to Edward
Elgar for supporting me throughout this publication process. Finally, my
deepest gratitude belongs to my parents, who always encouraged me to
follow my dreams and supported my aspirations. I dedicate this book to
them.
All errors remain my own.
Alexandra G. Balmer
Zurich, 17 October 2017
viii
Abbreviations
AAA best credit rating by Standard & Poor’s

AIG American International Group
AIGFP American International Group Financial Products
Basel II Second Bank Capital Accord
Basel III Third Bank Capital Accord
BCBS Basel Committee on Banking Supervision
BIS Bank for International Settlements
BOTCC Chicago Board of Trade Clearing Corporation
BRRD Bank Recovery and Resolution Directive
CBOT Chicago Board of Trade
CCP central counterparty
CCPRRR European Commission, Proposal for a Regulation of the
European Parliament and of the Council on a Framework
for the Recovery and Resolution of Central Counterparties
CDO collateralised debt obligation
CDS credit default swap
CEA Commodity Exchange Act
CFMA Commodity Futures Modernization Act
CFTC US Commodity Futures Trading Commission
CIGI Centre for International Governance Innovation
CME Chicago Mercantile Exchange
CPMI Committee on Payments and Market Infrastructures
CPSS Committee on Payment and Settlement Systems
CRD Capital Requirements Directive
CRR Capital Requirements Regulation
CSD Central Securities Depository
DCO derivatives clearing organisation
ix
x Regulating financial derivatives
Dodd-Frank Dodd-Frank Wall Street Reform and Consumer Protection

Act
EBA European Banking Authority
EC European Community
ECB European Central Bank
EIOPA European Insurance and Occupational Pensions Authority
EMIR European Market Infrastructure Regulation
EMIR II European Commission, Proposal for a Regulation of the
European Parliament and of the Council amending
Regulation (EU) No 648/2012 as regards the clearing
obligation, the suspension of the clearing obligation, the
reporting requirements, the risk-mitigation techniques for
OTC derivatives contracts not cleared by a central
counterparty, the registration and supervision of trade
repositories and the requirements for trade repositories
ESMA European Securities Market Authority
ESRB European Systemic Risk Board
EU European Union
EUR Euro
FASB Financial Accounting Standards Board
FDIC Federal Deposit Insurance Corporation
Fed Federal Reserve System
FINMA Swiss Financial Market Authority
FMI financial market infrastructure
FN footnote
FSAP Financial Services Action Plan
FSB Financial Stability Board
FSF Financial Stability Forum
FSOC Financial Stability Oversight Council
FTT Financial Transaction Tax
FX foreign exchange
G7 Group of Seven
G10 Group of Ten
G20 Group of Twenty
Abbreviations xi
G-SIFI global systemically important financial institution

ICMA International Capital Market Association
IMF International Monetary Fund
IOSCO International Organization of Securities Commissions
ISDA International Swaps and Derivatives Association
LCH LCH.Clearnet (London Clearing House)
LOLR lender of last resort
LTCM long-term capital management
MAD Market Abuse Directive
MAR Market Abuse Regulation
MBS mortgage-backed security
MiFID I Market Infrastructure Directive
MiFID II Market Infrastructure Directive
MiFIR Market Infrastructure Regulation
N recital
ODSG OTC Derivatives Supervisors Group
OJ Official Journal (EU)
OLA Orderly Liquidation Authority
OTC over-the-counter
OTF organised trading facility
PFMI Principles for Market Infrastructures
Pub. L. Public Law (US)
REFIT EU Regulatory Fitness Performance
SEC US Securities and Exchange Commission
SIDCO systemically important derivatives clearing organisation
SIFI systemically important financial institution
SIFMA Securities Industry and Financial Markets Association
SIX Swiss Exchange
SSS Securities Settlement System
Stat Statutes at Large (US)
TARP Troubled Asset Relief Program
TFEU Treaty of the Functioning of the European Union
TR trade repository
USC United States Code
xii Regulating financial derivatives
USD United States Dollar

WTO World Trade Organization
1. Introduction
To ask today’s regulators to save us from tomorrow’s crisis using yesterday’s
toolbox is to ask a border collie to catch a Frisbee by first applying
Newton’s Law of Gravity.1 (Andrew G Haldane)
The current regulatory direction, which is prevalent in every aspect of

financial regulation, is a push towards a more stringent and overreaching
regulation. Regulators no longer direct their powers to certain institutions
or solely to national interests by limiting their powers to one specific area
of financial regulation or even just one country. The current regulation is
pushing the regulatory boundaries of countries by promoting very strong
extraterritorial application to a protectionist level by also regulating
market access and third countries, while continuously regulating new
areas that were not previously regulated. Yet why is this necessary? Every
new regulation which is drafted finds its origin in a financial crisis or
some other scandal. Most of the new regulation finds its origin in the
2007/2008 financial crisis. Despite the fact that 10 years have passed, we
still are not seeing the ‘lessons of the crisis’ being implemented effect-
ively around the world. Derivatives were blamed for the crisis, yet the
implementation of the regulation to harness the derivatives market is still
ongoing and new regulation continues to be drafted. Is this our way of
appeasing tax-payers, by telling them that, with the right regulation, they
will be entirely protected from the private markets, from the banks; by
telling them that their savings are safe, that they can invest without any
risks, and that their tax money will never have to be used again to bail
out a failing financial institution or service provider?
The author is unable to cover all the regulatory topics that have been
rewritten and introduced since the financial crisis. As such, the focus lies
on one specific topic: the revolution in the derivatives market by
mandating clearing for over-the-counter derivatives. Based on the ana-
lysis of the objectives of international organisations and ongoing regula-
tory implementation of new rules, the reader will be provided with an in
1
Andrew G Haldane and Vasileios Madouros, ‘The Dog and the Frisbee’
(Federal Reserve Bank of Kansas City’s 366th Economic Policy Symposium
‘The Changing Policy Landscape’, Jackson Hole WY, 31 August 2012), 152.
1
2 Regulating financial derivatives
depth analysis of this new regulation. The book will show whether these
new rules have had an impact on the derivatives market, and if so, what
it is. The final decision regarding whether or not the regulation has
achieved its objective of stopping tax contributions from preventing
adverse effects on systemic risk is left up to the reader.
To most people, derivatives are an obscure financial instrument that
they neither understand nor wish to understand because economists and
Wall Street bankers have made them appear more complicated than they
are. At the very least, derivatives are known as the cause of the financial
crisis of 2007–2009 that brought Wall Street to its knees while simul-
taneously filling the pockets of a select few. Newspaper articles and the
Hollywood blockbuster film, The Big Short – starring photogenic
A-listers and based on Michael Lewis’s book – continuously reaffirm the
message: derivatives are bad! Yet can something that has been around for
centuries, representing a multi-trillion-dollar industry, be solely bad?
Derivatives, simplified, are a bet. They are agreements made between
two parties stating that one will pay the other a certain amount of money
depending on the outcome of a future event. Since common sense teaches
us that there is ever only one winner to a bet, derivatives have become the
source of great controversy over the last 30 years owing to their social
and economic impact.
In 2002, Warren Buffett called derivatives ‘financial weapons of mass
destruction’,2 and he was proven right in this regard. Derivatives permit
risk to be shifted around the market with the objective of reducing
systemic risk. Considering the market, prices may rise or fall depending
on external factors beyond the reach of the individual, such as food
shortages caused by drought or floods. To protect against sudden price
increases, derivatives can be used to fix a future price, thus shielding
oneself from such price increases. Here, the derivative contract – once
again simplified as a bet – takes on an insurance form and reduces the
risk for the buyer. Betting not only protects against risk; somewhat
counterintuitively, it is more beneficial to attempt to earn a profit by
predicting future prices and entering into a speculative bet. The specula-
tive element of derivatives is what makes them a threat to financial
stability and social welfare, as speculation does not protect risk-averse
2
Berkshire Hathaway, ‘2002 Annual Report Berkshire Hathaway Inc.’
(2003), 15.
Introduction 3
market participants from future risks, but instead creates risks to which
they would not have otherwise been exposed.3
As long as derivatives are used to hedge an existing risk, they
contribute to social welfare by reducing risk. When used to speculate,
risks which previously did not exist are created for individuals and the
financial system, thereby decreasing social welfare and financial stability.
At the end of a bet, wealth is exchanged and one party is determined to
be wrong and loses money. Financial risk is determined by the exchange
of wealth. Considering that the global size of the derivatives market
reached USD 670 trillion in 2008, its potential financial risk to the
overall economy becomes apparent.4 The global distribution and usage of
derivatives by financial firms5 and governments, hedging risks from
borrowed assets, make derivatives systemically relevant, as any distur-
bance resulting from or through the actions of any actor in this market
can lead to instability in the market and therefore undermine its financial
stability.6
The past eight years have witnessed the most significant public policy
debates surrounding the regulation of this financial tool as regulators and
international standard-setters have attempted to harness and tame deriva-
tives. However, their regulation is not new and this study will show that
derivatives once before were regulated in the United States. This was in
1993. Earlier regulation had banned purely speculative derivatives trades,
particularly off-exchange trading in the bilateral markets (so-called
over-the-counter, or OTC derivatives), so why is re-regulating a certain
market area so important and controversial? The reason is ‘mandatory
clearing’ of certain derivatives contracts. Mandatory clearing requires a
private organisation, the central counterparty (CCP), to take on public
policy objectives and guarantee each derivative contract it clears. Consid-
ering that in 2008 the global OTC derivatives market had a notional value
of USD 670 trillion, the core question becomes which private organ-
isation – or government – could guarantee such a risk position?
3
Lynn A Stout, ‘Legal Origin of the 2008 Financial Crisis’ (2011) 1
Harvard Business Law Review 1, 9–10.
4
Ibid 24.
5
Such as hedge funds, pension funds, mutual funds, investment banks and
proprietary trading divisions run by commercial banks and insurance companies.
See Lynn A Stout, ‘Legal Origin of the 2008 Financial Crisis’ (2011) 1 Harvard
Business Law Review 1, 25.
6
Garry J Schinasi, ‘Defining Financial Stability’ (October 2004) IMF
Working Paper 04, 6; Lynn A Stout, ‘Legal Origin of the 2008 Financial Crisis’
(2011) 1 Harvard Business Law Review 1, 25.
This question motivated the writing of this book. The study will cover
the following topics. First, the author will identify what derivatives are
and what they are used for. Then, central clearing is analysed from a
modern and contemporary view, considering which tools CCPs were
given to manage their risk exposure and ability to deal with a default, if
they need to guarantee a derivatives contract. After establishing the
significance of derivatives and clearing, the study then moves on to the
legal regulation thereof. Beginning with an historic view of how deriva-
tives were originally regulated, their deregulation – and the effects
thereof – are traced. Subsequently, the post-crisis response by inter-
national standard setters is summarised. Based on an understanding of
the global incentives and pressures, a comparative analysis of the
regulations proposed in response to the crisis in the European Union and
the United States is undertaken.
This ambitious regulatory project, pursued with great frenzy at first,
has turned into what can only be described as an unsuccessful launch.
While the United States created an extensive regulatory framework for
derivatives in 2010, the European Union has yet to enact legislation to
comply with half of the G20 commitments intended as part of the
derivatives reform. Additionally, the United States and the European
Union, representing the two most influential derivatives marketplaces,
have each proven themselves incapable of reaching an agreement on the
other’s regulation, thus leading to a fragmented market and a politically
motivated turf war.
The critical regulatory analysis shows that CCPs ultimately are becom-
ing too important to fail owing to mandatory clearing. Thus, the reform
as currently pursued is the result of a misconception of CCPs’ abilities to
eliminate systemic risk. This finding is followed by a novel suggestion to
deal with the CCPs’ exposure to derivatives risk: the creation of a global
CCP bail-out fund. Such a global CCP bail-out fund, together with
stringent risk-management practices for CCPs, can restrict government
involvement (particularly taxpayer funds), which was one of the core
reasons for mandatory clearing’s introduction in the first place. Such a
novel approach gives today’s regulators new tools to address tomorrow’s
crises, instead of the current approach of turning two blind eyes to the
super-systemic monster that CCPs have become and simply praying that
they will manage tomorrow’s risks using the same tools that failed
yesterday.
Because counterparties over-expanded their risk for profits in the years
leading up to the financial crisis of 2007–2009, regulatory reform became
necessary. The complexity of derivatives and the cross-jurisdictional
interconnectedness of derivatives markets have complicated the reform
Introduction 5
process, which is why new regulation is only recently being phased in

across jurisdictions. This ongoing process of legislation and application
makes this book very topical and lets the author contribute to the ongoing
debate in an area which surprisingly few authors have contributed to,
regarding how CCPs should be regulated to achieve the policy objectives
of financial stability.
1.1 FINANCIAL STABILITY

Financial stability is defined as ‘a condition in which the financial system
– intermediaries, markets and market infrastructures – can withstand
shocks without major disruption in financial intermediation and in the
general supply of financial services’.7 If financial stability is disrupted by
shocks, then financial infrastructures and the financial system can also be
disrupted. The actions of private actors using derivatives led to distur-
bances in the financial infrastructure, culminating in the global financial
crisis of 2007–2009, which eroded household wealth by USD 11 trillion.8
US taxpayers were required to bail out the American insurance company
AIG for USD 180 billion, in addition to the USD 700 billion required for
the Troubled Asset Relief Program and other short-term credit extended
to banks and hedge funds in excess of USD 3.3 trillion in order to
prevent the financial system from collapsing after the financial insti-
tutions refused to lend to each other.9 To prevent this from happening
again, regulatory reforms were drawn up. Yet despite these, the funda-
mental question remains as to whether derivatives have truly been
reformed from ‘financial weapons of mass destruction’ into decorative
confetti of the financial system, posing little risk to financial stability.10
Because derivatives are at a crossroads between finance, economics,
mathematics, computer science and law, tackling this topic is highly
complex. This book is limited to a legal analysis of the problem but
7
See European Central Bank, ‘Financial Stability and Macroprudential
Policy’ (3 September 2017) <https://www.ecb.europa.eu/ecb/tasks/stability/html/
index.en.html> accessed 3 September 2017.
8
The Financial Crisis Inquiry Commission, ‘The Financial Crisis Inquiry
Report’ (January 2011), xv.
9
Harvard Business Law Review 1, 2–3 and 28–9.
10
See John Dizard, ‘The next Financial Crisis: I Told You so, and It Wasn’t
My Fault’, Financial Times (London, 1 May 2015) <http://www.ft.com/intl/cms/
s/0/b40fb70e-effa-11e4-bb88-00144feab7de.html#axzz3zfz1zo5c> accessed 3
September 2017. Dizard claims that CCPs will be the next AIG.
includes elements taken from finance and economics where it is neces-

sary to improve topical understanding. In general, most authors focus on
one specific problem of either derivatives or clearing regulation, which is
why there is a gap in the literature considering the topic holistically. It is
in this regard that this book sets itself apart from previous literature. The
objective is to take the reader on a journey beginning with why
derivatives are relevant to financial stability and ending with the meas-
ures that should be undertaken in order to ensure that they enhance
financial stability, instead of posing a new risk thereto.
1.2 SYSTEMIC RISK AND MACRO-PRUDENTIAL

POLICY
Systemic risk and macro-prudential both lack uniform definitions in
financial market regulation.11 The financial system relies upon a stable
and sound functioning of the financial markets. Therefore, containing
risk, which could cause system-wide disruptions, is necessary. The latest
financial crisis displayed the effects of the absence of a holistic approach
to financial regulation and supervision, presenting the need to link the
individual supervision of banks with a broader oversight of the financial
system.12 A narrow consideration of individual institutions is referred to
as micro-prudential oversight, while the broader, more holistic oversight
of the financial system is macro-prudential oversight.13
A destabilisation of one or more institutions can spill over or cause
contagion to other institutions and ultimately affect the financial system
as a whole by causing systemic risk. The financial system is particularly
at risk from becoming systemic because of the interconnected nature of
interbank lending, derivatives and the payment and settlement system.
The speed with which financial institutions trade with one another
increases the chances of risk spreading from poorly monitored counter-
party credit risk and liquidity shortages. A sudden default or liquidity
shortage in a large bank could immediately affect all other institutions
dealing with it.14 A second risk factor is the usage of debt instead of
11
See Eilís Ferran and Kern Alexander, ‘Can Soft Law Bodies Be Effective?
Soft Systemic Risk Oversight Bodies and the Special Case of the European
Systemic Risk Board’ (June 2011) 36, 26–7 with further references.
12
Ibid 3.
13
Ibid.
14
James Bullard, Christopher J Neely and David C Wheelock, ‘Systemic
Risk and the Financial Crisis: A Primer’ (2009) 91 Federal Reserve of St Louis
Introduction 7
equity to attain profits. This is referred to as leveraging. In good times,

this permits large profits at little cost, but it increases exposure during a
financial downturn, as was proven in the latest financial crisis.15 Lastly,
financial firms tend to finance long-term illiquid positions with short-
term debt. Such a maturity mismatch can be particularly detrimental in
times of financial downturn if short-term debt is suddenly removed, e.g.
by depositors withdrawing their deposits, effectively removing liquidity
and potentially forcing the financial firm into bankruptcy.16
Loss of liquidity, bankruptcy and government intervention cause other
financial market participants to lose confidence in individual firms. Thus,
the interconnectedness of the financial market exacerbates contagion.
Such sudden market shifts affecting the financial system as a whole are
referred to as systemic risk. The Group of Ten defined systemic risk as
follows:
Systemic financial risk is the risk that an event will trigger a loss of economic
value or confidence in, and attendant increases in uncertainty about, a
substantial portion of the financial system that is serious enough to quite
probably have significant adverse effects on the real economy. Systemic risk
events can be sudden and unexpected, or the likelihood of their occurrence
can build up through time in the absence of appropriate policy responses. The
adverse real economic effects from systemic problems are generally seen as
arising from disruptions to the payment system, to credit flows, and from the
destruction of asset values. Two related assumptions underlie this definition.
First, economic shocks may become systemic because of the existence of
negative externalities associated with severe disruptions in the financial
system. If there were no spillover effects, or negative externalities, there
would be, arguably, no role for public policy. […] Second, systemic financial
events must be very likely to induce undesirable real effects, such as
substantial reductions in output and employment, in the absence of appropri-
ate policy responses. In this definition, a financial disruption that does not
have a high probability of causing a significant disruption of real economic
activity is not a systemic risk event.17
Review 403, 408–9; Lynn A Stout, ‘Legal Origin of the 2008 Financial Crisis’
(2011) 1 Harvard Business Law Review 1, 2–3.
15
James Bullard, Christopher J Neely and David C Wheelock, ‘Systemic
Risk and the Financial Crisis: A Primer’ (2009) 91 Federal Reserve of St Louis
Review 403, 409.
16
This happened to Bear Stearns in March of 2008 and Merrill Lynch
in September 2008. See James Bullard, Christopher J Neely and David C
Wheelock, ‘Systemic Risk and the Financial Crisis: A Primer’ (2009) 91 Federal
Reserve of St Louis Review 403, 409; Lynn A Stout, ‘Legal Origin of the 2008
Financial Crisis’ (2011) 1 Harvard Business Law Review 1, 26.
17
G10, ‘Consolidation in the Financial Sector’ (January 2001), 126.
To counterbalance and pre-empt the negative externalities of systemic

risk, macro-prudential policies are particularly important. Macro-
prudential policy considers the financial system as a whole by adopting
policies aimed at preventing risk build-up before it causes harm and
containing it before it can spread to other institutions where it can cause
systemic risk.18
In the regulatory and public debate following the financial crisis of
2007–2009, the focus shifted away from a micro-prudential to a macro-
prudential approach. While the micro-prudential approach regulates at the
firm level to remove risk, believing that this will reduce the overall
market risk exposure, macro-prudential regulation considers the larger
picture of the overall financial system to reduce market risk exposure in
general.19 Such a macro-prudential application of rules directly affects
how strongly individual firms are targeted by the regulation, as the rules
have a tighter or more lenient effect depending on how systemically
relevant the firm is.20 The objective of macro-prudential regulation is to
pre-emptively control risks and potential downfalls after an economic
boom period, acting counter-cyclically.21 Therefore, the regulation to
reduce systemic risk should primarily be aimed at making markets
counter-cyclical by eliminating spill-over.22 Systemic risk itself is gener-
ally caused by asset bubbles caused by financial liberalisation or innov-
ation and by the inability to properly assess how strongly an actor
impacts macro-economic stability.23 Ultimately, micro-prudential rules
need to be combined with macro-prudential systemic governance to
ensure the implementation of risk-management practices at the firm level
and the coordination of global governance rules.24 This combination of
18
European Central Bank, ‘Macroprudential Policy Strategy’ (3 September
2017) <https://www.ecb.europa.eu/ecb/tasks/stability/strategy/html/index.en.html>
accessed 3 September 2017.
19
Kern Alexander and Steven L Schwarcz, ‘The Macroprudential Quandary:
Unsystematic Efforts to Reform Financial Regulation’ in Ross P Buckley,
Emilios Avgouleas and Douglas Arner (eds), Reconceptualising Global Finance
and its Regulation (Cambridge University Press 2016), 127.
20
Ibid 128; Markus Brunnermeier and others, ‘The Fundamental Principles
of Financial Regulation’ (June 2009) 11, xviii.
21
Ibid 11, xviii–xix.
22
Ibid 31–2.
23
Ibid 3–4.
24
Introduction 9
micro-prudential and macro-prudential rules can be found in the new

regulation of OTC derivatives and central clearing. On the micro-
prudential side, the regulation includes rules for the individual CCP,
while on the macro-prudential side, the overall risk-management prac-
tices for CCP access, reporting and clearing are discussed.
To quote Tucker:
The macro-prudential policymaker will aim to have the financial system build
resilience during a pronounced and stability-threatening boom. That will
potentially dampen the boom itself, but crucially it will leave the financial
system better equipped to weather the bust without collapsing. Thus, the
amplitude of the credit cycle would be dampened, with deep recessions
somewhat less likely. Like monetary policy, the macro-prudential policymaker
acts counter-cyclically. And in both endeavours the central bank (or regulator)
is explicitly seeking to act – is under a statutory duty to act – in the wider
public interest, in the interests of the system as a whole.25
The OTC derivatives market was implicated as a major source of

systemic risk after the financial crisis.26 Consequently, the necessity to
tame OTC derivatives and mandate central clearing became one of the
prevalent solutions to prevent a future financial crisis. Central counter-
parties were deemed as a panacea solution to mitigate risk in a way that
can effectively prevent contagion in the derivatives market between
counterparties. The intention is to institutionalise risk management
through clearing, thereby reforming the derivatives market and preventing
misjudgements of risk between counterparties. This new light shone on
CCPs has caused heavy market reliance upon their proper functioning
and trustworthiness. It could be argued that there is an over-reliance upon
CCPs. Regulation aims to force derivatives users out of the direct
counterparty-to-counterparty market (the OTC market) and into regulated
exchanges by making them use a CCP to clear their contracts. Since
clearing by a CCP was not generally used in OTC transactions in the
pre-crisis era, the reliance upon CCPs to guarantee the functioning of risk
calculations and financial stability is a recent development stemming
from the regulatory reform. This new reliance on the ability of CCPs to
calculate risk and mitigate it accordingly using the tools provided to them
25
Paul Tucker, ‘Are Clearing Houses the New Central Banks?’ (Over-the-
counter Derivatives Symposium, Chicago, 11 April 2014), 7.
26
Rena S Miller and Kathleen Ann Ruane, ‘Dodd-Frank Wall Street Reform
and Consumer Protection Act: Title VII, Derivatives’ (November 2012), Congres-
sional Research Service R41298, ii.
from the regulators merits an in-depth analysis of both the purpose of a

CCP and the tools allocated to it to achieve the regulatory objectives.
1.3 STRUCTURE
As regulators have instituted CCPs to tame the OTC derivatives of the
last crisis, it is logical to ask whether this is indeed the expedient way or
if it will culminate in another financial crisis. These questions, analysed
from a macro-prudential perspective, will follow the reader from the
introduction to the conclusion.
The macro-prudential perspective allows this book to engage in a legal
policy debate with systemic risk management as its core topic. The
discussion on how current regulatory reforms impact systemic risk will
be directed particularly with regard to OTC derivatives. These derivatives
are a phenomenon of the past 40 years and were not traditionally subject
to the clearing mandate. Therefore, the focus is narrowed on the clearing
of OTC derivatives by means of a CCP.
Chapter 2 of this book explains the basic nature of derivative contracts
as a tool to manage risk. This tool can be used both to protect against
existing risks by hedging and to generate new risks by speculating.
Depending on how frequently derivatives are used in a similar context,
they can become more or less standardised. Standardisation influences
how they are traded, with standardised derivatives traded on exchanges
and bespoke contracts traded bilaterally OTC. To complete the intro-
duction to derivatives, the four core types of derivatives are then
introduced. Finally, the involvement of credit derivatives, particularly
CDS and the financial meltdown of AIG, are discussed.
Chapter 3 describes and defines clearing, particularly in light of the
new importance clearing takes on in the post-crisis financial system.
Clearing traditionally was only required for exchange-traded derivatives,
but the regulatory reform has mandated clearing for OTC derivatives as
well. The impact of clearing is demonstrated using the case of the default
of Lehman Brothers Special Financing Inc. in 2008 and the ability of the
central counterparty LCH.Clearnet to successfully wind down the USD 9
trillion exposure among its members. The case of Lehman Brothers
shows the importance of solid risk-management practices for CCPs. How
LCH.Clearnet managed to contain the outstanding positions is pertinent
to systemic risk management. This chapter also gives an overview of the
historical development of clearing and CCPs.
Chapter 4 first looks at the pre-crisis regulation of OTC derivatives in
the European Union and the United States. While the financial innovation
Introduction 11
of OTC derivatives certainly played a role in increasing risk stemming

from derivatives, evidence will be provided to show that it was the
complete deregulation of the OTC derivatives market, particularly by the
Commodities Futures Modernization Act in 2000, which permitted
the OTC market to reach a volume of USD 670 trillion. Following the
crisis, international standard-setting bodies began promoting a harmon-
ised global framework to reform the financial system, promote macro-
prudential policy objectives and reduce systemic risk. A selection of such
standards will be presented here. The global reform movement has made
CCPs of systemic importance to financial stability. The default of a CCP
would be felt by all conjoined financial institutions, making them
systemically relevant and too big to fail.
Subsequently, Chapter 5 comparatively analyses the implementation of
the derivatives reform in the European Union and the United States. The
analysis keeps the objective of harmonising global reforms in mind, by
providing insight into how the jurisdictions differ in their implemen-
tation, where they converge and how this affects collateral demands and
financial stability. Considering CCPs as systemically important insti-
tutions and too interconnected to fail, it is striking that the regulations
have not taken the potential default of a CCP into consideration. This
omission makes the intent of the clearing mandate to prevent a future
bail-out (as seen with AIG) dubious and raises the question of whether
the systemic risk has been increased – instead of mitigated – by the
reform.
The regulators have recognised that the reforms have all but been
completed and have identified many areas for improvement. Chapter 6
looks at the intended reforms in the EU, based on the draft proposal for
a recovery and resolution regime for CCPs, as well as a redraft of EMIR
to close gaps and reduce the regulatory burden for certain counterparties,
and information mismatches from trade reporting. This chapter also
considers the implications from President Trump’s executive order to
assess financial market regulation in the United States and the European
Union’s reaction to the impending departure of Britain from the Union.
Chapter 7 analyses the impact of the reform on financial stability. The
bilateral trading of OTC derivatives exposed its counterparties to counter-
party default risk. While netting and novation decrease counterparty
credit risk exposure in the financial market, they create new risks for the
CCP who must guarantee each contract. To counterbalance these risks,
the CCP collects collateral and sustains a default fund. Yet it will be
shown that the CCP faces difficulties in pricing the risk from the OTC
derivatives, as reliable data from previous transactions are missing, while
the large banks as counterparties profit from excellent models and
experience in assessing exposure to their counterparties. This is particu-

larly increased with new products such as credit default swaps mandated
for clearing. CCPs have been turned into organisations that concentrate
within, making them systemically relevant and prone to adverse selection
and moral hazard, and ultimately too big to fail. However, regulation has
failed to address this dilemma. The chapter closes with an original
contribution to the discussion – the author proposes creating a CCP
insurance fund. The objective of such a fund is to provide liquidity to
insolvent systemically important CCPs while increasing the CCPs’ own
risk management, decreasing moral hazard and ensuring that the costs are
supported by those who profit from clearing.
Chapter 8 concludes by combining and examining the lessons from the
crisis and regulatory reform. It reaffirms the core findings and suggested
amendments to ensure that the objectives of the reform are met and to
reignite the discourse surrounding an improved financial market stability.
2. Derivatives
2.1 DEFINITION
Derivatives are a financial tool that allows companies to achieve a level
of efficiency and sophistication which just two or three decades ago
could not have been fathomed.1 The Bank for International Settlements’
(BIS) latest statistics on the global OTC derivatives market show that by
the end of 2015 the gross notional amount2 outstanding totalled USD 493
trillion.3 The incredible size of this market indicates both its importance
to, and its potentially detrimental impact on, the stability of the global
financial system. To understand the power of derivatives, this chapter will
introduce the reader to the concept of derivatives by explaining which
derivatives are used, when, and to what extent, and the role they play in
financial stability.
A derivative is essentially a contract to reallocate risk.4 However,
because derivatives vary widely in content and application and can adapt
1
Norman M Feder, ‘Deconstructing Over-The-Counter Derivatives’ (2002)
2002 Columbia Business Law Review 677, 678.
2
The ‘notional value’ refers to the value of the underlying financial asset
upon which the derivative contract was written. Because it is impossible to
determine ex ante how much the contract will be worth at maturity, the notional
value remains an imperfect way to calculate the derivative market size, but
permits a vague impression of the total market size and exposure of the
derivative traders. See Lynn A Stout, ‘Legal Origin of the 2008 Financial Crisis’
(2011) 1 Harvard Business Law Review 1, 22–3. However, the gross exposure
from derivatives, meaning the total value of all contracts closed out and settled
simultaneously, is only a tiny fraction of the notional value, less than 10%. See
Jan D Luettringhaus, ‘Regulating Over-the-Counter Derivatives in the European
Union – Transatlantic (Dis)Harmony After EMIR and Dodd-Frank: The Impact
on (Re)Insurance Companies and Occupational Pension Funds’ (2012) 18 The
Columbia Journal of European Law 19, 20.
3
BIS, ‘Global OTC Derivatives Market’ (3 September 2017) <http://stats.
bis.org/statx/srs/table/d5.1> accessed 3 September 2017.
4
2002 Columbia Business Law Review 677, 682; The Financial Crisis Inquiry
Commission, ‘The Financial Crisis Inquiry Report’ (January 2011), 45–6.
13
to any situation, they are exceedingly difficult to define. Nevertheless,

certain structures are common to all derivatives. The International Swaps
and Derivatives Association (ISDA) offers the following short and
poignant definition for derivatives:
A derivative is a risk transfer agreement, the value of which is derived from

the value of an underlying asset.5
This definition incorporates all structures necessary for a derivatives

contract: two counterparties, one or more underlying assets and a
maturity date. First, there is a financially meaningful external item6 – a
risk – that a market participant is unwilling to internalise. Consequently,
the market participant must find another party willing to enter into a
contract with him to protect him from potential losses resulting from the
external item, which is referred to as ‘underlying’.7 Second, derivatives
contracts lack intrinsic value; they derive8 their value from an underlying
asset or multiple assets.9 Lastly, as derivatives protect from shifts in the
market valuation of the underlying, a maturity date needs to be set for its
fulfilment.10
Derivatives are differentiated from securities, despite derivatives some-
times being referred to as securities. While derivatives’ contract counter-
parties have claims against each other, holders of securities have a
proprietary right over these securities, not only towards the counterparty,
but erga omnes, i.e. anyone who may oppose the ownership.11
5
ISDA, ‘Product Description and Frequently Asked Questions’ (3 Septem-
ber 2017) <http://www.isda.org/educat/faqs.html#1> accessed 3 September 2017.
6
7
Ibid.
8
Etymologically, a derivative stems from the Latin verb ‘derivare’ which
translates to the English ‘derive/draw on’; Dennis Kunschke and Kai Schaffel-
huber, ‘Die OTC-Derivate Im Sinne Der EMIR Sowie Bestimmungen Der
Relevanten Parteien – Eine Juristische Analyse’ in Rüdiger Wilhelmi and others
(eds), Handbuch EMIR (Erich Schmidt Verlag 2016), N 1.
9
2002 Columbia Business Law Review 677, 681-2.
10
Michael Durbin, All About Derivatives (2nd ed, McGraw-Hill Education
2010), 1.
11
Chryssa Papathanassiou, ‘Central Counterparties and Derivatives’ in Kern
Alexander and Rahul Dhumale (eds), Research Handbook on International
Financial Regulation (Edward Elgar 2012), 219.
Derivatives 15
2.2 DERIVATIVE FUNCTIONS

Derivative contracts address isolated risks through their contractual
relationship and transfer risk from one party to another. The contracts are
engineered to reflect the value, or the changes in the value, of the
underlying and thereby shift their exposure risk and unbundle the specific
risk on a party willing to carry it.12 Therefore, the purpose of derivatives
is not to eliminate risk, but to shift it around the market and place it on
counterparties who are willing and able to absorb it. The selection and
transferal of risk according to specific wants and needs is referred to as
risk management.13
Since risk is a timeless and universal component of any transaction,
creating demand to protect against unexpected market shifts, derivatives
are clearly not a modern invention. In fact, one of the earliest recorded
usages of a derivatives contract dates back to the time of Aristotle.14
Modern risks stem from underlying assets. Anything can be considered
an underlying asset if it can be priced at regular intervals or traded on
exchanges. The most common underlying assets are shares, commodities,
reference rates of interest rates and indices.15
2.2.1 Purpose of Derivatives
Because derivatives allow for risk to be shifted between counterparties,

market participants engage in derivatives not only to protect themselves
against risk, but also to speculate. Hence, derivatives can be used to
hedge, to speculate and to profit from arbitrage. Historically, farmers
wished to lock in prices prior to seeding their fields and the need for
agricultural security brought the first wave of commercial derivatives
12
13
Ibid, 683.
14
Aristoteles recounts that mathematician and philosopher Thales of Milet
made a fortune by using options on olive presses in Miletus and Chios and thus
represents one of the earliest recounts of derivatives usage. See Internet Encyclo-
pedia of Philosophy, ‘Thales of Miletus (c 620 BCE–c 546 BCE)’ (3 September
2017) <http://www.iep.utm.edu/thales/#H14> accessed 3 September 2017.
15
ber 2017) <http://www.isda.org/educat/faqs.html#1> accessed 3 September 2017;
Franca Contratto, Konzeptionelle Ansätze Zur Regulierung von Derivaten Im
Schweizerischen Recht (Schulthess Juristische Medien 2006), 8; Norman M
Feder, ‘Deconstructing Over-The-Counter Derivatives’ (2002) 2002 Columbia
Business Law Review 677, 681.
usage to protect against price shifts.16 A speculator takes a position in the

market aimed at maximising personal profit, while an arbitrageur does
not take a market position, but benefits from price differences across
various markets.17
2.2.1.1 Hedging
To hedge is to protect oneself from risk, where risk in finance refers to a
variation in wealth.18 The objective of hedging a transaction is to protect
it against exposure, permitting a profit, since these exact circumstances
would have otherwise led to a loss.19 The ability of derivatives contracts
to reallocate risk makes them ideal to offset future price movement by
hedging.20 Hedging only addresses the possibility of external factors
affecting the future price or delivery of goods or money. Operational risk,
such as the risk of product failure, is an internal factor of future valuation
development which cannot, therefore, be reproduced in a derivatives
contract.21 Hedging fulfils an important function in promoting macro-
prudential stability. By allowing parties with equal and opposing risks to
hedge with one another, the entities reduce their uncertainties and can
ultimately lower their total risk exposure, thereby contributing to a more
stable economy.22
Derivatives can hedge two types of risk: market risk and credit risk.
While market risk addresses exposure to market movements, credit risk
refers to the risk arising if a counterparty defaults on its obligations upon
maturity owing to insolvency.23 Counterparties are exposed to both risks
whenever they expect to receive or deliver goods or money over time, as
there is a likelihood that external market factors may reduce either the
value of the goods or currency or the actual exchange thereof.
16
17
CPSS, ‘A Glossary of Terms Used in Payments and Settlement Systems’
(March 2003) <www.bis.org/cpmi/publ/d00b.pdf> accessed 3 September 2017, 7.
18
Harvard Business Law Review 1, 7.
19
20
Accounting Tools.
21
2002 Columbia Business Law Review 677, 687–8.
22
Ibid 718.
23
Ibid 687–91.
Derivatives 17
Hedging not only is employed by institutional investors and other large

financial and non-financial counterparties, but has also been exploited by
individuals with extensive investment portfolios wishing to hedge against
potential risks arising from their portfolios.24
2.2.1.1.1 Market risk To protect against future shifts in market move-

ments, derivatives are employed to protect against changes in prices, rates
or values. In such a case, the original contract is not affected as the
derivatives contract is a side deal between the party wishing to divest
itself of the risk and the party wishing to obtain the risk.25 Because of the
predetermined price, the value agreed upon by the counterparties to the
derivatives contract can ultimately vary greatly from the market value at
the maturity date. In some cases, the market value may be lower than the
bilateral agreement, causing the party receiving the payment to be better
off than it would be on the open market (‘in the money’). In the opposite
case, the value on the open market would have been higher, thus causing
a loss and leaving the party ‘out of the money’.26 This is the inherent risk
incurred with every derivative transaction.
2.2.1.1.2 Credit risk Credit risk addresses a second, separate risk

inherent to each contract: the risk that the creditworthiness of the
counterparty may deteriorate over the course of the contract to the point
where it becomes unable to fulfil its contractual obligation. The risk of
counterparty insolvency – not, however, breaches of contract for reasons
unrelated to credit – can also be addressed through derivatives con-
tracts.27 Credit risk refers to a specific entity, the so-called ‘reference
entity’. The credit worthiness of a reference entity can be interlinked with
general market movements and exposures, but a derivative tailored to
protect against credit risk would only require the protection seller to fulfil
his contractual obligation if the reference entity experienced a credit
event.28
24
Franca Contratto, Konzeptionelle Ansätze Zur Regulierung von Derivaten
Im Schweizerischen Recht (Schulthess Juristische Medien 2006), 24.
25
26
2010), 44–6.
27
28
2010), 60.
Therefore, derivatives addressing said risk allow the transferal of credit

risk, where the protection buyer pays the protection seller for his
willingness to carry the risk of counterparty credit deterioration or default
and reimburse the protection buyer in such an event.29 Because of
interlinkages, market and credit risk can occur simultaneously and either
risk can influence the other.30 Nevertheless, they are distinctly different
and separate risks to be mirrored in individual derivatives contracts.31
2.2.1.1.3 Risks from hedging Despite hedging having positive aspects

for the overall stability of the financial markets and economy, it also
carries certain risks. Such risks can include inaccurate contracts that do
not target the intended risk or fail to perform as intended, default by the
derivatives’ counterparty, lack of necessity for the contract ex post
because no risk arose from the underlying asset, and valuation errors
between the derivatives’ counterparties.32 Frequently, derivatives con-
tracts are used as underlying, increasing counterparty credit risk exposure
and costly contracts that may never actually be needed.33
2.2.1.2 Speculation
Contrary to persons using derivatives to hedge, speculators buy and sell
derivatives without exposure to the underlying risk or regardless of
underlying risk.34 Speculators seek profits by exploiting perceived oppor-
tunities resulting from expected future price changes or false credit
judgements in the market. This behaviour of projecting future market
changes and the intent of profiting from such changes unites speculators
and gamblers.35
Because speculators are willing to enter into market positions contrary
to commonly held opinion and willing to assume greater risk than others,
they are believed to fill an important void for derivatives counterparties.
By assuming the counterparty role to hedging trades, speculators provide
the market with liquidity. Such liquidity – in a perfect world – would
29
Ibid 61; Norman M Feder, ‘Deconstructing Over-The-Counter Deriva-
tives’ (2002) 2002 Columbia Business Law Review 677, 690.
30
See also Counterparty Risk Management Policy Group II, ‘Toward
Greater Financial Stability: A Private Sector Perspective’ (25 July 2005), 6–7.
31
32
Ibid 718.
33
Ibid 718.
34
Ibid 719.
35
Ibid 719.
Derivatives 19
provide opportunities to both short- and long-term hedgers.36 Optimally,

the contracts hedgers and speculators enter into with each other would
permit hedgers to reduce their overall exposure, whereas speculators
would increase their overall exposure. This mixture of end users should
achieve the derivatives’ objective of re-allocating risk across the market,
as speculators absorb the market risk other participants are trying to
deflect from their own books.37
In light of hedgers needing to identify potential future risk and
exposure from underlying assets to determine the economic sensibility of
entering into a derivatives contract and speculators attempting the same
calculations, the ultimate objective of both is to receive a profit from a
situation where there would have been a loss otherwise.38 This makes it
difficult to determine where hedging ends and speculation begins.
Hedging certainly contains speculative elements – why else hedge? If a
hedging transaction was entered into which proved to be obsolete ex post,
because either the credit event did not occur or the market developed
differently, hedgers lose their ‘bet’ no differently than speculators.39
Therefore, the boundary between derivatives usage for hedging and for
speculative purposes is indeterminable. While a pure hedge can be
beneficial to social welfare, pure speculation can reduce social welfare
since unnecessary risk positions in the financial system are created and
one party will always be on the wrong side of the speculative bet.40
Derivatives are not only virtually costless at the start, but also simplify
their usage for speculative purposes, as the potential gains far exceed the
wagers. The risk from the bet diminishes in the eye of the speculator as
the expected gain multiplies through the usage of derivatives to leverage
the trade.41 While hedge funds often justify their usage of derivatives for
hedging purposes, such hedging is not to be confused with a classic
36
Ibid 719.
37
Ibid 719; see also Franca Contratto, Konzeptionelle Ansätze Zur Regu-
lierung von Derivaten Im Schweizerischen Recht (Schulthess Juristische Medien
2006), 25 fn 105, with additional references. For a different opinion see Lynn A
Stout, ‘Legal Origin of the 2008 Financial Crisis’ (2011) 1 Harvard Business
Law Review 1, 30–31, claiming the speculative trading of derivatives does not
actually increase liquidity in the market of the underlying.
38
See Chapter 2, Section 2.2.1.1.
39
See also Norman M Feder, ‘Deconstructing Over-The-Counter Deriva-
tives’ (2002) 2002 Columbia Business Law Review 677, 720, with additional
references relating to the differentiation between speculators and hedgers.
40
41
See also Ibid 7–10.
hedge, as the fund uses them to hedge potential losses from speculative
trades. Therefore, there is no inherent need to enter into a derivatives
contract from the get-go and they are simply ‘hedging a bet’.42
2.2.1.3 Arbitrage
The third player in the derivatives market is the arbitrageur. Arbitrage,
simply put, is an item purchased in one market and simultaneously sold
in another market, while the difference in price (the ‘spread’) is cashed.
Arbitrageurs use price mismatches, artificially restricted opportunities or
expectations for inherent market changes to their financial advantage
before the market can react.43 For arbitrage to work, the market must
function imperfectly and arbitrageurs quickly. Speed is the key to taking
advantage of market imperfections and gaining benefit from even the
slightest market mismatches.44 Anything traded on trading facilitates
where the price is transparent, e.g. an exchange, can fall prey to price
shifts by error, thus making them vulnerable to arbitrageurs taking
advantage of price mismatches.
In conclusion, the similarity is striking in how all three purposes of
derivatives function and yet the importance of a functioning derivatives
market, especially for hedging purposes, is undisputed. The ability to
hedge against market price volatility can be the difference between
businesses staying viable despite market movements and businesses
defaulting. Speculators and arbitrageurs both contribute liquidity and
prevent market mismatches that could disrupt the smooth functioning of
the securities market. Therefore, derivatives fulfil a core function in
preserving financial stability while still contributing additional risk to the
market.
2.2.2 Trading Derivatives
In the analysis of the purpose of derivatives in the financial market, it

was mentioned that derivatives could be traded on exchanges. The
following part will identify where derivatives can be traded and why such
differentiation exists. Parties seeking a derivatives contract can choose
between two market places: they can either go to an exchange and
42
See ibid 25.
43
2002 Columbia Business Law Review 677, 720; see also John C Hull, Options,
Futures and Other Derivatives (6th ed, Pearson 2006), 10–16.
44
Derivatives 21
purchase a derivatives contract traded there or bilaterally seek a counter-

party with whom a bespoke contract may be negotiated to suit the
specific circumstances – this is referred to as an over-the-counter (OTC)
derivative. An understanding of how the two market places for derivatives
differ will better facilitate distinguishing between the risks stemming
from derivatives.
2.2.2.1 Exchange-traded derivatives

The laws governing exchanges are strict in order to protect their users
from market manipulation.45 They regulate which underlying can be used
in exchange-traded derivatives, but also the contractual settlement dates,
settlement amounts, and maturities.46 While this limits flexibility for
counterparties to model their specific risk, it allows the contract to trade
on the exchange multiple times between its inception and maturity date,
making counterparties fungible in turn. The benefit of interchangeable
counterparties is the ability to sell the contract prior to maturity, allowing
the buyer to limit his exposure for as long as necessary while selling the
contract before needing to physically deliver the underlying.47 Exchange-
traded derivatives, because they must appeal to multiple counterparties,
require liquidity and, to attract such demand, they must be highly
standardised.48 Standardisation is achieved by imposing inflexible terms
and conditions on the exchange-traded derivatives by the exchange itself.
They refer to settlement dates, settlement amounts and strike prices,
demand physical settlement of the contractual underlying and give the
maturity date.49
Exchanges have strict policies demanding large quantities of infor-
mation to be made accessible in order to define pricing and readiness for
45
For an account on the historic development of the common law approach
to exchange regulation in the United States, the codification of the Grain Futures
Act of 1922 and Commodity Exchange Act 1936, see Lynn A Stout, ‘Legal
Origin of the 2008 Financial Crisis’ (2011) 1 Harvard Business Law Review 1,
11–8.
46
47
Ibid 732.
48
Randall S Kroszner, ‘Can the Financial Markets Privately Regulate Risk?’
(1999) 31 Journal of Money, Credit, and Banking 596, 608.
49
2002 Columbia Business Law Review 677, 731–2; Michael Durbin, All About
Derivatives (2nd ed, McGraw-Hill Education 2010), 24.
trading and to gain access to their (electronic) trading platforms.50 While

exchanges attract liquid and frequently traded products because of their
naturally large pool of users, more specialised instruments are found off
exchanges, in the OTC market space.
2.2.2.2 Over-the-counter derivatives

In contrast to the rigid exchange rules, OTC derivatives do not hold
counterparties to any rules: their bilateral nature allows them to reflect
the needs of the counterparties. Any underlying can be used and bespoke
terms and conditions can be negotiated by the counterparties in OTC
transactions, giving them the utmost flexibility.51 This flexibility permits
an individualised hedge of the exposure, which on an exchange may not
have been achieved, but in turn makes the contracts illiquid and counter-
parties non-replaceable.52 Because of the ability to model any risk, OTC
derivatives are frequently used as tools by those who desire to manage
specific risks. This leads to differences in the maturity dates as well, with
OTC derivatives often having longer time horizons, as opposed to
exchange-traded ones.53
Trading derivatives in the United States anywhere but on exchanges
was not permitted until the Commodities Futures Trading Commission’s
‘safe harbor’ policy statement in 1989.54 The origin of the modern OTC
market can be traced back to the 1980s when banks and businesses began
trading interest rate swaps.55 The market for OTC derivatives grew more
rapidly than its exchange-traded counterparts throughout the 1990s,
bringing the notional value for all OTC derivatives contracts outstanding
to USD 592 trillion by 2008.56
50
Stephan G Cecchetti, Jacob Gyntelberg and Marc Hollanders, ‘Central
Counterparties for Over-the-Counter Derivatives’ [2009] BIS Quarterly Review
45, 49.
51
52
Ibid 735.
53
54
See Board of Trade of Chicago v Christie Grain & Stock Co (1905), 198
US 224, 236 and for the development until 1993 see Lynn A Stout, ‘Legal Origin
of the 2008 Financial Crisis’ (2011) 1 Harvard Business Law Review 1, 17–20.
55
56
Derivatives 23
With the advent of new risk management techniques, including the rise
of credit rating agencies, and financial innovation, counterparties became
increasingly comfortable with leaving the regulated market behind and
opting for personalised derivatives contracts in the OTC market.57
Bilateral markets promote the creation of new financial instruments and
allow users to tailor the products to their needs,58 thus facilitating
transactions and reducing costs. By the end of 2015, the global OTC
derivatives market was worth USD 493 trillion.59 Therefore, OTC deriva-
tives are at the heart of this book, while exchange-traded derivatives will
only be touched upon marginally.
OTC derivatives are considered complex financial instruments.60 Their
complexity and bilateral nature adds to their inability to be liquid
and easily priced. Liquidity is defined based on the average frequency
and size of trades, while keeping market conditions and the nature and
lifecycles of similar products of the same class of derivatives in mind. It
also considers the number of active market participants and their qualifi-
cation along with the ratio between market participants and traded
contracts in the analysed market. Lastly, it considers the average size of
spreads.61 Contracts that are too specialised to achieve the required
liquidity find themselves in the OTC market. The difficulty in pricing
these instruments adds to the market risk and obscurity of bilateral
products and the heavy reliance on the contracting parties to disclose all
relevant information in order to enable risk monitoring and management.
45, 46; Randall S Kroszner, ‘Can the Financial Markets Privately Regulate
Risk?’ (1999) 31 Journal of Money, Credit, and Banking 596, 608.
57
58
45, 49.
59
60
Counterparty Risk Management Policy Group II, ‘Toward Greater Finan-
cial Stability: A Private Sector Perspective’ (25 July 2005), 24–6.
61
Article 32(3) MiFIR. It remains to be seen whether these categories can
be weighed evenly or if some should be given more weight: Eversheds
Sutherland, ‘MiFID II and the Trading and Reporting of Derivatives: Impli-
cations for the Buy-Side’ (23 September 2014) <http://www.eversheds.com/
global/en/what/articles/index.page?ArticleID=en/ Financial_institutions/MiFID_
II_and_the_trading_and_reporting_of_derivatives> accessed 3 September 2017.
2.2.3 Types of Derivatives
With the knowledge of the market places where derivatives contracts can
be found, the next step is to identify what types of derivatives exist.
Derivatives can be subdivided into financial and credit derivatives,
depending on whether they address market risk or credit risk.
2.2.3.1 Financial derivatives

Financial derivatives address risks stemming from future price insecur-
ities relating to market risk. Despite the complex nature of derivatives
allowing them to model any risk, derivatives comprise basic building
blocks. These building blocks are found in forwards, futures, options and
swaps and will be introduced in the following subsections.
2.2.3.1.1 Forwards/futures Forward contracts remove uncertainties

relating to future price changes. Each forward contract will contain at
least an underlying, a maturity date (the value date), a settlement date for
delivery and receipt, and a forward value that is predetermined by the
counterparties.62 A forward creates the obligation for one party to buy
(long party) the agreed upon underlying commodity or security and for
the other party to sell (short party) the underlying at the agreed upon
price when entering into the forward (delivery price or contract price) on
a specific future date (delivery date).63 Forwards will only be executed if
the market price (spot price) is above the agreed price, i.e. if the real
market value is less advantageous, the forward is cancelled.64 For these
reasons, forwards are used for both speculation and hedging. The most
commonly used type of forward is foreign exchange forwards.65 For-
wards are not traded on exchanges but bilaterally, OTC. Their bilateral
nature allows for complex and non-standardised contracts. The forward
contract is traditionally settled physically (delivery-versus-payment) or
62
63
2010), 13; Norman M Feder, ‘Deconstructing Over-The-Counter Derivatives’
(2002) 2002 Columbia Business Law Review 677, 698.
64
2010), 14.
65
Ibid 14.
Derivatives 25
cash-settled on the maturity date, meaning that the settlement does not
occur until the delivery date unless the contract is unwound or cancelled
before.66
The concept of the futures contract is the same as the forward, with
one party agreeing to buy (long party) and one party agreeing to sell
(short party) an underlying commodity or security on a certain date at a
specified price.67 The main difference is that futures are highly standard-
ised forward contracts and are therefore traded on stock or commodity
exchanges.68 Historically, futures – then referred to as ‘difference con-
tracts’69 – were not permitted for speculative purposes or trading off-
exchange, making physical delivery the only valid form of settlement.
Contracts without the intention to exchange goods upon maturity or
contracts not traded on exchanges were not legally enforceable in the
United States until the late twentieth century.70
2.2.3.1.2 Options Options are traded both OTC and on exchanges.71

Options consist of an underlying, a strike price (which is pre-determined
by the counterparties as the price for transferal, whether actual or
presumed), a strike date when the option expires (the maturity date) and
the premium to be paid to the option writer to compensate him for not
exercising the call or put right.72 The option contract creates asymmetry
between the counterparties as the option holder cannot be forced to fulfil
the contract; therefore, a premium is exchanged between the counterpar-
ties to compensate the option writer to a certain extent. This gives options
an ‘insurance’-like feel.73 Options to buy are referred to as ‘call options’,
while options to sell are known as ‘put options’, with the option seller
66
Ibid 24.
67
Ibid 23.
68
2002 Columbia Business Law Review 677, 698; Michael Durbin, All About
Derivatives (2nd ed, McGraw-Hill Education 2010), 23.
69
70
See Irwin v Willar (1884), 110 US 499, 508–9; and Lynn A Stout, ‘Legal
11–13, 19.
71
72
Ibid 692.
73
Ibid 693.
called ‘option writer’ or ‘option seller’ and the counterparty, the buyer,
being the ‘option holder’ or ‘option buyer’.74
Options are price guarantees that can, but do not have to, result in a
future sale. To compensate for the fact that the option will only be
exercised if it is of benefit to the party holding the option, the option
holder must pay the deliverer a premium up front.75
2.2.3.1.3 Swaps The swap contract is an agreement between parties to

exchange future cash flows.76 The most frequently exchanged cash flow
originates from interest payments.77 Swaps are traditionally traded OTC,
with the interest rate swap being the most frequently traded swap.78 A
swap contains a series of payment obligations between two parties that
begin on the first of multiple scheduled settlement dates and end on the
maturity date with the time between the two being referred to as the
‘tenor’. In swap contracts where no notional amounts are exchanged,
the swap is on a notional basis; where notional amounts are exchanged, it
is on a physical exchange basis.79
It is necessary to make an important distinction regarding the term
‘swap’. Since the enactment of the Dodd-Frank Consumer Protection Act
in the United States in 2010, the word ‘swap’ has become the new term
for OTC derivative just as it once was called a ‘difference contract’.80
This book follows the European understanding of a swap as an exchange
of future cash flow, unless explicitly stated otherwise.
2.2.3.2 Credit derivatives

Credit derivatives do not deal with market risk, but with credit risk.
Credit risk refers to the risk of an obligor being unable to meet his
financial obligation owing to a credit event. Credit derivatives address
credit exposure to specific obligors (so-called ‘reference entities’) and
74
Ibid 692; Michael Durbin, All About Derivatives (2nd ed, McGraw-Hill
Education 2010), 37.
75
76
Ibid 698.
77
2010), 29.
78
Ibid 61; Norman M Feder, ‘Deconstructing Over-The-Counter Deriva-
tives’ (2002) 2002 Columbia Business Law Review 677, 702, 704.
79
Ibid 702.
80
See Title VII, Subtitle A, ‘Regulation of the Over-the-Counter Swaps
Market’ and definition in Section 721(a)(2) Dodd-Frank Act.
Derivatives 27
transfer such a risk to another party willing to carry this risk.81 The
element setting credit derivatives apart from other third parties providing
credit risk protection is that the protection is separated from the reference
asset and can be traded independently from its underlying.82 There are
multiple credit derivatives, but the most relevant and infamous credit
derivative in the post-financial crisis era is the credit default swap (CDS).
Because of the focus of this book on post-crisis regulatory changes on
clearing and OTC derivatives, only CDS will be described in further
detail.
A CDS is a promise from one party to another to pay the latter if a
third party defaults on its debt.83 Therefore, a CDS can be described as
an ‘insurance derivative’ because it transfers the risk of a potential credit
loss, normally in connection with a specific reference asset.84 A risk
holder turns to a protection seller to purchase protection in case the
reference entity experiences a credit event – such as default, bankruptcy
or credit rating loss85 – and in turn pays the protection seller a premium
for the length of the contract. On the other hand, the protection seller is
obliged to pay if a credit event occurs, which negatively impacts the
value of the reference underlying.86 The protection purchased is called a
credit default swap even though it has nothing to do with an actual swap,
because there is no exchange of future cash flows. The credit event
payment covers the difference in value between the principal amount and
the recovery value of the reference asset after default because the credit
event generally refers to the insolvency of the issuer of the reference
asset, such as a debt security.87 This allows the investor to shift the credit
81
82
Ibid 707.
83
Jeremy C Kress, ‘Credit Default Swaps, Clearinghouses and Systemic
Risk: Why Centralized Counterparties Must Have Access to Central Bank
Liquidity’ (2011) 48 Harvard Journal on Legislation 49, 52.
84
85
86
2010), 62; Norman M Feder, ‘Deconstructing Over-The-Counter Derivatives’
(2002) 2002 Columbia Business Law Review 677, 708.
87
Ibid. The CDS can extend to include any missed payments due by the
reference asset or even include a downgraded credit rating, albeit the default
being the most common credit event, while the reference asset can either be a
risk from his books, at a relatively small price in comparison to the

potential earnings, if his bet is right.88 Durbin goes as far as calling out
CDS by saying: ‘Indeed, a plausible argument can be made that credit
derivatives aren’t derivatives at all, but insurance policies gussied up as
“financial derivative securities” to keep insurance regulators at bay’.89
Credit derivatives only take hold if the value of the underlying is
affected by a credit event. Creating a market in which the risk of
third-party default is for sale results in a shark pool for speculators. Any
speculator considering the risk of a bond issuer defaulting to be near
impossible can sell a CDS, thus allowing easy money to enter his own
pocket by simply collecting the premium.90 The positive aspect of this is
that there is a liquid market in credit protection, therefore making it more
accessible to those in need.91
Credit derivatives were a late addition to the derivatives landscape,
created only in the late 1990s.92 They are traditionally traded OTC with
the help of market makers publishing non-binding, indicative prices on
electronic platforms. The final bilateral contracts follow guidelines pub-
lished by ISDA.93 Despite their relative novelty, the number of CDS
annually doubled in size between 2002 and 2008, reaching a peak at
USD 62 trillion in 2007.94 In 2008, large-scale credit events triggered the
activation of CDS, a process that had in turn led to great losses to the
CDS sellers (‘the insurers’), such as AIG, when they were supposed to
single item or a basket thereof. When baskets are used for reference assets, CDS
often include a first-to-default clause that is triggered as soon as the first asset in
the basket defaults. See Norman M Feder, ‘Deconstructing Over-The-Counter
Derivatives’ (2002) 2002 Columbia Business Law Review 677, 708–10; Michael
Lewis, The Big Short: Inside the Doomsday Machine (Norton 2011), 49.
88
See also Michael Durbin, All About Derivatives (2nd ed, McGraw-Hill
Education 2010), 59.
89
Ibid 197.
90
Ibid 61.
91
Ibid 61.
92
93
2010), 61; Michael Lewis, The Big Short: Inside the Doomsday Machine (Norton
2011), 49.
94
Derivatives 29
provide the credit protection they had sold, but could not, owing to failed
risk management and a lack of liquidity.95
2.2.3.3 Comparative summary

Derivatives address two main types of risk: market risk and credit risk.
However, they do not address operational risk, because whether a product
will succeed on the market is not determined by large-scale macro-
economic tendencies and a derivative’s objective is to shift risks associ-
ated with such macro-economic tendencies beyond the influence of the
individual. Considering how different the risks addressed by a future are
in comparison to the risks of entering into a credit default swap, despite
both being called derivatives, each creates unique market risks. The
uncertainties of future price developments are limited by the true market
value of the underlying to be delivered at maturity to the long party,
which creates an internal checks-and-balances system for the price
movement.96 The same is true for forwards, options and swaps, as all
four financial derivatives have a correlating open market value. Credit
derivatives, on the other hand, lack the same type of natural barrier; they
are more of an ‘asymmetric bet’.97 The CDS buyer can only lose his
premium for the fixed term of the contract if there is no credit event. If,
however, there is a credit event, he is able to leverage his profits up to 50
times the premium, making CDS a very interesting tool not only for
hedgers, but for speculators too.98 At the same time, the linkage between
derivatives is evident: for different types of necessity to mitigate their
own risk, investors can take advantage of different types of derivatives to
protect themselves from negative fallouts. A combination of interest rate
swaps and credit default swaps is often seen.99
To demonstrate the speculative nature of the derivatives market at the
onset of the financial crisis, a specific type of derivative, the credit
default swap, lends itself well to analysis. CDSs are purchased to protect
95
Rolf H Weber and others, ‘Addressing Systemic Risk: Financial Regula-
tory Design’ (2014) 49 Texas International Law Journal 149, 177.
96
2010), 25.
97
Michael Lewis, The Big Short: Inside the Doomsday Machine (Norton
2011), 29.
98
Ibid 29–30.
99
2010), 60.
against corporate or mortgage-bond default. Simplifying a CDS trans-

action,100 a bilaterally or OTC-traded derivative, a CDS seller agrees to
pay the CDS buyer the difference between the market price and the face
value of the bond, in case of default, even though neither owns the
underlying bond. In return, the CDS buyer pays an upfront premium.
While the market size for CDS reached USD 67 trillion in 2007, the US
mortgages101 that were written to cover defaults only reached USD 15
trillion.102
Considering the different exposure to and from the different types of
derivatives, a prudent regulator is expected to recognise the benefits and
limitations of each type of derivative and adapt its regulations accord-
ingly. The aspects enhancing and promoting market stability should be
expanded, while confining and constraining the aspects that can lead to
additional market risk. This concept will be further developed and
questioned throughout the research.
2.3 DERIVATIVES AND THE FINANCIAL CRISIS OF

2007–2009
2.3.1 The Crisis in a Nutshell
The correlation between the credit boom and the housing bubble as the
cause of the financial crisis of 2007–2009 is hardly disputed.103 The main
culprit was lending money to low-income Americans wishing to purchase
their own homes or to refinance credit card debt or other loans more
cheaply, owing to lower interest rates, but who did not have the financial
ability to repay their debts: so-called subprime lending.104 By 2005, the
100
For a full definition of credit default swaps see Secion 2.2.3.2.
101
American mortgages were at the core of the CDS trades. See Lynn A
Law Review 1, 24.
102
Ibid 24; Jeremy C Kress, ‘Credit Default Swaps, Clearinghouses and
Systemic Risk: Why Centralized Counterparties Must Have Access to Central
Bank Liquidity’ (2011) 48 Harvard Journal on Legislation 49, 54.
103
In place of many see Viral V Acharya and Matthew Richardson, ‘Causes
of the Financial Crisis’ (2009) 21 Critical Review 195, 195. For a diverging
opinion stating that deregulation played the larger role see Lynn A Stout, ‘Legal
2–3.
104
See Viral V Acharya and Matthew Richardson, ‘Causes of the Financial
Crisis’ (2009) 21 Critical Review 195, 196.
Derivatives 31
market for subprime mortgages had grown to USD 625 billion despite the
subprime mortgage market having blown up fewer than 10 years earlier
in the aftermath of Russia’s default on its bonds.105 Why does the bond
market play a role in subprime mortgages? Well, those providing
subprime loans learned their lesson from the first subprime mortgage
crisis. The lesson was not to cease giving loans to those unable to repay
them, but to sell the risk from the subprime loans to big Wall Street
investment banks. The removal of risk from one’s own balance sheet and
placing small concentrations thereof with a multitude of investors is
referred to as ‘securitisation’.106 Securitisation permitted banks to hold
less capital, as prescribed by the Basel Committee on Banking Super-
vision (BCBS). The BCBS published the Second Basel Capital Accord
(Basel II) in 2004, demanding that banks hold higher capital to offset
financial and operational risks.107 Securitisation permitted banks to sell
off their loans to others and circumvent holding higher – and more costly
– capital.108
Subprime mortgage borrowers were encouraged to take on loans
because interest rates were low. Additionally, lenders continued to lower
their lending standards, ultimately even providing loans to persons
without any income.109 What most did not realise was that their interest
rate premiums were only fixed for the first few years, after which time
they became floating110 and prone to increase, depending on market
conditions – indeed, the Federal Reserve increased interest rates in the
second quarter of 2005.111 Brown and Hao show that, while the securitis-
ation of household debt increased credit availability for consumers at all
levels of income and creditworthiness, the quality of household debt
105
2011), 15–6, 23.
106
Crisis’ (2009) 21 Critical Review 195, 196–7.
107
See generally BCBS, ‘International Convergence of Capital Measurement
and Capital Standards’ (June 2006) <http://www.bis.org/publ/bcbs128.htm>
108
Crisis’ (2009) 21 Critical Review 195, 198–9.
109
2011), 27–8; 54–5.
110
Ibid 30.
111
Ibid 54.
diminished as the ratio of debt liabilities to household income rose.112

The increase in debt in low- to middle-income households was particu-
larly detrimental to the market. Without the readily available CDS to
hedge these collateralised debt obligations and Wall Street’s willingness
to accept these hedges at advantageous terms, i.e. in the absence of cheap
credit default ‘insurance’, the risk to the financial market – as witnessed
– would probably not have been possible at this scale.113
At first, only prime mortgages were pooled into so-called mortgage-
backed securities (MBS) which were guaranteed by Fannie Mae and
Freddy Mac, but they gradually extended to include riskier subprime
mortgages. These asset-backed securities were then structured into differ-
ent classes (‘tranches’), where riskier tranche holders received higher
premiums as returns. The risks of the tranches were identified according
to their credit ratings from credit rating agencies.114 Credit rating
agencies distorted risk perception. AAA ratings, normally reserved for
government bonds, were freely handed out, despite the content frequently
being re-bundled subprime mortgages. High ratings related to low risk,
while low ratings meant high risks, but also high returns.115
To counterbalance the risk extending from MBS, CDSs were pur-
chased as default guarantees for MBS. The largest seller of CDS
protection was AIG.116 The CDSs permitted losses to be inflated and
spread across the market in a novel way. While they acted like insurance
policies, they were outside of the regulatory scope of insurance regulators
and lacked any reserves or collateral to protect from losses. They were
explicitly exempt from any regulatory oversight by the US regulator.117
112
Christopher Brown and Cheng Hao, ‘Treating Uncertainty as Risk: The
Credit Default Swap and the Paradox of Derivatives’ (2012) 46 Journal of
Economic Issues 303, 308.
113
Ibid 308.
114
Crisis’ (2009) 21 Critical Review 195, 199-200.
115
The de Larosière Group, ‘The High-Level Group on Financial Super-
vision in the EU Report’ (25 February 2009), 9; see also: Viral V Acharya and
Matthew Richardson, ‘Causes of the Financial Crisis’ (2009) 21 Critical Review
195, 201–2, 204–6.
116
Viral V Acharya and Alberto Bisin, ‘Counterparty Risk Externality:
Centralized versus over-the-Counter Markets’ (2014) 149 Journal of Economic
Theory 153, 154.
117
Report’ (January 2011), 50.
Derivatives 33
The banks that most heavily invested in subprime mortgages were Bear
Stearns, Merrill Lynch, Goldman Sachs, Lehman Brothers and Morgan
Stanley.118
The lowering of lending standards, owing to the fact that there was a
market to buy protection against credit risk, increased the possibility of
lenders giving subprime borrowers loans. CDS issuers blatantly dis-
regarded the true market, and because of their disregard for the default
risk of the subprime borrowers, mispriced the risk of the CDSs they
issued, assuming they were safe.119 The banks who had bought CDS
protection collected payments as long as they were made, knowing that
they were covered from any default risk that these subprime borrowers
might pose. When the subprime borrowers started defaulting on their loan
payments – creating the credit event – the lenders turned to the CDS
sellers and claimed the difference between principal amount and recovery
value. The CDS sellers were financially unprepared and overwhelmed by
the sheer number of claims and were unable to provide the protection
they sold, with AIG ultimately needing a governmental bail-out.120
2.3.2 The Case of AIG
To demonstrate counterparty credit risk, the case of AIG is illuminating.

AIG was the world’s largest insurer and sold protection in the OTC
derivative market to key Wall Street players. It was the London-based
subsidiary of AIG – AIG Financial Products (AIGFP) – that had entered
into countless CDS contracts with those seeking protection against
mortgage defaults. AIG and its subsequently necessary bail-out taught
regulators and supervisors this painful and costly lesson. Because the
parent company AIG guaranteed each CDS and enjoyed a high credit
rating, AIGFP was not asked to provide counterparties with collateral.
118
2011), 24, 31.
119
According to Christopher Brown and Cheng Hao, ‘Treating Uncertainty
as Risk: The Credit Default Swap and the Paradox of Derivatives’ (2012) 46
Journal of Economic Issues 303, 305–6, CDS spreads lacked any basis in sober
risk management and the market was dominated by a handful of infamous CDS
sellers, all in the game to maximise their own profits (AIG, Lehman Brothers and
Bear Stearns).
120
2010), 195.
By 2008, AIG had sold CDSs worth USD 527 billion.121 After the
financial panic following the near collapse of Merrill Lynch and the
bankruptcy of Lehman Brothers in September 2008,122 AIGFP was asked
to perform on the CDS contracts. It soon became apparent that AIGFP,
and subsequently AIG, were not in a position to fulfil the obligations into
which they had entered. Consequently, the liquidity in the market froze as
institutions refused to lend to each other. To halt the unravelling of the
financial market, the US Federal Reserve System provided AIG with a
USD 180 billion bail-out.123 Thus, taxpayers ultimately payed the price
for AIG’s lack of risk management.
The Financial Crisis Inquiry Report came to the conclusion that AIG
had failed owing to its sale of CDSs and the lack of initial collateral,
capital reserves or even hedging of its exposure. This was made possible
by a failure of both corporate governance and risk-management prac-
tices.124 Based in part on these findings, the global regulatory reform has
been defined by increasing initial margins and capital reserves, but also
tighter risk-management practices and enhanced corporate governance.
2.3.3 Lessons from the Crisis
The most recent financial crisis was not the first shock in the financial
market for which derivatives can be attributed blame. The names
Metallgesellschaft, Barings Bank, Orange County Pension Fund and
Long Term Capital Management all stand as testaments to a lack of
understanding of risk and an underestimation of the probability of market
121
Robert Lenzner, ‘Warren Buffett Predicts Major Financial Discontinuity
Involving Too Big To Fail Banks, Derivatives’ Forbes (New York, 30 April 2014)
<http://www.forbes.com/sites/robertlenzner/2014/04/30/seking-shelter-warren-
buffett-limits-receivables-from-major-banks/> accessed 3 September 2017.
122
123
Binyamin Apfelbaum, ‘Report Says New York Fed Didn’t Cut Deals on
AIG’ New York Times (New York, 31 October 2011) <http://www.nytimes.com/
2011/11/01/business/gao-says-new-york-fed-failed-to-push-aig-concessions.html?
mcubz=0> accessed 3 September 2017; Lynn A Stout, ‘Legal Origin of the 2008
Financial Crisis’ (2011) 1 Harvard Business Law Review 1, 3. For additional
information on the dramatic events leading up to the bail-out of AIG see The
Financial Crisis Inquiry Commission, ‘The Financial Crisis Inquiry Report’
(January 2011) 344–52; Katharina Pistor, ‘A Legal Theory of Finance’ (May
2013) 315–30, 318.
124
Report’ (January 2011) 352.
Derivatives 35
volatility. Metallgesellschaft overtly exposed itself to the financial risk of

mismatched maturities by holding long-term oil forwards and short-term
futures, while Barings Bank suffered from a rogue trader who took the
power of leveraging derivatives too far.125 Long Term Capital Manage-
ment, despite being a hedge fund, so heavily threatened the stability of
the financial system that the US Federal Reserve was prompted to bail it
out with nearly USD 4 billion.126 Compared with the nearly USD 4.2
trillion of public funds necessary to stabilise the economy and bail out
individual institutions in the years after 2008, the numbers pale in
comparison.
So what makes derivatives so dangerous? There are two reasons: the
first is their time horizon. Derivatives are contracts where one party
obliges itself to pay another party a certain amount of money depending
on a future development (i.e. market price, event).127 As with any
contract with a long maturity, the risk that the counterparty may no
longer be in a position to fulfil his contractual obligations increases.
Counterparty risk is notoriously difficult to evaluate as various factors
relating to the exposure are not of public record.128 In the situation where
derivatives were used to hedge exposure to a third party or credit event, a
counterparty defaulting on its obligation to cover this exposure leaves the
primary exposed to risk, just when he needs protection most. This not
only leaves the victim of the counterparty default to absorb losses he
tried to avoid by engaging in the contract in the first place, but he might
also have to replace the contract on which the counterparty defaulted at
unfavourable prices in the market and in turn harm additional counter-
parties with which he has entered into contracts if he then becomes
unable to fulfil his other contractual obligations owing to unforeseeable
losses.129 The second reason is the bilateral nature of the OTC market.
Agreement on the contractual terms, including price and collateral, is left
125
See for detailed accounts of the historic events Michael Durbin, All About
Derivatives (2nd ed, McGraw-Hill Education 2010), 215; Lynn A Stout, ‘Legal
20.
126
127
Craig Pirrong, ‘The Economics of Central Clearing: Theory and Practice’
(May 2011) 1, 6.
128
Theory 153, 154.
129
(May 2011) 1, 6.
to the counterparties. The opacity of the OTC market increases the

difficulty of adequately assessing and pricing exposure to counterparty
risk.130
The cause of the financial crisis was quickly identified as OTC
derivatives. There was a quick consensus that the opaque market could
not be trusted and something needed to be done to prevent future
taxpayer-funded bail-outs.131 Measures had to be taken to increase the
transparency of the OTC derivatives market, to permit advance warning
in case of risk build-up and to manage systemic risk originating from
counterparty credit risk and market risk better. Such a solution was found
almost immediately. LCH.Clearnet (LCH), a central counterparty and
clearinghouse, had managed to successfully manage its USD 9 trillion
exposure to Lehman Brothers Special Financing Inc.132
2.4 SUMMARY
Derivatives are a tool to shift risk from one party to another that is able
and willing to bear the risk at a lesser cost. If derivatives are used to
hedge a position, they promote a socially beneficial target; if used to
speculate, they create new risks and expose parties to risks to an extent
that they otherwise would not have faced. They can be traded in two
distinctly different markets: either OTC, where the parties bilaterally
negotiate the contractual terms, leading to greater flexibility for the
counterparties to model their risks, or on an exchange. If the counter-
parties face an exchange as their counterparty, the derivative is referred to
as exchange-traded and subject to more stringent rules regarding
standardisation and liquidity. The OTC markets’ downfall is its opacity,
complicating the ability to assess exposure to counterparties and potential
risk-pooling early on. However, the OTC market allows counterparties to
tailor the contracts according to their needs without complying with
exchange rules. This dynamic breeds risks because the counterparties
130
Theory 153, 154.
131
132
LCH.Clearnet, ‘$9 Trillion Lehman OTC Interest Rate Swap Default
Successfully Resolved’ (8 October 2008) Press Release <http://www.lch.
com:8080/media_centre/press_releases/2008-10-08.asp> accessed 3 September
2017.
Derivatives 37
may underestimate the riskiness emanating from the underlying, the

market volatility and the counterparty’s exposure. These risks are not
mitigated by the derivatives contract, but created only when entering into
the derivatives contract, and OTC derivatives are particularly susceptible
to these risks. Therefore, exchange-traded derivatives without speculative
purpose were the norm until the 1980s when OTC derivatives were
legalised in the United States and gained popularity.
After the financial crisis of 2007–2009 and the subsequent bail-out of
AIG owing to AIG’s overinvestment in credit derivatives (so-called credit
default swaps), a new regulatory approach for OTC derivatives became
necessary. As LCH had successfully managed to wind down a USD 9
trillion swap exposure to Lehman Brothers, while AIG needed to be
bailed out, the system used by LCH was seen as the way to prevent a
future taxpayer-funded bail-out.
LCH is an organisation that clears derivatives contracts – a central
counterparty. With the understanding of how derivatives work and their
contribution to creating the financial crisis, the next chapter analyses the
functioning of a clearing organisation as well as its risk management
procedures.
3. Clearing
3.1 INTRODUCTION
The crisis demonstrated that the financial system needed new approaches
to managing and mitigating systemic risk. First, prevention needed to be
reinforced to increase resilience towards shocks. Second, shocks needed
to be contained more successfully through an enhanced resolution
framework. Lastly, the financial infrastructure itself needed to be
reformed to reduce contagion and knock-on effects.1 As has been
demonstrated, the over-the-counter (OTC) derivatives market amplified
knock-on effects during the crisis, particularly in relation to counterparty
credit risk and liquidity shortages. In the absence of an effective financial
infrastructure, the risk of contagion spread from one counterparty to
another, causing systemic risk to be amplified by the OTC derivatives
market. Therefore, a solution needed to be found to deal with systemic
risk arising from the OTC market.
Clearing by means of a central counterparty (CCP) was selected as the
approach for three reasons: (i) the CCP can reduce exposure and
ultimately systemic risk by netting the positions of its clearing members;
(ii) it can enforce harmonised risk-management standards; and (iii) it can
mutualise losses among clearing members.2 This chapter will first
introduce the concept of clearing and describe a CCP’s successful risk
management procedure using LCH.Clearnet (LCH) and its response to
Lehman Brothers’ default as an example. Subsequently, an introduction
to the risk management procedures of a CCP will be provided and the
objectives of the clearing mandate demonstrated. This permits the reader
to comprehend why regulators have chosen clearing to mitigate the
systemic risk from OTC derivatives and the discussion of the benefits and
limitations of clearing. This chapter will demonstrate why clearing by
1
IMF, ‘Making Over-the-Counter Derivatives Safer: The Role of Central
Counterparties’ in IMF (ed.), Global Financial Stability Report April 2010:
Meeting New Challenges to Stability and Building a Safer System (IMF 2010), 2.
2
Ibid 2.
38
Clearing 39
means of a CCP ‘is not a panacea’,3 as systemic risk from the derivatives
contracts is not entirely removed. Instead, it is shifted from the bilateral
market to the CCP, thereby making CCPs themselves systemically
important.
3.1.1 Definition
Clearing has many different meanings in financial markets.4 This

prompted Turing to call clearing ‘the most over-used and least-
understood term in post-trade services’.5 When a derivative contract is
cleared by a CCP, the bilateral transaction between the two counterparties
is replaced by two symmetrical trades by the CCP with either counter-
party.6 Thereby, the CCP assumes all contractual rights and obligations
arising from the original contract. This process generally is referred to as
‘novation’.7
Therefore, clearing is a post-trade function to reconcile and resolve
obligations between counterparties.8 Clearing reduces risk by helping
counterparties to manage risks arising from the trade and before the
settlement thereof, such as operational, counterparty, settlement, market
3
Ibid 1. Clearing can take place at three levels: first, among trading
parties trading for their clients; second, by a central counterparty or clearing-
house; and third, by a central security depository or banking institution. This
book only focuses on clearing by a CCP; see also European Commission,
‘Functional Definition of a Central Counterparty Clearing House (CCP)’ (3
September 2017) <http://ec.europa.eu/internal_market/financial-markets/docs/
clearing/2004-consultation/each-annex3_en.pdf> accessed 3 September 2017.
4
See EuroCCP, ‘Clearing & CCP’s’ (Perspectives, 3 September 2017)
<https://euroccp.com/qa/clearing-ccp’s> accessed 3 September 2017.
5
Dermot Turing, Clearing and Settlement in Europe (Bloomsbury Profes-
sional 2012), 6.
6
Rama Cont and Thomas Kokholm, ‘Central Clearing of OTC Derivatives:
Bilateral vs Multilateral Netting’ (2012), 2; EuroCCP, ‘Clearing & CCP’s’
(Perspectives, 3 September 2017) <https://euroccp.com/qa/clearing-ccp’s>
7
Meeting New Challenges to Stability and Building a Safer System (IMF 2010), 6;
ICMA, ‘What Does a CCP Do? What Are the Pros and Cons?’ (3 September
2017) <http://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/short-
term-markets/Repo-Markets/frequently-asked-questions-on-repo/27-what-does-a-
ccp-do-what-are-the-pros-and-cons/> accessed 3 September 2017.
8
James T Moser, ‘Contracting Innovations and the Evolution of Clearing
and Settlement Methods at Futures Exchanges’ (1998) 26, 4.
and legal risks.9 A CCP provides the market with three benefits:
multilateral netting of exposure and payments; reduced counterparty risk
management; and enhanced market transparency for regulators and the
public by providing ongoing information regarding market activity and
exposure.10 These risk management tools were successfully used by LCH
to deal with Lehman Brothers’ default.
3.1.2 Central Counterparty or Clearinghouse
There is much confusion among authors and legislators surrounding the

concept of ‘central counterparties’ and ‘clearinghouses’, which is why
both will be briefly explained here. The definition for a clearinghouse is
broader as opposed to a central counterparty. A clearinghouse is a central
location or central processing mechanism through which payment
instructions or other financial obligations are agreed to be exchanged by
financial institutions. It steps in during the post-trade phase of financial
transactions and serves the sole purpose of ensuring payment and
delivery, thereby reducing costs and operational risks.11 A central coun-
terparty, however, is narrowly defined as an entity that steps in to assume
counterparty risk in financial transactions; this assumption of counter-
party risk is not inherent to clearinghouses.12
Unfortunately, despite the two fulfilling separate and non-
interchangeable functions in the financial infrastructure, they are fre-
quently confounded and the terms used interchangeably. The Committee
on Payment and Settlement Systems (CPSS) confounds the two in
defining a clearinghouse as:
9
EuroCCP, ‘Clearing & CCP’s’ (Perspectives, 3 September 2017) <https://
euroccp.com/qa/clearing-ccp’s> accessed 3 September 2017.
10
45, 46.
11
Heikki Marjosola, ‘Missing Pieces in the Patchwork of EU Financial
Stability Regime?’ (2015) 52 Common Market Law Review 1491, 1494–5;
Eidgenössisches Finanzdepartement, ‘Erläuterungsbericht Zur Verordnung Über
Die Finanzmarktinfrastrukturen Und Das Markverhalten Im Effekten- Und
Derivatehandel (Finanzmarktinfrastrukturverordnung, FinfraV)’ (20 August
2015), 7–8.
12
See also Philipp Haene and Andy Sturm, ‘Optimal Central Counterparty
Risk Management’ (June 2009) 8, 2.
Clearing 41
A central location or central processing mechanism through which financial

institutions agree to exchange payment instructions or other financial obliga-
tions (e.g. securities). The institutions settle for items exchanged at a
designated time based on the rules and procedures of the clearing house. In
some cases, the clearing house may assume significant counterparty, financial
or risk management responsibilities for the clearing system.13
Here, the assumption of counterparty credit risk was falsely included

within the scope of the tasks of a clearinghouse. Similar inconsistencies
can be found within the legislative process, as demonstrated by the
European Union. While Article 2(1) EMIR14 defines a CCP as ‘a legal
person that interposes itself between the counterparties to the contract
traded on one or more financial markets, becoming the buyer to every
seller and the seller to every buyer’, both were considered interchange-
able by Article 2(e) of the Settlement Finality Directive, where a
clearinghouse was defined as an ‘entity responsible for the calculation of
the net positions of institutions, a possible central counterparty and/or a
possible settlement agent’.15 Once again, CCPs and clearinghouses are
used interchangeably.16
In this book, whenever speaking of a CCP, the post-crisis clearing
entity assuming counterparty credit risk is explicitly referred to. Where a
clearinghouse is mentioned, the clearinghouse does not assume counter-
party credit risk and/or the term refers to the historic predecessor of
today’s CCP.
3.2 RISK MANAGEMENT TECHNIQUES

Clearing possesses the ability to remove counterparty exposure to default
risks on the OTC market. Clearing of OTC derivatives began with the
G10 report on settlement of 1998, written at a time when only Sweden
had a CCP to clear these derivatives.17 In 1999, LCH.Clearnet offered
clearing services to OTC swap contracts by means of the SwapClear
13
(March 2003) <www.bis.org/cpmi/publ/d00b.pdf> accessed 3 September 2017,
13.
14
Article 2(1) Regulation (EU) no. 648/2012 (EMIR).
15
Article 2(e) Directive 98/26/EC.
16
See ibid for another good example of confusion.
17
service. Nevertheless, CCPs themselves were uneasy about taking on

these products.18 The push for clearing additional derivatives besides
exchange-traded derivatives contracts continued. Specifically, the exten-
sion of maturity and the additional risk continued to increase their
susceptibility to market and credit risk, thereby increasing the necessity
of clearing services.19 OTC derivatives, particularly swaps, began to be
cleared by LCH.Clearnet’s subdivision, SwapClear, in 1999. This raised
the question of whether the risk-management practices could be equally
effective for OTC products as for exchange-traded ones – particularly
with regard to systemic risk.20
A central counterparty can reduce systemic risk from knock-on effects
by interposing itself as a counterparty to each trade, as well as netting
exposure and providing other risk management techniques to clearing
members and the market to contain any exposure to member default.21
The effects of clearing can be compared with a spider’s web, bringing
together multiple precautions to foster a safe and stable functioning of
the financial markets. The CCP has four major options to manage its risk
at all times. It can collect collateral and margins, net exposures and man
an adequate default fund.22 These risk management options will now be
considered in more detail.
18
Thomas Krantz, ‘Comment: Risks Remain in G20 Clearing Plan’, Finan-
cial Times (London, 29 January 2014) <http://www.ft.com/cms/s/0/60c82dec-
8827-11e3-a926-00144feab7de.html#axzz3wHmPGGCh> accessed 3 September
2017.
19
20
Randall S Kroszner, ‘Central Counterparty Clearing: History, Innovation
and Regulation’ (European Central Bank and Federal Reserve Bank of Chicago
Joint Conference on Issues Related to Central Counterparty Clearing, Frankfurt,
3 April 2006), 39; See also Counterparty Risk Management Policy Group II,
‘Toward Greater Financial Stability: A Private Sector Perspective’ (25 July 2005).
21
22
See also Chryssa Papathanassiou, ‘Central Counterparties and Deriva-
tives’ in Kern Alexander and Rahul Dhumale (eds), Research Handbook on
International Financial Regulation (Edward Elgar 2012), 219.
Clearing 43
3.2.1 The Specifics of Clearing
A CCP serves a multitude of purposes: it settles trades executed on an

exchange or OTC, acts as buffer against market contagion and ensures
that those belonging to a CCP can cover their losses or provides funds to
do so. Settling of trades executed on an exchange entails the CCP
transferring securities from the selling to the buying party and passing
cash from the buying to the selling party. CCPs function as a buffer
between trades and the rest of the market by sharing losses among
clearing members before they can affect the rest of the market. Lastly, by
selecting who can become a clearing member and demanding collateral
to be posted, clearinghouses select their members carefully and hold
collateral that can be sold easily, if necessary.23
3.2.1.1 Exchange-traded versus bilateral derivatives

While OTC derivatives can be permissible for clearing, clearing comes at
a cost to counterparties; therefore, they may prefer to not subject their
trade to clearing and carry the counterparty credit risk themselves.24
Netting could, however, be performed bilaterally (bilateral netting)25
without the addition of a CCP between the parties. This special treatment
of excluding large parts of the OTC derivatives market is what adds
additional risk to these trades and why this study continues to focus on
OTC derivatives instead of exchange-traded ones. Since the 1990s, there
has been a surge in CCPs clearing certain OTC derivatives. Exchanges,
contrarily, generally have a CCP attached to them because they bear the
risk of exchange member default and thus have to protect themselves
from the credit risk arising from the trade counterparties. The CCP’s
objective is to be the central entity and act as mandatory counterparty to
either trade counterparty, concentrating delivery and payment risk
within.26 Therefore, the core difference between exchange-traded and
OTC traded derivatives is that those traded on an exchange always profit
from clearing to guarantee their contracts, while those traded bilaterally
23
Yesha Yadav, ‘Clearinghouses in Complex Markets’ (2013) 101 George-
town Law Journal 387, 409.
24
ICMA, ‘What Does a CCP Do? What Are the Pros and Cons?’ (3
September 2017).
25
26
Norman M Feder, ‘Deconstructing Over-the-Counter Derivatives’ (2002)
do not automatically have access to a CCP and carry the counterparty

credit risk.27
3.2.1.2 Member selection

Only counterparties that are members of the CCP may bring their trades
to be cleared by the CCP. Clearing members28 are typically large
financial institutions, such as hedge funds and global banks.29 They use
the services of the CCP to clear trades for both clients and for their own
books. In order to qualify as a clearing member, strict minimum criteria
must be met.30
Because of novation’s extensive effects on the duties of the CCP, not
every counterparty can qualify as a clearing member. A clearing member
is a party that trades directly with the CCP and to which the guarantee
offer extends.31 Counterparties not qualifying as clearing members may
only trade with the CCP if they find a clearing member willing to trade
on their behalf through a mechanism referred to as client clearing.32 The
clearing members provide the financial resources necessary to guarantee
the survival of the CCP and its ability to cover the losses resulting from
another member’s default.33
3.2.1.3 Novation
Novation is a key component of the CCPs’ purpose. Historically, it can be
traced back to the Roman way of transferring an obligation to a third
27
28
Definition of a clearing member, see CPSS, ‘A Glossary of Terms Used in
Payments and Settlement Systems’ (March 2003) <www.bis.org/cpmi/publ/
d00b.pdf> accessed 3 September 2017, 13.
29
See Chapter 1, fn 5; Chapter 2, Section 2.2.1.1.
30
Lieven Hermans, Peter McGoldrick and Heiko Schmiedel, ‘Central
Counterparties and Systemic Risk’ (November 2013) 6, 3. Ben S Bernanke,
‘Clearing and Settlement during the Crash’ (1990) 3 The Review of Financial
Studies 133, 136; also outlining the problems of adverse selection and moral
hazard of clearing, see ibid 142.
31
13.
32
Craig Pirrong, ‘The Inefficiency of Clearing Mandates’ (2010) 665 Cato
Journal, 8.
33
Ibid.
Clearing 45
party and can be traced throughout European legal history.34 By means of

this process, the CCP becomes the seller to every buyer and the buyer to
every seller, interposing itself between the original contracting parties.35
By entering into legally binding contracts with both original contract
parties, the CCP now guarantees the execution of every trade should one
of the original parties become insolvent and incapable of fulfilling its
contractual financial obligation at the contractual due date.36 In this way,
it reduces counterparty credit risk while at the same time becoming liable
for the completion of the trade and the re-allocation of funds.37
Through clearing, the CCP alters exposure and linkage between the
actors of the financial system, changing the dynamics thereof. The
bilateral exposure between the original contracting parties is reduced as
the CCP interposes itself between the original buyer and seller and
becomes the centre of the complex web of exposures.38 In doing so,
counterparty credit and liquidity risk is lowered by centralising the
exposure network through multilateral netting and various other risk
management tools.39 Without clearing, counterparties are exposed to
three types of counterparty risk. This can be demonstrated particularly
well by considering a CDS contract. First, the protection seller could be
driven into financial distress by the sudden need to provide a large
34
35
Ibid 219–20; IMF, ‘Making Over-the-Counter Derivatives Safer: The Role
of Central Counterparties’ in IMF (ed.), Global Financial Stability Report April
2010: Meeting New Challenges to Stability and Building a Safer System (IMF
2010), 6.
36
Ben S Bernanke, ‘Clearing and Settlement during the Crash’ (1990) 3 The
Review of Financial Studies 133, 136.
37
town Law Journal 387, 409f; ICMA, ‘What Does a CCP Do? What Are the
Pros and Cons?’ (3 September 2017) <http://www.icmagroup.org/Regulatory-
Policy-and-Market-Practice/short-term-markets/Repo-Markets/frequently-asked-
questions-on-repo/27-what-does-a-ccp-do-what-are-the-pros-and-cons/> accessed
3 September 2017.
38
Counterparties and Systemic Risk’ (November 2013) 6, 3.
39
Dietrich Domanski, Leonardo Gambacorta and Cristina Picillo, ‘Central
Clearing: Trends and Current Issues’ [2015] BIS Quarterly Review 59, 60;
Lieven Hermans, Peter McGoldrick and Heiko Schmiedel, ‘Central Counter-
parties and Systemic Risk’ (November 2013) 6, 3. See also generally, Darrell
Duffie and Haoxiang Zhu, ‘Does a Central Clearing Counterparty Reduce
Counterparty Risk?’ (2011) 1 The Review of Asset Pricing Studies 74.
pay-out, therefore becoming unable to fulfil his obligation. Second, the

counterparties to the CDS could experience financial distress without an
underlying default, causing counterparty credit risk. Lastly, counterparty
default could be experienced through bilateral collateral exchanges, either
because the collateral is not segregated, or because the counterparty’s
collateral was re-hypothecated by the defaulter.40
Thereby, the CCP combines the exposures of the counterparties on its
own balance sheet, meaning that, if all clearing participants uphold their
obligations, the CCP holds matching books by settling losses and profits
at least daily or by collecting variation margins.41 In case of a member
default, the CCP takes on the obligations and rights of the failed party.42
This could potentially help to mitigate systemic risk, as default risk is
prevented from propagating between counterparties.43 All this is achieved
through novation.
3.2.1.4 Netting
By offsetting or netting, the CCP can offset multiple contracts all
between counterparties and the CCP, thereby decreasing the total out-
standing net value of the individual contracts and exposure to the
counterparties.44 The gross notional exposures in the financial markets
are excessive for many market participants owing to the average trans-
action size and because a clearing member may buy and sell the same
contract multiple times. In comparison, the net exposures are signifi-
cantly smaller.45 Permitting the CCP to net open positions of individual
clearing members against one another provides great benefits: not only
does the overall collateral requirement per trade decrease to cover the
overall net exposure, but netting also decreases outstanding contract
40
See Navneet Arora, Priyank Ghandi and Francis A Longstaff, ‘Counter-
party Credit Risk and the Credit Default Swap Market’ (2012) 103 Journal of
Financial Economics 280, 282.
41
Clearing: Trends and Current Issues’ [2015] BIS Quarterly Review 59, 61.
42
Ibid 60.
43
44
Financial Regulation (Edward Elgar 2012), 219; James T Moser, ‘Contracting
Innovations and the Evolution of Clearing and Settlement Methods at Futures
Exchanges’ (1998) 26, 5.
45
Clearing 47
positions, thereby reducing the likelihood of large counterparty default

positions. In case of default by a member, the values of derivatives
contracts in the money are transferred to the CCP from the other
creditors.46
Multilateral netting or offsetting of exposures across three or more
traders is one of the greatest possibilities that a CCP offers the cleared
market. Not only does netting reduce exposure, but it also reduces the
collateral requirement a trade participant must post for his trade.47 In the
case of a member default, positions can be netted, resulting in smaller
and fewer positions to be auctioned off to cover losses as opposed to the
bilateral market, where larger and many more positions need to be sold
off.48 Netting also changes creditor priority by giving participants in a
clearing arrangement priority over a defaulter’s other creditors and
creditors in bilateral markets, and shifts financial substance from a
defaulter’s non-derivatives creditors to its derivatives counterparties in the
event of a default.49
3.2.1.5 Standardisation
In order to successfully manage the multilateral netting of its novated
positions, derivatives contracts must be sufficiently standardised.
Through standardisation, cash flow characteristics can be harmonised.50
Sufficient standardisation promotes feasibility and therefore liquidity of
the products. To be eligible for clearing, products need reliable and
regular availability of prices. Such price transparency permits the CCP to
assess its risks and the products to become sufficiently liquid.51
3.2.1.6 Collateral collection

The CCP’s obligation to ensure contractual settlement despite potential
default by its clearing members necessitates the CCP to command
capital. This capital primarily stems from its members and is referred to
as collateral; it is the asset through which the collateral provider aims to
46
Ibid.
47
Journal, 8, 19.
48
Ibid.
49
Ibid 20.
50
51
Ibid 10.
guarantee contractual obligations to the collateral taker.52 The CCP uses

collateral to absorb losses arising from clearing member credit events
leading to the failure of the clearing member to fulfil the contractual
obligations concerning the derivative contract.53 Therefore, collateral is
posted to the CCP to account for the party’s market, credit, operational
and counterparty risk.54
Collateral must be highly liquid and its price should be relatively
consistent; therefore, cash or high-quality non-cash securities are permis-
sible.55 When collateral is posted by clearing members, it is referred to as
margin. Margin can in turn be subdivided into two categories: initial
margin and variation margin.56 The difference between the two is the
frequency with which contributions are adapted to market changes. While
initial margin is a fixed contribution to the CCP, variation margins are
regular, variable payments to the CCP to account for changes in the
positional valuation in accordance to price shifts in the market.57 All
collateral contributions are aimed at mitigating risks arising from a
participant’s default.58
Additionally, collateral must be held in segregated accounts to prevent
losses resulting from other defaults. Segregation refers to the process of a
52
53
54
Manmohan Singh, ‘Collateral Netting and Systemic Risk in the OTC
Derivatives Market’ (April 2010) 99, 5.
55
Clearing: Trends and Current Issues’ [2015] BIS Quarterly Review 59, 72–3;
Craig Pirrong, ‘The Inefficiency of Clearing Mandates’ (2010) 665 Cato Journal,
8. 21; IMF, ‘Making Over-the-Counter Derivatives Safer: The Role of Central
Meeting New Challenges to Stability and Building a Safer System (IMF 2010),
17.
56
Norman M Feder, ‘Deconstructing Over-the-Counter Derivatives’ (2002) 2002
Columbia Business Law Review 677, 733.
57
2002 Columbia Business Law Review 677, 733; IMF, ‘Making Over-the-Counter
Derivatives Safer: The Role of Central Counterparties’ in IMF (ed.), Global
Financial Stability Report April 2010: Meeting New Challenges to Stability and
Building a Safer System (IMF 2010), 12–13.
58
Clearing 49
clearing member holding two or more separate collateral portfolios.59

This is particularly important for client clearing, as the default of the
clearing member performing client clearing might otherwise be passed on
to the client. Segregated accounts permit the CCP and the regulator to
transfer the client positions to another clearing member so settlement and
hedging can continue unhindered for the client, in spite of the clearing
member’s default.60
3.2.1.6.1 Initial margin Initial margin is a predetermined, fixed-value

cash or non-cash collateral with the objective of protecting the CCP from
contract non-performance.61 It is the first collateral posted with the CCP
upon entering into a novated trade.62 Initial margin is posted to the CCP
by every party to a transaction to account for the risk that the particular
party brings to the CCP by having his trade cleared there and in
accordance to the contractual terms of the specific trade.63
3.2.1.6.2 Variation margin Despite collateral needing to satisfy cer-

tain criteria of low value fluctuation, the market value of the collateral
may drop. Furthermore, the creditworthiness of a counterparty may shift
or the riskiness of the contract increase. Variation margin addresses these
daily shifts in valuation and are a payment from the counterparty to the
59
14.
60
Ibid 13–14. For a discussion on re-hypothecation of collateral, see
generally Manmohan Singh, ‘Collateral Netting and Systemic Risk in the OTC
Derivatives Market’ (April 2010) 99; and Manmohan Singh, ‘Under-
Collateralisation and Rehypothecation in the OTC Derivatives Market’ (2010) 14
Financial Stability Review 113.
61
13.
62
63
CCP to maintain sufficient collateral depending on market risk ex-

posure.64 To ensure that the exposure does not increase unexpectedly
owing to changes in the creditworthiness of the participant or the value of
an asset provided as collateral, regular adaptations to changes in market
exposure are taken into consideration by marking the risk to market, the
so-called ‘mark-to-market’.65 Posting of collateral is subject to thresh-
olds, below which no collateral needs to change hands, and additional
factors, such as credit worthiness and exposure, further influence collat-
eral values.66
Mark-to-market encompasses the calculation of value based on the
current market value in comparison with the original or last valuation. If
the value of either the underlying or the collateral, or both, has decreased
in comparison to the original or last value, additional collateral will need
to be posted (margin call) to the CCP’s margin account, while no new
collateral is needed and may be returned from the CCP if the value has
increased.67
64
Ibid; Norman M Feder, ‘Deconstructing Over-the-Counter Derivatives’
(2002) 2002 Columbia Business Law Review 677, 733; IMF, ‘Making Over-the-
Counter Derivatives Safer: The Role of Central Counterparties’ in IMF (ed.),
Global Financial Stability Report April 2010: Meeting New Challenges to
Stability and Building a Safer System (IMF 2010), 13.
65
31.
66
2010), 26; Dietrich Domanski, Leonardo Gambacorta and Cristina Picillo,
‘Central Clearing: Trends and Current Issues’ [2015] BIS Quarterly Review 59,
61.
67
Mark-to-market is also known as fair-value accounting and translates to
valuing an asset or liability based on what a third party would pay on the market
for said asset or liability at the given time. If the market for said asset depresses,
to maintain the necessary collateral, more units of the asset (or another higher
quality asset) need to be held as collateral to maintain valuation. The Financial
Accounting Standards Board (FASB) Standard Number 157 deals with the
application of this principle. In the aftermath of the financial crisis, the rule was
amended to the extent that fair market value is only determined by an orderly
market, to prevent total value loss in case of a depressed market. Regular market
fluctuations continue to be incorporated. See FASB, ‘News Release 04/09/09’
(9 April 2009) Press Release <www.fasb.org/news/nr040909.shtml> accessed 3
September 2017; Yesha Yadav, ‘Clearinghouses in Complex Markets’ (2013) 101
Georgetown Law Journal 387, 419.
Clearing 51
3.2.1.6.3 Default fund Besides posting collateral as initial and varia-

tion margins, counterparties must also provide the CCP with collateral
for the CCP’s default fund.68 Default fund contributions are called upon
if the defaulting clearing member’s margin contributions were insufficient
to fulfil its obligations and to cover any exposure while other positions
are being liquidated.69 While default contributions should be regularly
reassessed using different measures and stress-testing, these contributions
are not re-evaluated as frequently as the initial and variation margins,
making them less volatile, but also less risk sensitive.70
3.2.1.6.4 Margin and derivatives With regard to collateral, there are

stark differences between those products that are suited for clearing and
those that are not. The total amount of collateral needed in a cleared
market transaction is markedly higher as compared with the bespoke
OTC market, especially with regard to the initial margin. The Inter-
national Monetary Fund (IMF) estimated an additional USD 150 billion71
in bank capital to be required as a result of the clearing mandate, while
other IMF employees predict even higher collateral requirements, such as
Singh, who predicts USD 200 billion.72 This collateralisation impacts the
market strongly and is different from the bilateral market where collateral
mechanisms are more flexible. For customers with lower cash flows,
especially, the bilateral market is more advantageous since they are
impacted less by the cash flow volatility which daily mark-to-market
68
Clearing: Trends and Current Issues’ [2015] BIS Quarterly Review 59, 61–2.
69
13.
70
Clearing: Trends and Current Issues’ [2015] BIS Quarterly Review 59, 61–2;
IMF, ‘Making Over-the-Counter Derivatives Safer: The Role of Central Counter-
parties’ in IMF (ed.), Global Financial Stability Report April 2010: Meeting New
Challenges to Stability and Building a Safer System (IMF 2010), 13–14.
71
See generally IMF, ‘Making Over-the-Counter Derivatives Safer: The
Role of Central Counterparties’ in IMF (ed.), Global Financial Stability Report
April 2010: Meeting New Challenges to Stability and Building a Safer System
(IMF 2010).
72
collateral calls are known to produce.73 Therefore, not even the reduction
in counterparty credit risk is expected to dissuade all end-users from
shifting their business from bilateral to cleared- and exchange-traded
venues.74
To promote clearing and the expected benefit of enhanced market
stability, and despite increased costs for collateral, non-cleared products
are mandated to increase their collateral value as well. Margin collection
can counteract moral hazard by forcing clearing members to keep each
other in check or risk having to pay if a clearing member defaults.
Margins perform two central roles: reducing systemic risk and promoting
usage of central clearing facilities.75
To avoid the systemic risk from accumulating through derivatives not
mandated or permissible for clearing, which could lead to spill-over
effects, strict margin requirements for these non-cleared products are
necessary. Additional potential measures may be necessary to reduce
pro-cyclicality and uncollateralised exposure build-up.76 Such pro-
cyclicality can be reduced because collateral is collected before there is a
credit event requiring access to such high-quality collateral, when mar-
kets may be more turbulent from the onset. This, in turn, reduces the
probability of fire sales and the volatility of collateral prices during
market turmoil.77 By imposing strict margin requirements on non-
centrally cleared derivatives contracts, the cost–benefits by circumventing
the clearing mandate can also be reduced. Regulatory arbitrage from
lower margin allocations could undercut this effort, which is why the
Basel Committee on Banking Supervision (BCBS) and International
Organisation of Securities Commissions (IOSCO) are aiming for high-
level standardisation across jurisdictions.78
73
Journal, 8, 21.
74
Ibid. 21.
75
BCBS and IOSCO, ‘Margin Requirements for Non-Centrally Cleared
Derivatives’ (March 2015), 3 <http://www.bis.org/bcbs/publ/d317.htm> accessed
3 September 2017.
76
BCBS and IOSCO, ‘Margin Requirements for Non-centrally Cleared
Derivatives’ (March 2015), 3. This may be true, but will largely depend on how
strictly collateral management is done and how liquid collateral remains.
77
For detailed discussion on the linkage between collateral spirals, fire-sales
and pro-cyclicality, see discussion in Markus Brunnermeier and others, ‘The
Fundamental Principles of Financial Regulation’ (June 2009) 11, 22–3.
78
Derivatives’ (March 2015), 3–4.
Clearing 53
Yet at the same time, margin practices are capable of creating

contagion and systemic risk on their own, well before any counterparty
default. The reason for this is the market changes that directly impact
the quality of collateral and the perception of collateral safety. Price
changes, originating from market imbalances, could lead to losses
resulting from the process of marking exposure to market. This then
leads to losses from the need to access additional liquidity: as the price
of assets increases, so too does their demand.79 This process is referred
to as a liquidity spiral.80 This directly impacts margin practices and the
implementation of haircuts on margins in stressed market conditions can
exacerbate this cycle by forcing a deleveraging, while increasing margin
requirements, fuelling the cycle even more, causing more losses and
higher margin requirements.81
Thus, margin contributions fulfil two distinctly different purposes.
Margin is dynamic, accounting for a specific transaction, based on the
specifications of a portfolio, and can adapt to changes in the portfolio’s
risk exposure. In the case of counterparty default, it is first the variation
margin of the defaulting party that is liquidated to absorb the resulting
losses, resulting in a ‘defaulter-pay’ mechanism. If this is not sufficient,
other sources of funding, including the default fund, are drawn upon.
3.2.1.7 Default resolution

Bilateral markets handle the resolution after the default of a counterparty
differently from cleared markets. What they both have in common is that,
when a default occurs, the counterparty to the trade must find another
trader to fill the defaulted party’s position or at least a very similar
contract.82 In a cleared market, when a party defaults, the CCP becomes
the counterparty to the defaulted position and must find ways to deal with
its exposure.83 To fill this position, the CCP can either trade on the open
market or, more often, hold an in-house auction for the other CCP
members to bid in.84
Internalising costs within CCP structure is the key feature of mutual-
isation. This concept was put to the test during the 2008 financial
79
Markus Brunnermeier and others, ‘The Fundamental Principles of Finan-
cial Regulation’ (June 2009) 11, 16–17.
80
Ibid 22.
81
Ibid 18–19 and 21.
82
Journal, 8, 22.
83
Ibid.
84
As did the LCH.Swapclear after Lehman’s bankruptcy, see ibid.
crisis when Lehman Brothers collapsed – and it succeeded perfectly.

LCH.Clearnet was able to wind down, close out or transfer a USD 9
trillion portfolio of interest rate swaps involving Lehman Brothers
without even needing to access its own default fund.85 In the event of a
participant not meeting his obligations to the counterparty at maturity, the
CCP first tries to either transfer the participant’s position to other
clearing members or liquidate (‘close out’) these positions. The import-
ance of client clearing segregation becomes apparent, as client positions
cannot be closed out and must be transferred to other surviving partici-
pants.86 Only if this does not cover the positions of the defaulting
clearing member will the default waterfall be activated to cover resulting
losses.
To contain a clearing member’s default within the CCP and prevent
contagion across the market, CCPs have to adopt a ‘waterfall’ cascade to
cover the resulting losses. CCPs should manage to survive simultaneous
defaults of multiple clearing members in extreme but plausible market
conditions.87 Because a CCP must fulfil the defaulted member’s obliga-
tions, it needs access to the member’s financial resources.88 This water-
fall is funded by initial and variation margins, default fund contributions
and the CCP’s own financial resources. While margins are reassessed
daily, default fund contributions are less frequently assessed, primarily in
connection with stress-testing, making this amount less volatile but also
less likely to adapt to changes in market structures, leaving the default
fund potentially under-capitalised.89
First, the defaulter’s own collateral contributions are used; this entails
both margins and default fund contributions, in that order. If this is
insufficient, the CCP will use the surviving members’ default fund
85
town Law Journal 387, 412; LCH.Clearnet, ‘$9 Trillion Lehman OTC Interest
Rate Swap Default Successfully Resolved’ (8 October 2008) Press Release
<http://www.lch.com:8080/media_centre/press_releases/2008-10-08.asp> accessed
3 September 2017.
86
87
18.
88
89
Clearing 55
contributions, but not their margins. In a third step, the CCP’s own
capital (‘skin in the game’) is used to cover losses, although steps two
and three may alter, depending on the internal rules of the CCP. If, after
completion of this waterfall mechanism, losses remain, the CCP may
then call upon ring-fenced unfunded resources. They must be ring-fenced
to guarantee their availability even if their contributor has failed.90
The objective is to decrease moral hazard and adverse selection, and
reduce asymmetric information problems by making participants contrib-
ute to the defaults of their fellow clearing members.91 Albeit a positive
notion, calling upon participants to provide the CCP with additional
collateral in an unstable economic environment may cause non-defaulting
participants to jeopardise their own liquidity and cause greater disrup-
tions and potential defaults from previously not-yet-defaulting members.
Such unexpected collateral calls may also undermine the efforts to reduce
systemic risk and exacerbate the spread of liquidity shortages and
defaults across financial institutions, particularly between CCPs and
banks as their interaction increases beyond simple netting networks.92 In
theory, a CCP limits the amount of additional collateral that clearing
members may be demanded to contribute to the default fund if a clearing
member defaults, while others may have ‘to the last drop’ policies.93
To reduce this contagion effect, clearing by means of a CCP plays a
major role in reducing this risk. Netting and the ability to auction off
illiquid positions or transfer them to non-defaulting members can contain
negative externalities within a predefined liquidity pool. Through netting,
multiple parties’ positions weigh in, thereby reducing the total amount of
positions to be replaced and the potential coinciding price shift. Add-
itionally, by auctioning off the defaulter’s contractual obligations, fire
sales can be avoided as potential buyers are directly available and have an
incentive or even obligation to partake in the auction and price fluctu-
ations can be capped with the help of the CCPs to replace original
90
Ibid; Lieven Hermans, Peter McGoldrick and Heiko Schmiedel, ‘Central
91
Clearing: Trends and Current Issues’ [2015] BIS Quarterly Review 59, 61–2.
92
Ibid 62.
93
This is the so-called ‘Maxwell House’ rule, which allows a CCP to
demand additional financing from its clearing members, if its own capital is
insufficient in the case of a member default. See Craig Pirrong, ‘The Inefficiency
of Clearing Mandates’ (2010) 665 Cato Journal, 8, 13.
contracts at (more or less) full value.94 Together, and despite the default
of a clearing member, a smoother transition can be achieved as compared
with the OTC market. To achieve the goal of stabilising the OTC markets
with the help of CCPs, regulators around the world have pushed to turn
them into ‘an important bulwark in the financial system’.95
3.2.1.8 Transparency and reporting

Clearing also increases market transparency, as the CCP maintains
transaction records of the counterparties’ positions and trades.96 Such
records permit regulators and the public to assess risk exposure and
build-up in the system. Additionally, all trades should be reported to a
central trade repository that collects and shares information.97 One of the
expected benefits of the mandatory clearing of OTC derivatives is
improved insight into the market transactions owing to trade reporting.
Optimally, trade reporting should allow for market participants, CCPs
and regulators to monitor exposures across derivatives markets. In order
to achieve this policy objective, the information provided to the market
must be useful and easily comprehensible, as well as used rationally.98
When making data accessible, certain details need to be accounted for,
including the visibility of offsetting positions, risk from underlying
and non-transparent structures and dependencies, as well as other
exposures.99
Trade repositories are the ‘storage facility’ as they maintain electronic
records of the transactions performed. Their objective is to manage the
flood of information and, by compiling all relevant information in one
location, enhance transparency of transactional information for both
regulators and stakeholders.100 By collecting, storing and disseminating
all data, the objective is to enable an early detection of potential risk
94
(May 2011) 1, 10–11.
95
Ibid 11.
96
97
Ibid 8.
98
Yesha Yadav, ‘Clearinghouses and Regulation by Proxy’ (2014) 43
Georgia Journal of International and Comparative Law 161. Yesha Yadav,
‘Clearinghouses in Complex Markets’ (2013) 101 Georgetown Law Journal 387,
420 et seq.
99
Ibid 423–4.
100
CPSS and IOSCO, ‘Principles for Financial Market Infrastructures’ (April
2012) <http://www.bis.org/cpmi/publ/d101a.pdf> accessed 3 September 2017.
Clearing 57
accumulation in the financial market and prevent market abuse.101 The

responsibilities of trade repositories include providing continuous infor-
mation to a number of stakeholders that is reliable and accurate, allowing
for risk reduction, operational efficiency and prevention of market
abuse.102 The new, central role of market information storage has turned
trade repositories into systemically important institutions; such a discus-
sion is, however, not a part of this research.
3.2.2 Review
Before the effects of this new emphasis on financial stability are

considered in more detail, it is worthwhile to examine how clearing
originated. Despite the fact that clearing fulfils a public policy objective,
it did not evolve out of public sector initiatives. Clearing was developed
by exchanges and in interbank dealings. The former was established to
help exchange members deal with counterparty default, while the latter
developed in the absence of a central bank.
3.3 THE ORIGINS OF CLEARING

Clearing developed from the private market needs for public policy
objectives in the absence of other financial market infrastructures avail-
able to achieve these objectives. Historically, two types of clearinghouses
could be distinguished: bank and futures clearinghouses.103 While bank
clearinghouses settled obligations by netting payments between members
by first collecting payments and then crediting or debiting the respective
member account to the extent of the member’s account balance, futures
clearinghouses guaranteed the fulfilment of futures contracts.104 The
original purpose of clearinghouses was to reduce exposure to non-
performance for their members and the clearinghouses ensured this by
collecting margin and marking contracts to market.105
101
Ibid 9.
102
Ibid 9–10.
103
James T Moser, ‘Contracting Innovations and the Evolution of Clearing
and Settlement Methods at Futures Exchanges’ (1998) 26, 7.
104
Ibid.
105
Ibid.
3.3.1 Derivative Clearinghouses
The cornerstone for clearinghouses was laid in 1848 by the Chicago

Board of Trade (CBOT), a private standard-setter. By 1856, CBOT was
the founder of standardisation and rating for various commodities. It
grew to become the most successful futures exchange in the world and
the ideological forerunner of setting financial standards that Moody’s,
Standard and Poor’s and Fitch Ratings would use for credit ratings half a
century later.106 The self-regulatory approach taken by CBOT promoted
exchange-trading, standardisation and increased membership value.
Exchanges were born from the idea of bringing buyers and sellers
together, enabling them to trade in shares, bonds or commodity deriva-
tives easily, providing a liquid and dynamic capital market and creating
economies of scale and scope.107 Standardised contracts enable a simple
transferal between parties. While this early exchange permitted hedging
against market risk, there was no mechanism to address credit risk from
the failure of a counterparty to deliver, either physically or in cash.108
In 1883, CBOT established the first clearinghouse, but it did not have
novation function. The guaranteeing function of the clearinghouse –
so-called complete clearing109 – was copied from the European coffee
exchanges that had a caisse de liquidation or Liquidationskasse attached
that insured exchange members against default losses by the Minneapolis
Grain Exchange in 1891.110 Only in 1925 was the Chicago Board of
Trade Clearing Corporation founded. It financed itself by mandating that
106
(1999) 31 Journal of Money, Credit, and Banking 596, 599–600.
107
108
109
For more details on other forms of clearing such as ‘direct’ and ‘ringing’,
see James T Moser, ‘Contracting Innovations and the Evolution of Clearing and
Settlement Methods at Futures Exchanges’ (1998) 26, 31–9.
110
(1999) 31 Journal of Money, Credit, and Banking 596, 602; Randall S Kroszner,
‘Central Counterparty Clearing: History, Innovation and Regulation’ (European
Central Bank and Federal Reserve Bank of Chicago Joint Conference on Issues
Related to Central Counterparty Clearing, Frankfurt, 3 April 2006), 38.
Clearing 59
all members purchase shares in the corporation through margin pay-

ments, establishing a default fund and maintaining a credit line with
banks.111
A different ownership approach was taken by the Chicago Eggs and
Butter Board when it reorganised itself to become the Chicago Mercan-
tile Exchange in 1919. The Exchange included the clearinghouse into the
ownership structure of the exchange instead of having a separate clearing
institution, thus allowing both to be owned by its members. This structure
mutualised loss among all members and allowed for additional funds to
be drawn on from the clearing members if needed, resulting in a different
structure than the Chicago Board of Trade Clearing Corporation
approach.112
CBOT had recognised early on the importance of creating incentives
for its members to adhere to its risk-management practices, and also to
set the basic structures to which CCPs still adhere today: they collected
initial and variation margins, commanded reserves and a default fund,
and had permission to investigate the books of any member whose
solvency is questioned.113 The gradual process of evolving from a mere
exchange to a clearinghouse with the objective of reducing transactional
costs by collecting margin and netting positions, to a CCP as we know it
today, assuming counterparty credit risk and guaranteeing the contract, is
striking.114 Through risk management and continuous evolution, the
original CCP’s structure and ownership model115 permitted it to weather
all great financial downturns successfully.116 It is important to recall to
111
(1999) 31 Journal of Money, Credit, and Banking 596, 602–3.
112
Ibid 604.
113
3 April 2006), 38.
114
Ibid.
115
Exchange members were also owners of the CCP, providing incentives for
them not to bring undue risk to their CCP. Other incentives were created in the
waterfall default fund, placing ultimate financial burden upon the surviving
members. See also Ibid.
116
(1999) 31 Journal of Money, Credit, and Banking 596, 603; Randall S Kroszner,
‘Central Counterparty Clearing: History, Innovation and Regulation’ (European
Central Bank and Federal Reserve Bank of Chicago Joint Conference on Issues
Related to Central Counterparty Clearing, Frankfurt, 3 April 2006), 37.
memory that this process – ultimately fulfilling public policy objectives –

was achieved purely from private institutions without any governmental
pressure.
Before the creation of the Federal Reserve System, clearinghouses
fulfilled the function of making simple inter-bank transfers.117 Clearing-
houses netted outstanding amounts between different banks to offset
demands and reduce settlement positions. Bank clearinghouses also
demanded securities from the banks prior to ensuring settlement, espe-
cially if said bank was issuing notes too quickly; thus, they provided
checks-and-balances in the banknote system.118 While they did not
expressly guarantee any contracts, they could facilitate and broker
takeovers,119 similar to auctioning off the positions of a defaulted
clearing member in the derivatives clearinghouses.
Therefore, clearinghouses for both derivatives and banks evolved as a
mechanism to deal with market and systemic risk. They aim to reduce
exposure to risk and align the incentives of members with those of the
clearinghouse to promote stability and substantiated growth.
3.3.2 Recent Developments
The last 20 years have seen a segregation of exchanges and CCPs.

Clearinghouses were created for agricultural futures, some operating as
profit centres while others only charge minimal fees.120 Interestingly,
CCPs themselves were uneasy about the idea of taking on the additional
work. While clearinghouses were created for exchange-traded securities
for which they are able to rely on the price information and liquidity of a
product based on their own findings and information, when they take on
a product from the OTC market, the contractual counterparties set the
price and provide the information to the CCP with far less certainty.121
While some exchanges continue to incorporate a CCP, many more are
separate and exchanges do not require their users to be members of their
117
For detailed account of how the inter-bank system works, see Randall S
Kroszner, ‘Can the Financial Markets Privately Regulate Risk?’ (1999) 31
Journal of Money, Credit, and Banking 596, 605.
118
Ibid 605–6.
119
Ibid 606.
120
Thomas Krantz, ‘Comment: Risks Remain in G20 Clearing Plan’ Finan-
cial Times (London, 29 January 2014) <http://www.ft.com/cms/s/0/60c82dec-
8827-11e3-a926-00144feab7de.html#axzz3wHmPGGCh> accessed 3 September
2017.
121
Ibid.
Clearing 61
clearinghouses anymore. This process is further accentuated through

client clearing, where a non-clearing member uses a clearing member to
access the services of a CCP.122 Another important change has been their
reorganisation into a for-profit corporation instead of mutual associations,
which has had a direct impact on the risk management process.123
Additional risks from sudden market shocks are found to be exacerbated
if complex financial instruments are concerned, as their valuation is
susceptible to particularly large swings in valuation within a short period
of time.124 For CCPs, the inability to price the risk effectively for new
products, paired with the risk of collateral asset value decline, introduces
new risks. The lack of liquidity of the positions also affects the close-out
abilities of the CCP in case of counterparty default.125
A modern CCP fulfils three major functions for its members: it
confirms the details of the transaction performed, it limits counterparty
default risk and it disperses both risk and losses among its members. In
short, it ensures payment and delivery126 and it has been placed at the
forefront of regulatory reform because one CCP proved itself to be
valuable following the default of Lehman Brothers.
3.4 LCH.CLEARNET: A SUCCESS STORY

Amid multiple defaults and regulatory interventions required to stabilise
the financial markets because of derivatives in the autumn of 2008, there
was one success story: LCH. LCH demonstrated that it is indeed possible
to deal with a large counterparty default without adding to market turmoil
if certain risk management procedures are in place. Additionally, the
122
3 April 2006), 39.
123
Ibid.
124
cial Stability: A Private Sector Perspective’ (25 July 2005), 7–9.
125
3 April 2006), 39.
126
Heikki Marjosola, ‘Missing Pieces in the Patchwork of EU Financial
Stability Regime?’ (2015) 52 Common Market Law Review 1491, 1495 with
additional remarks.
defaulter – and not the surviving members – was forced to pay.127 When
Lehman Brothers defaulted, LCH was exposed to them with USD
9 trillion in interest rate swaps, comprising more than 66,000 trans-
actions. This case was instrumental in the decision to implement clearing
for all derivatives and will therefore be considered more closely. Using
the lessons learned from LCH’s success, the individual risk-management
practices of post-crisis CCP clearing will then be analysed in greater
detail.
One week prior to Lehman Brothers’ failure to pay the requested
margins to LCH, LCH had begun preparing for such a possibility.128
LCH was faced with a decision regarding which positions were client
positions and could be transferred to a non-defaulted member and which
were house positions and needed to be hedged and then liquidated. This
process was complicated by the fact that Lehman Brothers had
co-mingled its own positions with those of LCH.129 The CCP decided
that the most effective and least disruptive resolution option was to
transfer the positions which they were certain they belonged to the
defaulter to other clearing members and auction off the remainder of the
positions.130 Within five days, this process resulted in the risk exposure
from the default dropping by 90% and, by 3 October 2008, LCH had
successfully managed to liquidate the entire USD 9 trillion portfolio.131
Its greatest success was the fact that the default was contained within the
margins that Lehman Brothers had provided to LCH and hence the
default fund was never touched. This forced the defaulter to bear the cost
and not the other clearing members.132
127
LCH.Clearnet, ‘Managing the Lehman Brothers’ Default’ (3 September
2017) <http://www.lchclearnet.com:8080/swaps/swapclear_for_clearing_members/
managing_the_lehman_brothers_default.asp> accessed 3 September 2017.
128
See Natasha de Terán, ‘How the World’s Largest Default Was Unravelled’
Financial News London (London, 13 October 2008) <http://www.efinancial
news.com/story/2008-10-13/how-the-largest-default-was-unravelled> accessed 3
September 2017.
129
See also Paul Cusenza and Randi Abernethy, ‘Dodd-Frank and the Move
to Clearing’ [2010] Insight Magazine 22, 23.
130
Ibid; Natasha de Terán, ‘How the World’s Largest Default Was Un-
ravelled’ Financial News London (London, 13 October 2008).
131
Paul Cusenza and Randi Abernethy, ‘Dodd-Frank and the Move to
Clearing’ [2010] Insight Magazine 22, 24; LCH.Clearnet, ‘Managing the Lehman
Brothers’ Default’ (3 September 2017).
132
Ibid.
Clearing 63
LCH was able to deal with the exposure successfully with the help of
two mechanisms: collateral collection and a predetermined default pro-
cedure. An additional contributing factor to the success of LCH may have
been its previous experience with clearing member defaults. Before
Lehman Brothers, LCH successfully managed the default of four of its
clearing members.133 Following this insight into how LCH dealt with the
USD 9 trillion fall-out, the individual risk management techniques of
CCPs will now be closely analysed.
3.5 SUMMARY
This chapter has provided evidence that clearing positively influences
systemic risk stemming from OTC derivatives, as the CCP nets multi-
lateral exposure and reduces counterparty credit risk. Clearing organ-
isations have been around for over two centuries and resulted from
private organisations working towards achieving public policy objectives.
The latest financial crisis has changed the dynamics of clearing funda-
mentally. While derivatives clearing was originally intended for
exchange-traded products, regulation has mandated clearing for OTC
derivatives as well because of the effectiveness of LCH in winding down
its exposure to Lehman Brothers. The clearing mandate fundamentally
alters the connection between clearing members and CCP. This chapter
has introduced the concept of clearing, where a CCP becomes the
counterparty to each derivative contract through novation, assuming a
guarantor position to the counterparty. It is able to net exposure between
all counterparties, thereby reducing exposure and systemic risk from
counterparty default. To manage the risks to which it is exposed, the CCP
ensures that it commands a prudent default mechanism. Additionally, it
may select its members according to certain criteria and collect collateral
from its clearing members. Collateral, in the form of initial and variation
margins, ensures that the CCP has a buffer to manage its exposure to the
133
The defaults prior to Lehman Brothers were Drexel Burnham Lambert
(1990), Woodhouse, Drake and Carey (1991), Barings (1995) and Griffin (1998),
along with three near defaults – Yamaichi Securities (1997), Enron Metals (2001)
and Refco Securities and Refco Overseas (2005). Since then, LCH has success-
fully dealt with two additional defaults: MF Global (2011) and Cyprus Popular
Bank (2013). See for details on each LCH.Clearnet, ‘LCH.Clearnet’s Default
History’ (3 September 2017) <http://www.lch.com/documents/515114/515811/
LCH+Clearnet’s+default+history+May-13_tcm6-63482.pdf/245cb035-5755-48bf-
83d3-23b283764e56> accessed 3 September 2017.
counterparties and their trades, as well as shifts in the valuation of the

collateral itself, and other risks arising therefrom. The CCP also requires
its members to post collateral to the CCP’s default fund. The default fund
is used by the CCP if the individual contributions of the defaulting
member are insufficient to cover the exposure until additional liquidity
can be freed up. In so doing, the CCP contains the risk within, mutualises
risk among its members and prevents knock-on effects. The CCP
therefore contributes to macro-economic policy objectives of containing
and mitigating systemic risk related to derivatives. LCH proved that
CCPs can succeed during times of great market distress and complete
their objective in a timely manner.
Next, the regulation before the crisis, particularly in the United States,
must be discussed. The US regulation – or lack thereof – in the years
leading up to the crisis promoted the speculative usage of OTC deriva-
tives and the expansion of the OTC market. The facts speak for
themselves: before the enactment of the Commodity Futures Modern-
ization Act in 2000, the OTC market was worth USD 95.2 trillion. Only
eight years later, the market had grown to a staggering USD 673 trillion,
more than seven times its original value.134
134
Report’ (January 2011), xxiv–xxv; Lynn A Stout, ‘Legal Origin of the 2008
Financial Crisis’ (2011) 1 Harvard Business Law Review 1, 1.
4. Pre-crisis regulation of derivatives
and clearing
4.1 INTRODUCTION
The previous chapters have introduced the reader to derivatives and the
concept of clearing without sufficiently considering the regulatory frame-
work to which they were constrained. The following chapter is divided
into two parts. The first part will consider the pre-crisis regulatory
framework for over-the-counter (OTC) derivatives in the European Union
and the United States. It will provide evidence that two factors permitted
the OTC derivatives market to blossom: first, the International Swaps and
Derivatives Association (ISDA); and second, the enactment of the
Commodity Futures Modernization Act (CFMA) in the United States.
ISDA is a global non-governmental organisation that promoted the
standardisation of OTC derivatives contracts through master agreements
it provided. The CFMA changed existing regulations and permitted the
speculative usage of derivatives, which had previously been banned under
US law.
The second part considers the response of the international community
to the financial crisis of 2007–2009, by beginning with the Group of
Twenty (G20) meeting in Washington, DC in November 2008.1 This
meeting is considered the inception of the clearing mandate for OTC
derivatives. The chapter then highlights the regulatory proposals provided
by international standard setters, such as the Financial Stability Board
(FSB), Basel Committee on Banking Supervision (BCBS), International
Organisation of Securities Commissions (IOSCO) and Committee on
Payment and Settlement Systems (CPSS). These standards are soft law;
therefore, they are not binding for national legislators, but they provide
1
G20, ‘G20 Leaders Statement: The Pittsburgh Summit’ (25 September
2009) <http://www.g20.utoronto.ca/2009/2009communique0925.html> accessed
3 September 2017.
65
guidance for the legislation process.2 The soft law process has become of
great importance for global finance and for financial law, particularly
since the last financial crisis. While soft law is not directly enforceable, it
can facilitate consensus and foster a harmonised regulatory approach.3
The benefit of soft law is that it circumvents complicated legislative
processes, thereby promoting convergence and action in a timely manner.
The rise of soft law also empowers the institutions that create these laws
since they benefit from a short reaction time and dynamic input for the
hard law process, as they only have a few members. This in turn also
raises questions regarding their democratic legitimacy, as the inter-
national standard-setting bodies in the financial market are not created by
states, but by ‘informal associations of state representatives and/or
professionals’.4
The abolition of strict rules against OTC trading and speculation
permitted the OTC derivatives market to grow to USD 673 trillion by
2008 and it is the objective of post-crisis soft law standards to combat
systemic risk with harmonised macro-prudential reforms. This then
permits an analysis comparing the objectives with the national legislation
to examine whether these objectives were indeed met.
4.2 PRE-CRISIS REGULATION

As has been demonstrated, exchanges have been subject to strict rules
from their inception; therefore, once again this chapter focuses on OTC
derivatives. The existence of the Bretton Woods System, with the US
dollar pegged to the price of gold, provided the exchange rate market
with security. This changed when the United States abolished the gold
standard under President Nixon and with the subsequent collapse of the
2
Eilís Ferran and Kern Alexander, ‘Can Soft Law Bodies Be Effective?
Systemic Risk Board’ (June 2011) 36, 5–7.
3
Ibid 6.
4
Ibid 6–7, 9, 13. For detailed discussion on the democratic legitimacy of
the G20, see Kern Alexander and others, ‘The Legitimacy of the G20 – a
Critique under International Law’ (May 2014), 22. Also Andrew F Cooper and
Colin I Bradford Jr, ‘The G20 and the Post-crisis Economic Order’, CIGI G20
Papers no. 3 (June 2010), 4; Jan Baumann, ‘Der Siegeszug Des Soft Law’ SRF
(Bern, 27 August 2015) <http://www.srf.ch/news/wirtschaft/der-siegeszug-des-
soft-law> accessed 3 September 2017.
Pre-crisis regulation of derivatives and clearing 67
Bretton Woods System in 1973.5 The importance of derivatives increased

thereafter as they permitted counterparties to mitigate exposure to
exchange rate volatility by hedging their exposure. Thereby, currency
derivatives, such as currency swaps and futures, gained significance.6 The
New York International Commercial Exchange (1970) and Chicago’s
International Monetary Market (1972) became the first exchanges where
currency futures could be traded. Simultaneously, the importance of the
OTC market for such derivatives began to grow because it permitted
market participants to match the contracts to their specific needs.7 The
ensuing rise of the OTC market was made possible by strong financial
innovation, deregulation of the market area, and a powerful international
non-state actor, ISDA. Because exchanges have been governed by strict
laws, once again the focus is only on OTC derivatives.
4.2.1 Pre-crisis National Regulation
As demonstrated, OTC derivatives are subject to the negotiated terms of

the counterparties and, if applicable, any overriding laws. The origin of
OTC derivatives lay in interest rate and currency swaps until they grew to
include exotic derivatives such as credit derivatives and weather deriva-
tives.8 In the beginning, the parties called and telexed with one another to
broker the deal and set the parameters of the agreement. These initial
agreements needed to be complemented by additional general terms that
rarely changed; therefore, the contracting parties began standardising
agreements with supplements to adapt the contractual terms to their
needs.9 At the same time, exchanges began publishing product prices on
sites such as Reuters, Bloomberg and Telekurs, generating supply and
5
IMF, ‘The End of Bretton Woods System (1972–81)’ (3 September 2017)
<https://www.imf.org/external/about/histend.htm> accessed 3 September 2017.
Peter M Graber, ‘The Collapse of the Bretton Woods System’ in Michael D Bodo
and Barry Eichengreen (eds), A Retrospective on the Bretton Woods System:
Lessons for International Monetary Reform (University of Chicago Press 1993),
462–3.
6
Bas Straathof and Paolo Calió, ‘Currency Derivatives and the Disconnec-
tion between Exchange Rate Volatility and International Trade’ (February 2012)
203, 2–3.
7
Ibid 3.
8
Allen & Overy, ‘An Introduction to the Documentation of OTC Deriva-
tives “Ten Themes”’ (May 2002), 1 <http://www.isda.org/educat/pdf/ten-themes.
pdf> accessed 3 September 2017.
9
Ibid 2–3; Norman M Feder, ‘Deconstructing Over-the-Counter Deriva-
demand for products that previously had remained illiquid. This price
transparency also attracted new clients that otherwise would not have
traded in derivatives.10
4.2.1.1 United States of America

Speculation was forbidden in the United States for social welfare
purposes before the enactment of the CFMA in 2000. The US Supreme
Court decision Irwin v. Williar describes then-judicial practice well:
The generally accepted doctrine in this country is […] that a contract for the
sale of goods to be delivered at a future day is valid, even though the seller
has not the goods, nor any other means of getting them than to go into the
market and buy them; but such a contract is only valid when the parties really
intend and agree that the goods are to be delivered by the seller and the price
to be paid by the buyer; and if, under guise of such a contract, the real intent
be merely to speculate in the rise or fall of prices, and the goods are not to be
delivered, but one party is to pay to the other the difference between the
contract price and the market price of the goods at the date fixed for executing
the contract, then the whole transaction constitutes nothing more than a
wager, and is null and void.11
Speculation was considered a form of gambling and therefore discour-

aged. By disallowing wagers, speculators were forced to incur the cost
and inconvenience of trading in the spot market. Additionally, the
intention was to dissuade any incentive to manipulate the underlying
asset.12 The restriction on speculation by difference contracts – the term
for derivatives contracts at the time – shifted the trading of such
speculative contracts into private venues, the commodity exchanges.13
There, ‘elevator receipts’ – later renamed futures – were traded, with
physical delivery practically circumvented by purchasing a second
futures contract for delivery of the same quantity of goods on the same
delivery date, off-setting the original contract.14 While these speculative
trades could not be enforced in the courts, they could be enforced within
the exchanges, allowing for the futures market to grow astronomically.15
10
Franca Contratto, Konzeptionelle Ansätze Zur Regulierung von Derivaten
Im Schweizerischen Recht (Schulthess Juristische Medien 2006), 65.
11
See Irwin v Willar (1884), 110 US 499, 508–9.
12
13
Ibid 12, 14–15.
14
Ibid 15.
15
In 1888, the US harvested 415 million bushels of wheat, while futures
contracts for 25 quadrillion bushels of wheat changed hands. See ibid.
At the same time, a first ‘OTC market’ developed with ‘bucketshops’

selling futures to anyone. Speculative futures trades by bucketshops were
voided by the US Supreme Court in 1905, while they became legally
enforceable on exchanges because set-off was considered delivery by the
Supreme Court.16
The Grain Futures Act of 1922 was re-enacted as the Commodity
Exchange Act (CEA) in 1936. It empowered the Commodity Futures
Trading Commission to oversee and regulate private commodity
exchanges, particularly to detect and prevent market manipulation.17
Additionally, it strictly prohibited trading of off-exchange futures,18
making them illegal and judicially unenforceable.19 Beyond these regu-
lated futures, new underlying assets surfaced, such as interest rates,
housing prices, mortgage default rates and even the weather.20 These
derivatives contracts traded in the OTC market were illegal under the
CEA; hence the US Commodity Futures Trading Commission (CFTC)
was approached to determine whether these swaps would be submitted to
the exchange trading requirements of the law.21 In 1989, the CFTC issued
a ‘safe harbor’ policy statement, exempting swaps from regulation.22
Congress supported the ongoing deregulation of the derivatives market
and this process culminated in the exemption of OTC swaps from the
CEA, state anti-wagering and anti-bucketshop laws in 1992.23 As a result,
multiple derivative-fuelled disasters followed in the ensuing years,
16
Board of Trade of Chicago v Christie Grain & Stock Co (1905), 198 US
224. See also Lynn A Stout, ‘Legal Origin of the 2008 Financial Crisis’ (2011) 1
17
Leading to long turf wars between the CFTC and the Securities Exchange
Commission. For discussion see generally Jerry W Markham, ‘Super Regulator:
A Comparative Analysis of Securities and Derivatives Regulation in the United
States, The United Kingdom, and Japan’ (2003) 28 The Brook Journal of
International Law 356, 356–62.
18
The original futures, e.g. on cotton and grain, were expanded to include
‘all other goods and articles’ in 1974. See Lynn A Stout, ‘Legal Origin of the
2008 Financial Crisis’ (2011) 1 Harvard Business Law Review 1, 18 fn 61.
19
Ibid 17–18. See also The Financial Crisis Inquiry Commission, ‘The
Financial Crisis Inquiry Report’ (January 2011), 46.
20
Report’ (January 2011), 46.
21
22
Policy Statement Concerning Swap Transactions, 54 Federal Registration
30, 694 (21 July 1989).
23
For more details see Lynn A Stout, ‘Legal Origin of the 2008 Financial
Crisis’ (2011) 1 Harvard Business Law Review 1, 19–20.
brought on by losses on the OTC market.24 Despite these developments

culminating in the bail-out of Long Term Capital Management, a
moratorium on derivatives regulation was passed in October 1998, and
when the CFMA was passed, OTC derivatives became exempt and
shielded from any regulation.25
One woman took a courageous stance against the pressure to deregu-
late OTC derivatives – Brooksley Born. As Chairwoman of the CFTC
between 1996 and 1999, she encouraged regulation of the OTC market
because she feared the detrimental abilities of credit default swap (CDS)
and swaps to affect financial stability.26 Her plans, published in a concept
paper, were thwarted, mostly because of the headwind created by the
former Chairman of the Federal Reserve, Alan Greenspan, the former
Secretary of the Treasury, Robert Rubin, and by the former Chairman of
the Securities and Exchanges Commission, Larry Summers. The three
were strongly opposed to any regulation of the OTC derivatives market,
claiming that it would cause a financial crisis if the market were
regulated and that there was no systemic risk arising from OTC deriva-
tives. Congress ultimately passed a moratorium on the regulation of OTC
derivatives, despite the bail-out of Long Term Capital Management,
because it miscalculated the risk stemming from derivatives in 1998.27
After Born’s resignation, the CFMA was enacted in 2000 and pro-
claimed to reduce systemic risk by providing legal certainty as to the
exemption of all parties eligible for speculative trading in all OTC
derivatives. This was done by simply excluding most derivatives from the
24
Ibid; The Financial Crisis Inquiry Commission, ‘The Financial Crisis
Inquiry Report’ (January 2011), 46–7.
25
Report’ (January 2011), 47–8.
26
Manuel Roig-Franzia, ‘Brooksley Born: The Cassandra of the Derivatives
Crisis’ Washington Post (Washington, DC, 26 May 2009) <http://www.
washingtonpost.com/wp-dyn/content/article/2009/05/25/AR2009052502108.html>
accessed 3 September 2017; Lynn A Stout, ‘Legal Origin of the 2008 Financial
Crisis’ (2011) 1 Harvard Business Law Review 1, 20–21.
27
Manuel Roig-Franzia, ‘Brooksley Born: The Cassandra of the Derivatives
Crisis’ Washington Post (Washington, DC, 26 May 2009) <http://www.
washingtonpost.com/wp-dyn/content/article/2009/05/25/AR2009052502108.html>
accessed 3 September 2017; John Carney, ‘The Warning: Brooksley Born’s Battle
with Alan Greenspan, Robert Rubin And Larry Summers’ Business Insider (New
York, 21 October 2009) <http://www.businessinsider.com/the-warning-brooksley-
borns-battle-with-alan-greenspan-robert-rubin-and-larry-summers-2009-10?IR=T>
CEA’s scope.28 An analysis of the events following the exemption of

OTC derivatives from the oversight and regulation of exchanges and the
CFTC led to the conclusion that the deregulation was the source of the
latest derivatives-fuelled financial crisis.29 The CFMA allowed the OTC
derivatives market to be deregulated, in turn causing this market to
expand beyond expectations from USD 95 trillion at the end of 2000 to
USD 673 trillion in just eight years.30 This deregulation of an entire
market sector and the ongoing turf war31 between the Securities
Exchange Commission and the CFTC made the derivatives-fuelled finan-
cial crisis possible in the first place.32
4.2.1.2 European Union

As opposed to the United States, the EU lacked any regulation of OTC
derivatives. The UK outright vetoed any regulation of said market for
fear of competitive disadvantages with the United States.33 While the
BCBS did publish a report on OTC derivatives34 and the Lamfalussy
Report35 identified them as a risk to European financial stability, no steps
28
29
Same opinion: The Financial Crisis Inquiry Commission, ‘The Financial
Crisis Inquiry Report’ (January 2011), xxiv; see also Alexey Artamonov, ‘Cross-
Border Application of OTC Derivatives Rules: Revisiting the Substituted Com-
pliance Approach’ (2015) 1 Journal of Financial Regulation 206, 207; Lynn A
Law Review 1, 20–24.
30
Report’ (January 2011), xxiv–xxv.
31
Jerry W Markham, ‘Super Regulator: A Comparative Analysis of Secur-
ities and Derivatives Regulation in the United States, The United Kingdom, and
Japan’ (2003) 28 The Brook Journal of International Law 356, 356–62.
32
For an analysis of how this unsystematic financial regulation increased
systemic risk from derivatives, see Kern Alexander and Steven L Schwarcz, ‘The
Macroprudential Quandary: Unsystematic Efforts to Reform Financial Regu-
lation’ in Ross P Buckley, Emilios Avgouleas and Douglas Arner (eds), Recon-
ceptualising Global Finance and its Regulation (Cambridge University Press
2016), 151–2.
33
Lucia Quaglia, The EU and Global Financial Regulation (Oxford Univer-
sity Press 2014), 93–5.
34
See BIS, ‘OTC Derivatives: Settlement Procedures and Counterparty
Risk Management’ (September 1998) <http://www.bis.org/cpmi/publ/d27.pdf>
35
Alexandre Lamfalussy and others, ‘Final Report of the Committee of
Wise Men on the Regulation of the European Securities Market’ (15 February
were taken to regulate OTC derivatives.36 Exchange-traded derivatives,

however, were regulated in 2004 with the Directive on Markets in
Financial Infrastructures (MiFID I). 37
4.2.2 Pre-crisis Non-governmental Regulation
ISDA was the most influential non-state actor with regard to deriva-
tives.38 It enabled counterparties to efficiently conduct OTC derivatives
transactions by providing them with boilerplate contracts to adapt to the
economic and legal specialties of the jurisdiction. Therefore, ISDA will
be looked at in further detail here.
ISDA, originally referred to as the International Swap Dealers Associ-
ation, began developing standards for model agreements regarding OTC
swap transactions in 1984 in New York.39 In 1985, ISDA published its
first ‘Code’ – the 1985 Edition of the Code of Standard Wording,
Assumptions and Provisions for Swaps – and continued to produce new
Codes in the years to come. The original Codes contained glossary terms
to define the contracts and practices of the leading US dollar interest rate
swap players and expanded to include other currencies and global
practices.40 ISDA continued to evolve its contracts to include other OTC
derivatives and to make the Code more accessible and inclusive, and
changed the Code’s name to the ‘ISDA Master Agreement’ in 1987.41
ISDA Master Agreements provided standard contracts to aid bilateral
2001) <http://ec.europa.eu/internal_market/securities/docs/lamfalussy/wisemen/
final-report-wise-men_en.pdf> accessed 3 September 2017.
36
Ibid, 66, 70, 83, 91.
37
See Directive 2004/39/EC.
38
See Norman M Feder, ‘Deconstructing Over-the-Counter Derivatives’
(2002) 2002 Columbia Business Law Review 677, 740–41 for other organ-
isations providing standardised agreements.
39
tives “Ten Themes”’ (May 2002), 1.
40
Ibid 2–3; Norman M Feder, ‘Deconstructing Over-the-Counter Deriva-
41
ISDA, ‘About ISDA’ (3 September 2017) <http://www2.isda.org/about-
isda/> accessed 3 September 2017; Allen & Overy, ‘An Introduction to the
Documentation of OTC Derivatives “Ten Themes”’ (May 2002), 2–3; 5–7, for
detailed accounts on how the 1992 ISDA Master Agreement worked.
discussions, to promote enforceability of netting and collateral pro-

visions, to reduce transaction and negotiation costs and to ‘significantly
reduce credit and legal risk’ across all jurisdictions.42
ISDA acted as the monopolistic private regulator – a ‘transnational
private regulator’43 – providing boilerplate contractual terms of the
non-economic aspects of OTC derivatives trades before the crisis to
major issuers, brokers and legal advisors to be adapted to different legal
jurisdictions and systems around the world. It is believed that it was only
with the help of ISDA that this trillion-dollar industry was capable of
appearing and thriving on the global market.44 ISDA’s influence was so
great that it managed to lobby regulators across the globe to make
governmental regulation compliant with ISDA contracts in order to
maintain its position in the market.45 Its domination of the OTC
derivatives market continued as it provided materials, terms and stand-
ards that developed into documentation as the market evolved and
financial innovation was observed.46 This led to a harmonised application
of contractual terms across jurisdictions as the Master Agreement pro-
vided boilerplate contracts as the basis for accepted non-economic terms,
defined procedures for default events and answered questions on applic-
able law and jurisdictions, etc. At the same time, the economic terms
were left up to the contracting parties to set.47
The 2010 FSB report found that ISDA’s involvement had allowed the
CDS market to become highly standardised after 2005, which in turn led
‘to greater operational efficiencies, encouraging higher volumes in
standardised transactions, and […] providing the requisite operational
42
ISDA, ‘About ISDA’ (3 September 2017) <http://www2.isda.org/about-
isda/> accessed 3 September 2017.
43
Gabriel V Rauterberg and Andrew Verstain, ‘Assessing Transnational
Private Regulation of the OTC Derivatives Market: ISDA, the BBA, and the
Future of Financial Reform’ (2013) 54 Virginia Journal of International Law 9,
46–7.
44
Katharina Pistor, ‘A Legal Theory of Finance’ (May 2013) 315–30, 321.
45
Ibid.
46
Gabriel V Rauterberg and Andrew Verstain, ‘Assessing Transnational
23.
47
Ibid.
environment for the implementation of centralised risk-reducing infra-

structure’,48 such as portfolio compression, reporting and clearing that
had been made possible with the help of the ISDA ‘Big Bang Protocol’.49
The protocol was published on 12 March 2009 as a reaction to the
financial crisis. Its objective was to help market participants trading CDS
to unify their contracts before and after the cut-off date of 7 April 2009 in
case of a credit event and allow for an auction of open positions.50 This
new protocol was created because ISDA realised that the counterparties
had largely agreed upon uncollateralised contracts, as the ISDA agree-
ments permitted them to determine the economic provisions bilaterally.51
The objective was to allow counterparties’ auction settlement for CDS,
and ultimately to calm the CDS market and return it to a functioning
market place.52
4.2.3 Review
The United States was the only analysed jurisdiction that had a consistent
regulation of its derivatives market and banned speculative and off-
exchange usage of derivatives. The unfortunate decision to deregulate the
OTC derivatives market was an enabler for the financial crisis. The EU
lacked any regulation for OTC derivatives. In the absence of national
regulation, a non-state actor positioned itself to provide the market with
guidance.
ISDA was of undeniable importance to the development of the OTC
derivatives market. The ISDA Master Agreements enabled counterparties
from around the world to enter into OTC derivatives contracts quickly
and with legal enforcement options. It emphasised its quasi-governmental
position with rules precluding anyone who had not purchased their
48
FSB, ‘Implementing OTC Derivatives Market Reforms’ (25 October
2010), 15 <http://www.fsb.org/wp-content/uploads/r_101025.pdf> accessed 3
September 2017.
49
ISDA, ‘Credit Derivatives Determinations Committees and Auction Set-
tlement CDS Protocol 2009’ (12 March 2009) <http://www.isda.org/bigbangprot/
docs/Big-Bang-Protocol.pdf> accessed 3 September 2017.
50
Ibid.
51
Derivatives Market’ (April 2010) 99, 5–8.
52
ISDA, ‘Big Bang Protocol – Frequently Asked Questions’ (3 September
2017) <http://www.isda.org/bigbangprot/bbprot_faq.html#sf9> accessed 3 Sep-
tember 2017.
Master Agreement from ISDA itself from enjoying protection.53 Without

the work of this non-state actor, the likelihood that the OTC derivatives
market could have grown to reach USD 673 trillion in notional amount
outstanding is negligible.
Once the extent of the financial crisis became obvious, the United
States – pressured by internal politics – began steering the global
community to adopt its view of the post-crisis order.54 To achieve this
objective, the international reform agenda was commandeered by US
initiatives through the influence of international standard setters, particu-
larly the G20.
4.3 INTERNATIONAL REFORM AGENDA

The international community, particularly the G20 and the Financial
Stability Board, began addressing the shortfalls of the global financial
system quickly. This was particularly brought on by pressure from the
public and journalists.55 A streamlined selection of the standards has been
made to gain insight into the international objectives and post-crisis
reaction.
4.3.1 The Origin
The G20’s objective is to ‘promote discussion, and [to] study and review
policy issues among industrialized countries and emerging markets with a
view to promoting international financial stability’.56 It was founded in
1999 by the finance ministers of the Group of Seven (G7) and is an
international forum for finance ministers and central bank governors
53
See Gabriel V Rauterberg and Andrew Verstain, ‘Assessing Transnational
40.
54
Lucia Quaglia, The EU and Global Financial Regulation (Oxford Univer-
sity Press 2014), 94.
55
For a discussion on the media pressure based on distorted facts and biased
accounts as well as short-term ambitions by politicians, see Kern Alexander and
Steven L Schwarcz, ‘The Macroprudential Quandary: Unsystematic Efforts to
Reform Financial Regulation’ in Ross P Buckley, Emilios Avgouleas and
Douglas Arner (eds), Reconceptualising Global Finance and its Regulation
(Cambridge University Press 2016), 130.
56
University of Toronto, ‘G20 Members’ (3 September 2017) <http://www.
g20.utoronto.ca/members.html> accessed 3 September 2017.
representing 19 countries plus the European Union, with representatives

of the Bretton Woods Institutions: the World Bank and the International
Monetary Fund (IMF).57 The informal nature of the G20 helped to
facilitate dialogue on an international level and facilitate the finding of
quick solutions, despite its non-transparent institutional structure and lack
of accountability and democratic legitimacy.58 The first meeting, in
November 2008 in Washington, DC, coincided with the most important
regulatory impact the G20 had had to date. Under former US President
George W. Bush, the G20 finance ministers were invited to coordinate the
global response to the financial crisis, which they did by committing to
take various actions.59 They tasked experts to continue investigating how
to strengthen ‘the resilience and transparency of credit derivatives mar-
kets and reducing their systemic risks, including by improving the
infrastructure of over-the-counter markets’.60
ISDA had led a meeting61 in the meantime to address the weaknesses
of operational infrastructures and industry leaders independently com-
mitted to developing a robust central clearing infrastructure for OTC
derivatives.62 Nevertheless, the ideological birthplace of the clearing
mandate for OTC derivatives is considered to be the G20 meeting in
Pittsburgh in September 2009.63 There, four key changes were agreed
upon and commitments made to implement the changes by the end of
2012:
57
Ibid.
58
See Kern Alexander and others, ‘The Legitimacy of the G20 – a Critique
under International Law’ (May 2014), 22.
59
G20, ‘Declaration of the Summit on Financial Markets and the World
Economy’ (15 November 2008) <http://www.g20.utoronto.ca/2008/2008
declaration1115.html> accessed 3 September 2017.
60
Ibid; see also Lucia Quaglia, The EU and Global Financial Regulation
(Oxford University Press 2014), 94.
61
ISDA, ‘Statement Regarding June 9 Meeting on Over-the-Counter
Derivatives’ (9 June 2008) Press Release <https://www2.isda.org/attachment/
MjE2Mg==/ma080609.html> accessed 3 September 2017.
62
ISDA, ‘New York Fed Welcomes Expanded Industry Commitments on
Over-the-Counter Derivatives’ (31 July 2008) Press Release <https://www2.isda.
org/attachment/MjE1OQ==/an080731.html> accessed 3 September 2017; see
also Anon., ‘Market Participants to the Fed Commitments’ (3 September 2017)
<https://www2.isda.org/attachment/MjkxNA==/073108%20Supplement.pdf> ac-
cessed 3 September 2017.
63
2009).
(1) mandatory reporting of all OTC derivatives contracts to trade

repositories;
(2) all standardised OTC derivatives to be mandated for clearing by a
central counterparty;
(3) trading on exchanges or electronic trading platforms where possible
for sufficiently standardised contracts; and
(4) increased capital and margining requirements for non-centrally
cleared OTC contracts.64
The FSB – as a successor to the Financial Stability Forum – was deemed

the supervisor of the implementation process.65 The FSB was tasked with
overseeing systemic risk generally, by working together with the IMF,
thus issuing early warnings. As opposed to international economic
organisations, such as the World Trade Organization or IMF – which
were all founded by a treaty – the FSB is an international standard-
setting body without legal personality or a founding treaty.66 The FSB is
particularly important when too-big-to-fail and systemic risk problems
arise.67
4.3.2 The First Results
In October 2010, the FSB followed up with a report titled ‘Implementing

OTC Derivatives Market Reforms’68 which was supported by the CPSS,69
the IOSCO and the European Commission.70 The FSB made multiple
recommendations, particularly regarding the increased standardisation of
64
Ibid, Commitment 13; FSB, ‘Making Derivatives Markets Safer’
(3 September 2017) <http://www.fsb.org/what-we-do/policy-development/otc-
derivatives/> accessed 3 September 2017.
65
2009); FSB, ‘Implementing OTC Derivatives Market Reforms’ (25 October
2010).
66
Systemic Risk Board’ (June 2011) 36, 9.
67
Ibid 11.
68
2010).
69
The CPSS was renamed in 2014 and is called Committee on Payments
and Market Infrastructures (CPMI) today. See BIS, ‘CPSS – New Charter and
Renamed as Committee on Payments and Market Infrastructures’, 1 September
2014.
70
2010), iii.
contracts, increased quantity of contracts to be centrally cleared and

heightened risk management requirements for bilateral counterparty risk
requirements.71
Furthermore, promoting all standardised products to be traded on
exchanges or electronic trading platforms,72 and reporting in a complete
and timely fashion to trade repositories,73 the FSB stressed the necessity
of global cooperation in every aspect to foster a safe development of the
derivatives market. To achieve this, the FSB called on the OTC Deriva-
tives Supervisors Group (ODSG),74 the Bank for International Settle-
ments (BIS) and the IOSCO to create additional recommendations and
commitments to continue the efforts of implementing the G20 commit-
ments by the end of 2012.75
4.3.2.1 Determining clearing eligibility

In February 2012, IOSCO released standards on how to determine
derivatives appropriate for clearing to prevent arbitrage and risk from
being created anew.76 It proposed two approaches to defining a product
71
Ibid 3–5. The primary objective is that, by forcing more OTC contracts to
be monitored by CCPs, this will increase the price reliability of contracts and
risk assessment for CCPs. Particularly see Recommendation 6: ‘they should not
require a particular CCP to clear any product that it cannot risk-manage
effectively, […] when authorities determine that an OTC derivative product is
standardised and suitable for clearing, but no CCP is willing to clear that
product, the authorities should investigate the reason for this’.
72
2010), 5–6.
73
Ibid 6–7.
74
The ODSG was founded in 2005 by the New York FED. It is a mixed
group, containing both regulators and major market players, particularly to
address risks from the growing CDS market. It coordinates with ISDA to
coordinate collective progress. See Federal Reserve Bank of New York, ‘OTC
Derivatives Supervisors Group’ (3 September 2017) <https://www.newyork
fed.org/markets/otc_derivatives_supervisors_group.h tml#tabs-1> accessed 3
September 2017.
75
2010), 7; see also generally Jason Quarry and others, ‘OTC Derivatives Clearing:
Perspectives on the Regulatory Landscaper and Considerations for Policymakers’
(31 May 2012) <http://www.oliverwyman.com/content/dam/oliver-wyman/
global/en/files/archive/2012/OTC_Derivatives_Clearing.pdf> accessed 3 Septem-
ber 2017.
76
IOSCO, ‘Requirements for Mandatory Clearing’ (February 2012), 5–6, 11
<https://www.iosco.org/library/pubdocs/pdf/IOSCOPD374.pdf> accessed 3 Sep-
tember 2017.
or set of products for clearing: top-down and bottom-up. In the top-down

approach, the regulator assesses whether a product should be subject to
clearing in the absence of a central counterparty (CCP) clearing or
demanding to be able to clear the product. In the bottom-up approach, the
CCP itself proposes additional products for clearing besides the ones it is
authorised to clear.77 Using both approaches together, exemptions from
mandatory clearing should only be permitted where they do not under-
mine financial market stability, while considering the global effects posed
by non-harmonised rules. Therefore, regulators should engage in cross-
border discussions and assess the potential impact of regulating or
deregulating certain products.78
Derivatives subject to the clearing mandate should be unambiguously
identifiable, along with where the product is traded, the timeframe when
clearing begins, and any potential restrictions regarding CCP clearing
(volume or other).79 When considering a derivative for clearing, the level
of standardisation is key. Here, IOSCO expands upon the 2010 FSB
report, defining sufficient standardisation taking in contractual terms and
supporting taking operational processes into consideration.80 Before
deeming a product fit for mandatory clearing, the liquidity across the
entire market for the product must also be considered. IOSCO recom-
mends taking volume and value, average transaction size, bid-offer
spread, the amount of trading platforms and/or liquidity providers, as
well as active market participants, and limitations for CCPs into consider-
ation.81 Lastly, the regulator should also first consider the availability of
reliable, fair market pricing of a product for all market participants as an
indicator of the qualification for central clearing. Additional indicators
can be found by comparing third-country jurisdiction decisions and
comparing their arguments to one’s own national demands.82
Exemptions are suggested in the form of three categories: product,
participant and fixed period. If a product is exempt this could be due to a
lack of standardisation or market liquidity. Market participants can be
exempted from the clearing mandate because they pose little risk to the
overall market or would be burdened too heavily if subjected to clearing.
Lastly, if regulators need more time to adopt regulation for certain
products or participants, clearing can be suspended for a fixed period of
77
Ibid 5 and 12–14.
78
Ibid 5–6.
79
Ibid 14–15.
80
Ibid 16–17 and 27–8.
81
Ibid 17.
82
Ibid 17–18 and 20.
time.83 The importance of ongoing monitoring and adaptation to changes

is also set forth.84 Across the jurisdictions that had implemented clearing
before 2012, intra-group transactions and small financial counterparties,
as well as many non-financial counterparties, were frequently exempted,
and therefore explicitly mentioned by the IOSCO report. The IOSCO
requirements stress the importance of maintaining globally harmonised
rules and preventing exploitation of loopholes. While intra-group trans-
actions, as well as hedging by small financial and non-financial counter-
parties, genuinely pose smaller risks for the global financial system’s
stability, such preferential treatment may be exploited and the boundaries
between hedging and speculation wear thin. Particularly for the last
group of counterparties, the report suggests using thresholds instead of
general exemptions from clearing rules.85
4.3.2.2 Financial market infrastructures

In April 2012, the Committee on Payment and Settlement Systems and
the International Organisation of Securities Commissions published the
Principles for Financial Market Infrastructures.86 It contains 24 principles
for financial market infrastructures (FMIs) to foster financial stability
through effective risk management to ‘facilitate the clearing, settlement,
and recording of monetary and other financial transactions’,87 with the
objective of enhancing financial stability through the usage of FMIs.88
FMIs are defined as ‘a multilateral system among participating insti-
tutions, including the operator of the system, used for the purposes of
clearing, settling, or recording payments, securities, derivatives, or other
financial transactions’.89 Despite FMIs’ good performance during the
crisis, they were targeted by standard setters owing to their critical role in
the functioning and stability of the financial system and the economy at
large. The principles apply to the payment systems with systemic
importance such as clearing, settlement and the keeping of records:
Central Securities Depositories (CSDs),90 Securities Settlement Systems
83
Ibid 31.
84
Ibid 41–2.
85
Ibid 32–3.
86
2012).
87
Ibid 5.
88
Ibid 1–4.
89
Ibid 7.
90
CSDs promote the integrity of securities, by providing central safe-
keeping services to ensure that securities are neither changed, created or
(SSSs),91 Central Counterparties (CCPs) and Trade Repositories (TRs).

Because of their role as custodians, they concentrate risk and, in the case
of bad management, can aid the spread of shocks across different
financial markets.92
To prevent further systemic crises caused by fragmented or poorly
designed laws governing FMIs, the CPSS–IOSCO principle aims to
improve trust and confidence in the FMIs to reduce negative externalities
from potential future shocks.93 The scope of the principles encompasses
all CSDs, SSSs, CCPs and TRs in domestic, cross-border and multi-
currency trades because each has the potential ‘to trigger or transmit
systemic disruptions’,94 including, but not limited to, ‘systems that are
the sole payment system in a country or the principal system in terms of
the aggregate value of payments; […] and systems that settle payments
used to effect settlement in other systemically important FMIs’.95 The
CPSS–IOSCO principle stresses the importance of having strong meas-
ures in place to allow for the recovery or winding down and transferal of
assets of an FMI if it is no longer sustainable as a going concern or is
insolvent.96
4.3.3 Further Developments
Despite the reform having been intended by the G20 to be implemented

by the end of 2012, it is an ongoing process. In January 2015, IOSCO
released its final standards to mitigate risk from non-centrally cleared
destroyed, be this fraudulently or accidentally. Securities are moved to CSD

either electronically or physically from the settlement system, to be safeguarded
by the CSD. Target2-Securities is an initiative in the Eurozone by the European
Central Bank as a single settlement platform for all participating CSDs. See
CPSS and IOSCO, ‘Principles for Financial Market Infrastructures’ (April 2012),
5, 8; Dermot Turing, Clearing and Settlement in Europe (Bloomsbury Profes-
sional 2012), 16.
91
SSSs allow for the transferal of securities against a predefined function,
which can be delivery versus payment or free of payment. Most common version
is DVP where the security is only delivered if payment occurs. In many
jurisdictions CDS also operate the SSS owing to their proximate functions. See
CPSS and IOSCO, ‘Principles for Financial Market Infrastructures’ (April 2012),
8–9.
92
Ibid 5.
93
Ibid 10–13.
94
Ibid 12.
95
Ibid.
96
Ibid 14–15.
derivatives.97 The standards were developed together with the BCBS and
the Committee on Payments and Market Infrastructures (CPMI, formerly
CPSS).98 They are to be transposed into national regulation by the
appropriate authorities.99 These nine standards refer to ‘financial entities
and systemically important non-financial entities’100 insofar as they
engage in non-centrally cleared OTC derivatives transactions with one
another. Other standards include trade confirmation following execu-
tion,101 exact valuation of the transaction at any stage, from execution to
termination, to determine the correct amount of margin,102 a mechanism
to rectify any disputes relating to valuations or other material terms to
prevent and/or settle disputes between market participants in a timely
fashion103 and to ensure that any regulatory differences are minimised to
avoid inconsistencies and arbitrage on the global scale, as well as
additional compliance cost.104
In March 2015, the BCBS and IOSCO released their final policy
framework indicating the minimum standards for the margin require-
ments of non-centrally cleared derivatives.105 Despite regulatory ambi-
tions to push for standardisation and exchange-trading, derivatives
contracts in notional amounts of trillions of dollars remain un-
clearable.106 To alleviate regulatory discrepancies, the BCBS and IOSCO
created eight key principles to encourage central clearing for as many
OTC derivatives as possible and to lessen the incentive to circumvent
these rules by having equally costly margin and collateral requirements
for non-centrally cleared derivatives. The principles are applicable to
almost all non-cleared derivatives types107 and all financial firms and
97
IOSCO, ‘Risk Mitigation Standards for Non-Centrally Cleared OTC
Derivatives’ (28 January 2015) <https://www.iosco.org/library/pubdocs/pdf/
IOSCOPD469.pdf> accessed 3 September 2017.
98
Ibid 1.
99
Ibid 4.
100
Ibid Standard 1, 1.3.
101
Ibid Standard 3.
102
Ibid Standard 4.
103
Ibid Standard 7.
104
Ibid Standard 9.
105
Derivatives’ (March 2015).
106
Ibid 3.
107
Except for physically settled FX forwards and swaps: ibid 7. Additional
recommendations for these specific types of derivatives are made, but owing to
their specific nature, they shall not be considered further here.
systemically important non-financial entities.108 Resulting from the high

concentration of the largest financial key market participants trading a
highly significant amount of non-cleared derivatives with one another,
initial and variation margin requirements are vital. Exemptions were
made for non-financial entities lacking systemic importance, as most of
these transactions are already exempted from the clearing mandate by
most national regulations.109
4.3.3.1 Recovery and resolution

In the autumn of 2014, the FSB redrafted its Key Attributes of Effective
Resolution Regimes for Financial Institutions (Key Attributes) to accom-
modate the individual sectors, particularly financial market infrastruc-
tures, as defined by the Principles for Financial Market Infrastructure.110
Their objective is to resolve financial institutions, particularly global
systemically important institutions (‘G-SIFIs’111), without either disrupt-
ing the overall financial system or financially burdening taxpayers.112
CCPs are considered both a financial market infrastructure and of
significance to the overall stability of the financial system; therefore a
CCP is an SIFI.113 G-SIFIs are particularly important to financial stability
and susceptible to risks as they are considered too-big-to-fail. These
institutions were subjected to particular scrutiny following the events of
the 2007–2009 financial crisis by international standard setters.114
The Key Attributes provide guidelines for timely entrance into resolu-
tion in order to permit viable assets to still be collected and distributed.
For CCPs, this means a moratorium on unsecured creditors and cus-
tomers, while protecting netting and collateral agreements, or shifting to
108
Ibid 8–11.
109
Ibid 8–9.
110
FSB, ‘Key Attributes of Effective Resolution Regimes for Financial
Institutions’ (15 October 2014) <www.fsb.org/wp-content/uploads/r_141015.pdf>
111
FSB, ‘Addressing SIFIs’ (3 September 2017) <http://www.fsb.org/what-
we-do/policy-development/systematically-important-financial-institutions-sifis/>
112
Institutions’ (15 October 2014), 3.
113
Ibid 57.
114
FSB, ‘Addressing SIFIs’ (3 September 2017) <http://www.fsb.org/what-
we-do/policy-development/systematically-important-financial-institutions-sifis/>
a bridge institution.115 The CPMI–IOSCO additionally provides tools for

CCPs to re-establish a matched book in case of counterparty default.116
National regulators are expected to interpret these attributes as guidelines
for their own regulation.
4.3.3.2 Margin requirements

Initial margin is expected to noticeably decrease available liquidity in the
market, thereby posing logistical and operational challenges, but could be
reduced by putting thresholds in place below which no initial margin
needs be collected.117 The suggestion is to set the threshold for initial
margin no higher than EUR 50 million, while variation margin should be
exchanged daily on a bilateral basis, with the total margin transfer
between parties being de-minimis EUR 500,000.118 What is paramount is
that the collected collateral for both initial and variation margins can be
liquidated in a short time to allow for their purposeful usage. Another
strict requirement is that they retain their value even in times of stress,
requiring haircuts119 and reasonable diversification of collateral.120 The
standards list cash, high-quality government and central bank securities,
high-quality corporate bonds, high-quality covered bonds, equities, such
as major stock indices, and gold as non-exhaustive but demonstrative
collateral.121
The standards requirement also suggests a combination of internal or
third-party quantitative model-based or schedule-based haircuts, given
that these are approved by supervisors and in accordance with internal
governance standards, to guarantee that the used models are transparent
115
Institutions’ (15 October 2014), 8, 3.2(xi), Annex 3, 4.8.
116
CPMI and IOSCO, ‘Recovery of Financial Market Infrastructures’ (Octo-
ber 2014), 24–7 <https://www.bis.org/cpmi/publ/d121.pdf> accessed 3 Septem-
ber 2017.
117
Derivatives’ (March 2015), 9.
118
Ibid 10.
119
Haircuts are applied to reflect potential collateral value decline between
the time when the counterparty defaults and the liquidation of the positions. See
IMF, ‘Making Over-the-Counter Derivatives Safer: The Role of Central Counter-
parties’ in IMF (ed.), Global Financial Stability Report April 2010: Meeting New
Challenges to Stability and Building a Safer System (IMF 2010), 4 fn 5.
120
Derivatives’ (March 2015), 17.
121
Ibid 17–18.
and able to limit pro-cyclical effects.122 Another important aspect of

margin management is how the initial margin, once exchanged, is held by
the counterparty, particularly in light of potential counterparty bank-
ruptcy. If the margin is not held in a segregated account or even
re-hypothecated, re-pledged or re-used, the original margin provider (the
posting party) may not be protected from the default of the counterparty
as intended.123 All requirements are to be phased in gradually, ensuring
the monitoring of exposure and effectiveness of the policy, together with
the overall global implementations.124
4.4 SUMMARY
This chapter has shown that changes in the legal regulatory framework,
particularly in the United States, acted as an enabler of the financial
crisis. Therefore, the crisis needs to be addressed using legal measures to
return to the more stable environment that existed before the ‘safe
harbor’ era and the enactment of the CFMA. The United States has taken
the lead by promoting the G20 as a ‘recession busting group’125 and
initiating mandatory clearing for all OTC derivatives.
International standard setters accepted the challenge of providing
guidance and supervision of the ongoing regulatory implementation
process. They have published standards on how to determine derivatives
suitable for clearing and how non-suitable derivatives can be dealt with
so that they do not undermine financial stability – namely through higher
collateral requirements. The soft law provided by the international soft
institutions is an expansion of the hard law regulatory toolkit and
promotes quick and flexible adaptation to approach questions pertaining
to global financial law. Using these standard setters, systemic risk can be
addressed directly and their guidelines promote a better harmonised
macro-prudential approach to financial market regulation.126
122
Ibid 18.
123
Ibid 20.
124
Ibid 24–5.
125
Andrew F Cooper and Colin I Bradford Jr, ‘The G20 and the Post-crisis
Economic Order’, CIGI G20 Papers no. 3 (June 2010), 4.
126
Financial market infrastructures are particularly important to the

smooth and orderly functioning of the financial system. Therefore, their
regulation is especially important. The European Commission defines the
importance of CCPs as follows:
FMIs may be the sole provider of such services, or with a low degree of
substitutability, and are thus often seen as essential utilities providing a
service of common interest. Given their central and critical role in the
functioning of financial markets, regulations aim to ensure that FMIs have
strong risk management tools. Despite robust controls, the daunting scenario
of the failure of an FMI cannot be excluded. The failure of an FMI that
occupies a critical size or position in a market could have immediate systemic
implications: some segments of financial markets might just cease to operate,
and its disorderly collapse would lead to considerable losses or uncertainty for
other financial institutions. In addition, FMIs are characterized by inter-
dependencies with other financial institutions or between themselves which
imply that the contagion of a failure would spread rapidly (…) Failure of a
CCP along the above lines would imply that their members would suddenly
face very significant counterparty credit risk and replacement costs on trades
that were guaranteed by the CCP. If there is a lack of alternatives for
performing the same functions as the financially ailing or operationally
malfunctioning CCP, the financial stability of the whole system could be at
risk – all the more when the uncertainties surrounding the scale and
distribution of losses borne by the CCP would damage market confidence and
disrupt even further the functioning of financial markets.127
This comparison between earlier regulation and new objectives provides

insight into how the national legislation will be drafted. A harmonised
global approach is the objective to prevent regulatory arbitrage possibil-
ities, reduce compliance costs and avoid undetected risk accumulation in
the global financial system. While the global standards are not binding
for national regulators, G20 member states who agreed to the standards at
the meetings are expected to follow them nonetheless. Because of the
power of the G20 countries, other non-G20 member states are also
expected to follow these rules in order to have norms considered to be
equivalent to those of the United States and EU – the current market
leaders in terms of market size for derivatives trading. While the global
127
European Commission, ‘Consultation on a Possible Framework for
the Recovery and Resolution of Financial Institutions Other than Banks’ (5
October 2012), 11, 13 <ec.europa.eu/finance/consultations/2012/nonbanks/docs/
consultation-document_en.pdf> accessed 3 September 2017.
ambitions hint to how systemic risk arising from derivatives and clearing
of derivatives should be dealt with, they do not answer how individual
countries effectively deal with these risks. To find these answers, national
laws must be considered, as they will be in the next chapter.
5. Current regulation and
implementation
5.1 INTRODUCTION
Global co-ordination has increased since the financial crisis and measures
to identify and address systemic risk through more macro-prudentially-
oriented national regulatory bodies have increased. In the EU, the
European Systemic Risk Board (ESRB) has been tasked with this
objective. In the United States, the Financial Stability Oversight Council
was created.1 Yet how has the derivatives market been reformed by the
clearing mandate?
As has been shown, derivatives perform vital functions for the global
financial markets. However, derivatives also create new risks to which the
counterparties expose themselves when entering into derivatives con-
tracts. Those traded bilaterally are particularly prone to counterparty risk
and exposure from poor risk-management practices. The previous chapter
demonstrated the objective of the global community in the aftermath of
the financial crisis, which is to harness these risks by providing a
framework to counteract negative externalities and potentially systemic
risk originating from over-the-counter (OTC) derivatives contracts. At the
2009 G20 meeting in Pittsburgh, four objectives were agreed upon in
order to reform derivatives.2 Eight years have passed and many inter-
national standards have been published since to guide regulators. Thus,
the regulatory progress and implementation of the reforms in various
jurisdictions are to be considered next. Despite the G20 commitment to
implement all reforms by the end of 2012, the process is still ongoing.3
Unfortunately, as will be shown, no uniform global approach was found
1
2
See Chapter 4, Section 4.3.1.
3
G20, ‘Cannes Summit Final Declaration – Building Our Common Future:
Renewed Collective Action for the Benefit of All’ (4 November 2011)
<www.g20.utoronto.ca/summits/2011cannes.html> accessed 3 September 2017.
88
Current regulation and implementation 89
to tackle the implementation of the commitments. In fact, the implemen-

tation of the reform is yet to be completed as the phasing-in of European
Market Infrastructure Regulation (EMIR) continues while the EU and the
United States struggled to agree on a common approach for mutual
recognition regarding the equivalence of reforms.4 The EU and the
United States are by far the jurisdictions of greatest importance for OTC
derivatives.5 Additionally, both are members of the G20.
The following will detail the micro-prudential risk management tech-
niques for clearing as well as their macro-prudential impact in the EU.
Furthermore, elements of the EU regulation and implementation will be
highlighted in comparison with the United States. The remainder of the
G20 commitments – (i) exchange-trading, (ii) reporting and (iii) risk-
mitigation techniques – will be considered only marginally. The technical
standards were purposefully disregarded because they do not directly
contribute to the legal policy debate. The policy decisions are made in
regulations, acts and directives – not in technical standards. While the
technical standards ultimately influence the effectiveness of a regulation,
they can be adjusted quickly and frequently to accommodate changes in
the market. Additionally, as the macro-prudential decisions are taken at
the level of the regulator and not on the level of technical standard-
setters, they lie beyond the scope of this book.
5.2 EUROPEAN UNION

In the European Union, the crisis strengthened regulatory ambitions to
harmonise financial regulations across all 28 member states. To comply
4
The following allows for a good insight on how the two struggled to
reach consensus: European Commission, ‘European Commission and the United
States Commodity Futures Commission: Common Approach for Transatlantic
CCPs’ (10 February 2016) Press Release <http://europa.eu/rapid/press-release_
IP-16-281_en.htm> accessed 3 September 2017; Shearman & Sterling, ‘Update
on Third Country Equivalence Under EMIR’ (17 March 2016) <http://www.
shearman.com/~/media/Files/NewsInsights/Publications/2016/03/Update-on-Third-
Country-Equivalence-Under-EMIR-FIAFR-031716.pdf> accessed 3 September
2017; Shearman & Sterling, ‘EU-US Agreement on Regulation of Central
Counterparties’ (16 February 2016) <http://www.shearman.com/~/media/Files/
NewsInsights/Publications/2016/02/EUUS-Agreement-On-Regulation-Of-Central-
Counterparties-FIAFR-021616.pdf> accessed 3 September 2017.
5
with the G20 commitments on derivatives, the EU issued one directive

and two regulations.6
5.2.1 European Regulation
EMIR7 is the regulation turning the clearing mandate commitment into

harmonised law across all member states. EMIR was adopted on 29
March 2012 by the European Parliament as one of the post-crisis
regulatory reforms for OTC derivatives, counterparties and trade reposi-
tories. EMIR’s objective is to implement the 2009 G20 Pittsburgh
commitments on clearing and reporting for OTC derivatives. Further-
more, EMIR is the result of the de Larosière Report,8 which concluded
that the supervisory framework of the financial sector needed to be
strengthened and recommended a system of European financial super-
visors.9 EMIR seeks to make the OTC derivatives market more trans-
parent, provide consistent rules for European central counterparties
(CCPs), and establish legal norms on equivalence for legal, supervisory
and enforcement measures for third countries.10 The European Securities
and Market Association (ESMA) has been mandated to oversee this
process.11
The European Parliament and Council adopted a three-point approach
to EMIR: (i) uniformity; (ii) selection; and (iii) risk mitigation. Uniform-
ity ensures the equal application of the regulation across the EU member
states to reduce room for arbitrage and prevent different standards and
requirements.12 Also, the EU selects classes of OTC derivatives with as
few exemptions as possible for mandated clearing, keeping the intercon-
nectedness of counterparties and the uniqueness of different derivatives
classes in mind.13 Lastly, risk mitigation techniques themselves must be
addressed, not only to deal with clearing, but also for those derivatives
6
Rüdiger Wilhelmi and Benjamin Bluhm, ‘Systemische Risiken Im
Zusammenhang Mit OTC Derivaten’ in Rüdiger Wilhelmi and others (eds),
Handbuch EMIR (Erich Schmidt), 30–31.
7
Regulation (EU) No. 648/2012.
8
vision in the EU Report’ (25 February 2009).
9
Recital 1 EMIR; Rüdiger Wilhelmi and Benjamin Bluhm, ‘Systemische
Risiken Im Zusammenhang Mit OTC Derivaten’ in Rüdiger Wilhelmi and others
(eds), Handbuch EMIR (Erich Schmidt), 30–33.
10
Recitals 4–10 EMIR.
11
Recital 10 EMIR.
12
13
contracts and counterparties that are deemed not suited for clearing.14 As
a Regulation, EMIR is directly applicable and does not require a
transcription into national law, thereby limiting the influence of national
regulators and legislators and suppressing any possibility of member state
interpretation.
The second G20 commitment regarding trading on exchanges or
electronic platforms is being addressed in the Markets in Financial
Instruments Directive II (MiFID II).15 This directive is harmonising
regulation for the trading of financial instruments and trade venues. The
objective is to increase transparency and provide investors with better
protection, thereby rebuilding confidence, closing regulatory gaps and
increasing regulatory powers for supervisors in charge of the actors
providing investment services and related activities on a professional
basis.16 MiFID I, the predecessor of MiFID II, was among the various
regulations of the ‘Financial Services Action Plan’, which included other
regulations, such as the Market Abuse Directive,17 but also company law,
audit and accounting reforms.18 A reform was deemed necessary as the
intended aims of MiFID I,19 including significant innovation and market
structure changes and increased competition between trading venues
coinciding with lower costs for issuers and investors, as well as a more
14
15
Directive 2014/65/EU (MiFID II).
16
Recitals 4 and 12 MiFID II; Regulation (EU) No. 600/2014 (MiFIR);
Rüdiger Wilhelmi and Benjamin Bluhm, ‘Systemische Risiken Im Zusammen-
hang Mit OTC Derivaten’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR
(Erich Schmidt), 31–3.
17
Directive 2014/57/EU.
18
David Wright, ‘Markets in Financial Instruments Directive (MiFID)’
(MiFID – non-equities market transparency – Public hearing, Brussels, 11
September 2007), Slide 3 <http://ec.europa.eu/internal_market/securities/docs/
isd/ppp_press_conference_en.pdf> accessed 3 September 2017. For an analysis
of the changes in MAD II/MAR, see Kern Alexander and Vladimir Maly, ‘The
New EU Market Abuse Regime and the Derivatives Market’ 9 Law and Financial
Markets Review 243, 243–50. Special consideration is also given regarding
higher capital in CRD IV/CRR, see in particular Article 300 et seqq. and Article
381 et seqq. Regulation (EU) 575/2013. For a discussion of higher capital
requirements as a result of interlinkages with EMIR, see Olaf Achtelik and
Michael Steinmüller, ‘Zusammenspiel Zwischen EMIR Und Der Verordnung
(EU) Nr. 575/2013 (CRR)’ in Rüdiger Wilhelmi and others (eds), Handbuch
EMIR (Erich Schmidt), 523–48.
19
To prevent any misunderstanding or confusion Directive 2004/39/EC will
always be referred to as ‘MiFID I’, while Directive 2014/65/EU is referred to as
‘MiFID II’.
liquid integrated capital market,20 were not achieved. Additional pro-

visions to harmonise EMIR and MiFID II are found in the Markets in
Financial Instruments Regulation (MiFIR).
Confusion exists surrounding the hierarchy of the new EU laws,
particularly MiFID I/II, EMIR and MiFIR, thus, a few comments are
appropriate. When MiFID I was implemented in 2007, regulators noticed
that some aspects had slipped through the regulatory net they had aimed
to cast, so they decided to recast MiFID I as MiFID II in order to remedy
this discrepancy. However, during the process of drafting MiFID II the
financial crisis occurred, leading to further regulation – EMIR. Unlike
regulations, directives such as MiFID II necessitate national transposition
in order to become effective in the member state jurisdictions. Between
the two, discrepancies occurred. Therefore, MiFIR was enacted to close
the gap and to amend EMIR to harmonise the EU laws even further.21
This is the reason why there are multiple directives and regulations
covering some of the same aspects of the financial market. However,
EMIR also relies on MiFID II for certain provisions, including the
definition of a derivative.22
5.2.2 European Supervision
The ESMA23 was established in Paris in 2011 with the purpose of

promoting a smooth functioning of the financial markets across the EU
by creating a single rulebook for the financial market and ensuring that it
is uniformly implemented across the EU.24 It also supervises certain
financial institutions, credit rating agencies and trade repositories, and
20
David Wright, ‘Markets in Financial Instruments Directive (MiFID)’
(MiFID – non-equities market transparency – Public hearing, Brussels, 11
September 2007), Slide 12.
21
See Recital 3 MiFIR; furthermore Recitals 27, 35, 37 MiFIR.
22
The definition can be found in Annex I, Section C MiFID II.
23
Established by Regulation (EU) No. 1095/2010.
24
ESMA, ‘About ESMA’ (3 September 2017) <https://www.esma.
europa.eu/about-esma/who-we-are> accessed 3 September 2017. Rüdiger Wil-
helmi and Benjamin Bluhm, ‘Systemische Risiken Im Zusammenhang Mit OTC
Derivaten’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich
Schmidt), 35–6, N 12–3; Dennis Kunschke, ‘EMIR Im Kontext Des Euro-
päischen Aufsichtssystems’ in Rüdiger Wilhelmi and others (eds), Handbuch
EMIR (Erich Schmidt), 41–4.
assesses risk and third-country equivalency for CCPs and TRs.25 ESMA
is part of the European System of Financial Supervision, which also
includes the European Banking Authority26 and the European Insurance
and Occupational Pensions Authority.27 Additionally, the ESRB, a soft
law body within the EU, acts as macro-prudential regulatory oversight to
monitor the regulatory progress and ensure that the reform does not
undermine systemic risk.28
With regard to the EU’s CCPs, ESMA is in charge of creating the
technical standards for the functioning of the CCPs, such as capital
requirements and supervisory colleges, and for writing the guidelines for
CCP interoperability.29 The colleges in charge of supervising and author-
ising the European CCPs are to be made up of national supervisors and
ESMA members.30 ESMA also keeps updated databanks for the regu-
lation of OTC derivatives and risk mitigation techniques, in accordance
with the European regulation.31
Additionally, ESMA is in charge of defining which foreign CCPs are
considered equivalent (Articles 13 and 25 EMIR) based on a comparison
of foreign countries’ supervision and regulation with that of the European
25
ESMA, ‘Central Counterparties and Trade Repositories’ (3 September
2017) <https://www.esma.europa.eu/regulation/post-trading/central-counterparties-
ccps> accessed 3 September 2017.
26
27
28
and its Regulation (Cambridge University Press 2016), 142–4; Eilís Ferran and
Kern Alexander, ‘Can Soft Law Bodies Be Effective? Soft Systemic Risk
Oversight Bodies and the Special Case of the European Systemic Risk Board’
(June 2011) 36, 25; Dennis Kunschke, ‘EMIR Im Kontext Des Europäischen
Aufsichtssystems’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich
Schmidt), 38–40. For detailed discussion of the structure and tasks of the ESRB,
see Eilís Ferran and Kern Alexander, ‘Can Soft Law Bodies Be Effective? Soft
Systemic Risk Oversight Bodies and the Special Case of the European Systemic
Risk Board’ (June 2011) 36, 20–5.
29
ESMA, ‘Central Counterparties’ (3 September 2017) <https://www.esma.
europa.eu/policy-rules/post-trading/central-counterparties> accessed 3 September
2017. ESMA, Central Counterparties.
30
Ibid.
31
ESMA, ‘OTC Derivatives and Clearing Obligation’ (3 September 2017)
<https://www.esma.europa.eu/regulation/post-trading/otc-derivatives-and-clearing-
obligation> accessed 3 September 2017.
Union.32 This is an objective-based approach, where ESMA takes on a

holistic view of the legal regime of a third country and compares it
line-by-line with the regulation applicable in the EU to see if the ‘applic-
able legal and supervisory arrangements should be equivalent to Union
requirements in respect of the regulatory objectives they achieve’.33 Sub-
sequently, it gives its technical advice to the Commission.34
5.3 TOPICS OF REFORM

The following is subdivided into three parts that do not follow the
structure of the primary legal sources, but rather the author’s own
structure, in order to simplify understanding. First, the clearing require-
ments for derivatives will be considered. Second, risk management
options and default procedures for CCPs are analysed. They directly
correlate to the CCPs’ ability to strengthen the resilience against systemic
shocks and contribute to financial stability. While risk-management
32
Rüdiger Wilhelmi and Benjamin Bluhm, ‘Systemische Risiken Im
Zusammenhang Mit OTC Derivaten’ in Rüdiger Wilhelmi and others (eds),
Handbuch EMIR (Erich Schmidt), 35–6, N 12–3.
33
Instead of numerous: Commission Implementing Decision (EU) 2015/
2042 of 13 November 2015 on the equivalence of the regulatory framework of
Switzerland for central counterparties to the requirements of Regulation (EU)
No. 648/2012 of the European Parliament and of the Council on OTC deriva-
tives, central counterparties and trade repositories OJ L 298/42, 14.11.2015,
Recital 2.
Commission Implementing Decision (EU) 2015/2040 of 13 November 2015
on the equivalence of the regulatory framework of certain provinces of Canada
for central counterparties to the requirements of Regulation (EU) No. 648/2012
of the European Parliament and of the Council on OTC derivatives, central
counterparties and trade repositories OJ L 298/32, 14.11.2015, Recital 2.
Commission Implementing Decision (EU) 2015/2042 of 30 October 2014 on
the equivalence of the regulatory framework of Hong Kong for central counter-
parties to the requirements of Regulation (EU) No. 648/2012 of the European
Parliament and of the Council on OTC derivatives, central counterparties and
trade repositories OJ L 311/62, 31.10.2014, Recital 2.
Commission Implementing Decision (EU) 2015/2042 of 30 October 2014 on
the equivalence of the regulatory framework of Singapore for central counter-
parties to the requirements of Regulation (EU) No. 648/2012 of the European
Parliament and of the Council on OTC derivatives, central counterparties and
trade repositories OJ L 311/58, 31.10.2014, Recital 2.
34
Alexey Artamonov, ‘Cross-border Application of OTC Derivatives Rules:
Revisiting the Substituted Compliance Approach’ (2015) 1 Journal of Financial
Regulation 206, 218.
practices for CCPs are, strictly regarded, of micro-prudential impact,

their overall importance and performance ability directly impact macro-
prudential aspects. Such micro-prudential aspects include the clearing
mandate per se, collateral requirements and a default waterfall mech-
anism, all of which can have direct macro-prudential impact. Macro-
prudential risks may arise despite a financial market infrastructure (FMI)
being micro-prudentially sound.35
5.3.1 European Market Infrastructure Regulation
The following will analyse EMIR, which is the regulation at the core of
the EU’s reform on clearing and derivatives’ risk management.
EMIR contains both micro-prudential and macro-prudential aspects.
On the micro-prudential level, the regulation contains requirements for
CCP operation as well as requirements for risk management super-
vision.36 Thereby, risk is concentrated within CCPs, making them sys-
temically important institutions.37 Another micro-prudential requirement
is clearing for OTC derivatives contracts.38 This clearing requirement
brings counterparty and liquidity risk to the CCP.39 Additionally, EMIR
sets strict requirements regarding collateral eligibility from members and
has a default waterfall mechanism in place to prevent the likelihood of
crisis propagation.40 All of these requirements in turn have a major
35
Lieven Hermans, Peter McGoldrick and Heiko Schmiedel, ‘Central Coun-
terparties and Systemic Risk’ (November 2013) 6, 2. For a detailed discussion
regarding the definition of a derivative and controversy thereof in EMIR, see
Dennis Kunschke and Kai Schaffelhuber, ‘Die OTC-Derivate Im Sinne Der EMIR
Sowie Bestimmungen Der Relevanten Parteien – Eine Juristische Analyse’ in
Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt 2016),
59–68; ESMA, ‘Letter to Commissioner Barnier Re: Classification of Financial
Instruments as Derivatives’ (14 February 2014) <https://www.esma.europa.eu/
sites/default/files/library/2015/11/2014-184_letter_to_commissioner_barnier_-
_classification_of_financal_instruments.pdf> accessed 3 September 2017.
36
Micro-prudential regulatory norms can be found in Title IV Chapter 3
EMIR and Commission Delegated Regulation (EU) No. 153/2013.
37
Counterparties and Systemic Risk’ (November 2013) 6, 2; See also International
Law Association, ‘Draft July 2016, Johannesburg Conference’, Twelfth Report
(2016) <on file with author>, 11–2.
38
39
Ibid 4.
40
Ibid 6.
macro-prudential impact as they directly affect risk distribution,41 espe-

cially since CCPs may be considered too-big-to-fail.42 Macro-prudential
risks may arise despite the CCP being micro-prudentially healthy, by
changing requirements that create externalities in the market. These could
be created through changed margin practices, requiring clearing members
to provide additional margin to the CCP. If one or more members were
unable to raise this, the solvency and crisis resilience of the CCP would
be directly negatively impacted. Co-dependency of CCPs upon their
systemically important members may subject CCPs to systemic risk,
despite being micro-prudentially sound themselves.43
5.3.1.1 Counterparties affected

In the EU, EMIR imposes a clearing mandate for financial and certain
non-financial counterparties located in the European Union.44 Differenti-
ation between financial and non-financial counterparties, pension and
insurance schemes, and intra-group transactions is to be made.45 ESMA
then refines the guidelines and technical standards for these classes.
Occupational pension funds, investment firms, credit institutions and
others are defined as financial counterparties.46 Whenever such financial
41
Albeit the FSB has been unable to provide rules on how macro-prudential
rules should be implemented and supervised. The FSB is continuing to follow the
implementation and effects macro-prudential rules have in the OTC derivatives
market reform. See Kern Alexander and Steven L Schwarcz, ‘The Macro-
prudential Quandary: Unsystematic Efforts to Reform Financial Regulation’ in
Ross P Buckley, Emilios Avgouleas and Douglas Arner (eds), Reconceptualising
Global Finance and its Regulation (Cambridge University Press 2016), 133–4.
42
43
Ibid 4–5.
44
Article 10 EMIR; Olaf Achtelik, ‘Clearingpflicht, Art. 4 EMIR’ in
Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt 2016), 77,
N 6.
45
Recital 25–40 EMIR; Dennis Kunschke and Kai Schaffelhuber, ‘Die
OTC-Derivate Im Sinne Der EMIR Sowie Bestimmungen Der Relevanten
Parteien – Eine Juristische Analyse’ in Rüdiger Wilhelmi and others (eds),
Handbuch EMIR (Erich Schmidt 2016), 69–71.
46
Article 2(8) EMIR; see also Jan D Luettringhaus, ‘Regulating Over-the-
Counter Derivatives in the European Union – Transatlantic (Dis)Harmony After
EMIR and Dodd-Frank: The Impact on (Re)Insurance Companies and Occupa-
tional Pension Funds’ (2012) 18 The Columbia Journal of European Law 19, 22;
Dennis Kunschke and Kai Schaffelhuber, ‘Die OTC-Derivate Im Sinne Der
EMIR Sowie Bestimmungen Der Relevanten Parteien – Eine Juristische Analyse’
entities enter into an OTC derivatives contract mandated for clearing,

they are required to clear their contract by a CCP in accordance with
Article 4 EMIR.47 To access the services of the CCP, they must become
clearing members or find a clearing member willing to clear their trades
on their behalf.48 Access is granted by the CCP in a non-discriminatory
way.49
All European financial firms that are counterparty to an OTC deriva-
tives contract must have their contracts cleared, while non-financial
counterparties may be exempt from the clearing obligation, as long as
they do not pose a risk to the financial system.50 This exemption is
applicable provided that a defined threshold is not exceeded, in which
case, the non-financial counterparties are not considered to impact
systemic risk enough to require mandatory clearing.51 Pursuant to Article
4(1)(a)(i) EMIR, two financial counterparties entering into a trade must
always subject their trades for clearing, while trades between non-
financial counterparties and financial, as well as between non-financial
counterparties, only require mandatory clearing if the threshold for the
clearing obligation has been exceeded.52 Trades with and amongst small
non-financial counterparties – referring to those non-financial counter-
parties below the clearing threshold – are always exempt from mandatory
clearing obligation, as clearing would represent too great of a burden for
these small entities and would thus not be proportionate to their low risk
to the overall financial system.53 Typical small non-financial counter-
parties are commodity traders, only trading in derivatives to hedge their
physical trades and immediate market risks.
in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt 2016),
69, N 19.
47
Certain counterparties not included within the clearing mandate, may
voluntarily mandate their derivatives contracts for clearing: Olaf Achtelik,
‘Clearingpflicht, Art. 4 EMIR’ in Rüdiger Wilhelmi and others (eds), Handbuch
EMIR (Erich Schmidt 2016), 78, N 10.
48
Article 4(2), Article 39 and Article 48 EMIR.
49
Article 7 EMIR.
50
Dennis Kunschke and Kai Schaffelhuber, ‘Die OTC-Derivate Im Sinne
Der EMIR Sowie Bestimmungen Der Relevanten Parteien – Eine Juristische
Analyse’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt
2016), 69–71, N 21, 24; Olaf Achtelik, ‘Clearingpflicht, Art. 4 EMIR’ in Rüdiger
Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt 2016), 78–81.
51
Olaf Achtelik, ‘Clearingpflicht, Art. 4 EMIR’ in Rüdiger Wilhelmi and
others (eds), Handbuch EMIR (Erich Schmidt 2016), 79, N 12.
52
See Article 4(1) and Article 10 EMIR.
53
Article 4(1)(a)(iii) EMIR.
EMIR can have extra-territorial effects, if the trade between two

non-EU counterparties has ‘direct, substantial and foreseeable effects
within the Union’.54 This particularly refers to situations in which
counterparties attempt to circumvent EU rules by trading EU-relevant
contracts through their non-EU subsidiaries.
Furthermore, hedging transactions are exempt from the threshold.55
Additionally, occupational pension funds are exempt for the first three
years from the clearing obligation and intra-group transactions for both
financial and non-financial counterparties are exempt.56 The latter must,
however, fulfil their reporting and other risk mitigation obligations.57
EMIR states additional risk mitigation requirements for financial and
non-financial counterparties whose OTC derivatives contracts are not
eligible for clearing. This includes due diligence and appropriate meas-
ures to be taken to monitor and mitigate both counterparty credit and
operational risk (Article 11(1) EMIR). Further measures are electronic
confirmation where possible, in any case in a timely fashion, of the
relevant contractual terms (‘portfolio confirmation’; sub-para. a), dispute
resolution mechanisms, identification of outstanding contracts and a
resilient portfolio to settle any discrepancies (‘portfolio compression’;
sub-para. b). Financial counterparties are expected to hold additional
funds to cover any risk arising from the contracts not protected by the
collateral exchanged (Article 11(4) EMIR). The collateral must be held in
54
Article 4(1)(a)(v) EMIR. See also Christian Sigmundt, ‘Sachverhalte Mit
Drittstaatberührung’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR
(Erich Schmidt), 142–52.
55
Article 10 EMIR; ESMA, ‘OTC Derivatives and Clearing Obligation’ (3
September 2017). A current list of which derivatives are permitted for clearing
can be found at <www.esma.europa.eu/regulation/post-trading/otc-derivatives-
and-clearing-obligation> (13 July 2016). Jan D Luettringhaus, ‘Regulating Over-
the-Counter Derivatives in the European Union – Transatlantic (Dis)Harmony
After EMIR and Dodd-Frank: The Impact on (Re)Insurance Companies and
Occupational Pension Funds’ (2012) 18 The Columbia Journal of European Law
19, 23.
56
Dennis Kunschke and Kai Schaffelhuber, ‘Die OTC-Derivate Im Sinne
Der EMIR Sowie Bestimmungen Der Relevanten Parteien – Eine Juristische
Analyse’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt
2016), 72, N 27.
57
Jan D Luettringhaus, ‘Regulating Over-the-Counter Derivatives in the
European Union – Transatlantic (Dis)Harmony After EMIR and Dodd-Frank:
The Impact on (Re)Insurance Companies and Occupational Pension Funds’
(2012) 18 The Columbia Journal of European Law 19, 24; Olaf Achtelik,
‘Clearingpflicht, Art. 4 EMIR’ in Rüdiger Wilhelmi and others (eds), Handbuch
EMIR (Erich Schmidt 2016), 82, N 18.
segregated accounts and exchanged in a timely and accurate way.

Financial counterparties must always exchange collateral on an ongoing
basis above a de minimis threshold, whereas non-financial counterparties
must only exchange collateral once they surpass the clearing threshold
(Article 11(3) EMIR).
For OTC derivatives, the new implications from MiFID II are that
financial counterparties (as defined in Article 2(8) EMIR) and non-
financial counterparties above the threshold (pursuant to Article 10(1)(b)
EMIR) trade these derivatives contracts in a trading venue if they are
subject to the clearing mandate.58 ESMA will decide which derivatives
classes are to be traded on Organised Trading Facilities, based on the
willingness of a trading facility to admit a derivative for trading and
sufficient third-party interest and liquidity of this contract.59
5.3.1.2 Qualified derivatives

The clearing mandate only takes effect if the derivative contract has been
mandated for clearing.60 Article 5(4) EMIR defines which OTC deriva-
tives are subject to the clearing mandate, focussing on standardisation of
contractual details and automated post-trade processes of wide accept-
ance, as well as the volume and liquidity of the individual contracts.61
Specifically in the event of a crisis, the margin requirements would
58
Article 28(1) MiFIR; Eversheds Sutherland, ‘MiFID II and the Trading
and Reporting of Derivatives: Implications for the Buy-Side’ (23 September
2014) <http://www.eversheds.com/global/en/what/articles/index.page?ArticleID=
en/Financial_institutions/MiFID_II_and_the_trading_and_reporting_of_derivatives>
accessed 3 September 2017; Dennis Kunschke and Kai Schaffelhuber, ‘Die
OTC-Derivate Im Sinne Der EMIR Sowie Bestimmungen Der Relevanten
Parteien – Eine Juristische Analyse’ in Rüdiger Wilhelmi and others (eds),
59
Article 29(3) MiFIR, Article 32(1)(a)–(2)(b) MiFIR; Eversheds Suther-
land, ‘MiFID II and the Trading and Reporting of Derivatives: Implications for
the Buy-Side’ (23 September 2014) <http://www.eversheds.com/global/en/what/
articles/index.page?ArticleID=en/Financial_institutions/MiFID_II_and_the_trading_
and_reporting_of_derivatives> accessed 3 September 2017; Eidgenössisches
Finanzdepartement, ‘Erläuterungsbericht Zur Verordnung Über Die Finanzmark-
tinfrastrukturen Und Das Markverhalten Im Effekten- Und Derivatehandel
(Finanzmarktinfrastrukturverordnung, FinfraV)’ (20 August 2015); Oliver Heist,
‘Schwellenwertberechnung Und Hedging’ in Rüdiger Wilhelmi and others (eds),
Handbuch EMIR (Erich Schmidt), 177–8, N 7–11.
60
Article 4 EMIR; Olaf Achtelik, ‘Clearingpflicht, Art. 4 EMIR’ in Rüdiger
Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt 2016), 76, N 3–4.
61
See Article 7 Commission Delegated Regulation (EU) No. 149/2013.
suffice to stymie further market contagion based on the volume of trades

and the value thereof.62
EMIR foresees two types of regulatory approaches to differentiate
between top-down and bottom-up.63 Using the top-down approach,
ESMA – of its own initiative – defines which derivatives should be
subject to mandatory clearing, depending on their impact on financial
stability and depending on which categories have not yet received
authorisation for clearing by any CCP.64 Using the bottom-up approach, a
competent national regulator notifies ESMA that a CCP has been
authorised to clear a product, upon which ESMA may include the
product as mandated for clearing across the Union. After consideration,
ESMA submits standards to the European Commission for endorsement
to reduce the overall level of systemic risk.65 Derivatives exempt from the
clearing obligation are subject to risk-mitigation techniques, to ensure
that they do not undermine financial stability. These include timely
confirmation, portfolio reconciliation and compression, and notification
to the trade repository.66
5.3.1.3 Establishing a CCP

In order for a CCP to be approved in the EU, the legal entity must apply
for authorisation with the competent authority of the member state in
62
Article 7(2)(a)–(d) Commission Delegated Regulation (EU) No. 149/
2013.
63
Article 5(3) EMIR.
64
Olaf Achtelik, ‘Clearingpflicht, Art. 4 EMIR’ in Rüdiger Wilhelmi and
others (eds), Handbuch EMIR (Erich Schmidt 2016), 91–2, N 34–5.
65
Ibid 90–91, N 32. Article 5(3)–(4) EMIR; ESMA, ‘OTC Derivatives and
Clearing Obligation’ (3 September 2017). See also Eidgenössisches Finanz-
departement, ‘Erläuterungsbericht Zur Verordnung Über Die Finanzmarktinfra-
strukturen Und Das Markverhalten Im Effekten- Und Derivatehandel
(Finanzmarktinfrastrukturverordnung, FinfraV)’ (20 August 2015), 9. A current
list of which derivatives are permitted for clearing can be found at <www.
esma.europa.eu/regulation/post-trading/otc-derivatives-and-clearing-obligation>
(17 September 2017); Jan D Luettringhaus, ‘Regulating Over-the-Counter
Derivatives in the European Union – Transatlantic (Dis)Harmony After EMIR
and Dodd-Frank: The Impact on (Re)Insurance Companies and Occupational
Pension Funds’ (2012) 18 The Columbia Journal of European Law 19, 23.
66
For detailed discussion of these techniques, see Olaf Achtelik and
Michael Steinmüller, ‘Risikominderungstechniken Für Nicht Durch Eine CCP
Geclearte OTC-Derivatkontrakte’ in Rüdiger Wilhelmi and others (eds), Hand-
buch EMIR (Erich Schmidt 2016), 107–39; Dominik Zeitz, ‘Meldung an
Transaktionsregister (Überblick)’ in Rüdiger Wilhelmi and others (eds), Hand-
buch EMIR (Erich Schmidt), 140, N 1–2.
which it is established pursuant to Articles 14 and 17 EMIR.67 Board

members must be considered as qualified to fulfil their obligation.68 The
minimum capital requirement is EUR 7.5 million.69 Oversight and
supervision of the CCP established is left to the member states; they
must, however, report to ESMA and the ESCB.70
EMIR remains silent regarding optimal institutional or ownership
structures of CCPs.71 Some EU member states require CCPs to obtain a
bank licence or bank ownership, while others do not.72 A bank licence
and/or ownership would aid in guaranteeing the financial lifeline neces-
sary in case of multiple defaults, as the requirements to obtain a bank
licence are strict. The ownership of a CCP may directly influence the
risk-management practices used by the CCP. CCPs established in a third
country require approval by ESMA according to Article 25 EMIR.73
5.3.1.4 CCP interoperability

EU CCPs are permitted to enter into an interoperability arrangement with
another CCP (Articles 51–54 EMIR)74 as long as initial margin is
67
Julian Redeke and Olaf Achtelik, ‘Zulassung Und Anerkennung von
CCPs’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt
2016), 235, N 2–3.
68
Article 27(1) EMIR; Julian Redeke, ‘Corporate Governance von CCP’ in
Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt), 213, N 4.
69
Article 16(1) EMIR. In calculating the effective necessary minimum
capital, the CPSS–IOSCO Principles for Market Infrastructures should be
considered. See also Delegated Regulation (EU) 152/2013; Julian Redeke and
Olaf Achtelik, ‘Zulassung Und Anerkennung von CCPs’ in Rüdiger Wilhelmi and
others (eds), Handbuch EMIR (Erich Schmidt 2016), 240–41, N 18–9.
70
Articles 22(1) and 23(1) EMIR; Julian Redeke and Olaf Achtelik,
‘Zulassung Und Anerkennung von CCPs’ in Rüdiger Wilhelmi and others (eds),
71
Article 30 EMIR. For detailed discussion on the corporate governance
requirements for CCPs, see Julian Redeke, ‘Corporate Governance von CCP’ in
Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt), 211–33.
72
Kern Alexander, ‘The European Regulation of Central Counterparties:
Some International Challenges’ in Kern Alexander and Rahul Dhumale (eds),
Research Handbook on International Financial Regulation (Edward Elgar 2012),
246.
73
Julian Redeke and Olaf Achtelik, ‘Zulassung Und Anerkennung von
CCPs’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt
2016), 250–51, N 36.
74
Christian Sigmundt, ‘Interoperabilität Zwischen CCPs’ in Rüdiger
Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt), 267, N 5 and 269,
N 10.
exchanged between the two (Article 53(1)–(2) EMIR) to a segregated

account.75 Any exposure to an affiliated CCP must be monitored in near
real time for liquidity and credit exposure.76 The rules on risk manage-
ment are relatively thin (Article 52 EMIR), requiring CCPs to ‘identify,
monitor and effectively manage credit and liquidity risks’ so the potential
default of a CCP clearing member does not spread to the other CCP
(Article 52(1)(c) EMIR).77 Also, the effects of interoperability are
monitored in case this affects the credit and liquidity risk as a result of
member concentration and financial resource pooling (Article 52(1)(d)
EMIR).78 In such cases, EMIR requires the securing of additional
financial resources which, while not being defined explicitly, are likely
to be central bank funds or additional payments by the surviving
members.79
5.3.1.5 Risk management

Core risk-management practices are margin collections, default proced-
ures and the default fund.80 The micro-prudential risk management norms
75
Ibid 273–82.
76
77
245. See also discussion in Christian Sigmundt, ‘Interoperabilität Zwischen
CCPs’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt),
270–72; N 15–8.
78
See also Lieven Hermans, Peter McGoldrick and Heiko Schmiedel,
‘Central Counterparties and Systemic Risk’ (November 2013) 6, 6.
79
See Article 50 EMIR on settlement, where central bank money explicitly
is stated in the regulation and Article 43 (1) EMIR that requires CCPs to have
‘sufficient pre-funded available financial resources’ which Kern Alexander iden-
tifies as central bank money: Kern Alexander, ‘The European Regulation of
Central Counterparties: Some International Challenges’ in Kern Alexander and
Rahul Dhumale (eds), Research Handbook on International Financial Regulation
(Edward Elgar 2012), 245. It could however also be an extension of the
survivor-pays mechanism to compensate for any losses not covered by the
defaulter, see Andre Alfes, ‘Die Sicherungsmechanismen Der CCP’ in Rüdiger
Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt), 301–3. The
legislation is unclear in this regard.
80
EMIR generally follows the CPSS–IOSCO Principles for Financial Mar-
ket Infrastructures. Andre Alfes, ‘Die Sicherungsmechanismen Der CCP’ in
Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt), 291,
N 1–2.
are stated in Title IV, Chapter 3 of EMIR and have a three-tiered risk
management structure, ranging from exposure reduction by posting
margins subjected to haircuts to default fund contributions and stress-
testing.81 In comparison with the CPSS–IOSCO PFMI, EMIR is more
demanding with regard to close-out periods for certain products and rules
for margins and haircut practices aimed at reducing pro-cyclicality
effects, but it also has stricter capital requirements in place.82
Clearing members must provide the CCP with margin. The margin
must be sufficient to cover 99% of price movements; for OTC derivatives
99.5% of price volatility for the past 12 months should be covered.83 The
high-quality margin collateral, such as cash, gold or certain bonds, is to
be called and collected on an intraday basis, once the predefined
threshold is surpassed.84 ESMA does not expect a shortage of high-
quality collateral owing to the continued issuance of such collateral.85 All
collateral must by highly liquid and of minimum credit and market risk,86
and additional liquidity by both clearing members and other sources may
be accessed.87 In case of counterparty default, the CCP will use a
waterfall mechanism to contain and neutralise all losses from this default
with the following contributions.88 First, the margins posted by the
81
82
See also ibid 6; Andre Alfes, ‘Die Sicherungsmechanismen Der CCP’ in
Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt), 299, N 37.
83
Article 41 (1) EMIR; Article 24 Commission Delegated Regulation (EU)
153/2013. Kern Alexander, ‘The European Regulation of Central Counterparties:
245; Lieven Hermans, Peter McGoldrick and Heiko Schmiedel, ‘Central Coun-
terparties and Systemic Risk’ (November 2013) 6, 6 fn 7.
84
Article 46 (1) EMIR; regarding the type of collateral see Articles 37–42
Commission Delegated Regulation (EU) 153/2013; Andre Alfes, ‘Die
Sicherungsmechanismen Der CCP’ in Rüdiger Wilhelmi and others (eds),
Handbuch EMIR (Erich Schmidt), 309–313.
85
See ESMA, ‘Report on Trends, Risks, and Vulnerabilities’ (February
2013) 1 <https://www.esma.europa.eu/sites/default/files/library/2015/11/2013-
212_trends_risks_vulnerabilities.pdf> accessed 3 September 2017.
86
Article 46 EMIR.
87
Article 43(1) and (3) EMIR. Discussion of initial and variation margin
according to EMIR at: Andre Alfes, ‘Die Sicherungsmechanismen Der CCP’ in
Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt), 294–9.
88
defaulting member are used (Article 45(1) EMIR). Second, the member’s
default fund contribution is liquidated (Article 45(2) EMIR). If the
defaulting member’s individual contributions are insufficient, the CCP
must now use its own pre-funded financial resources to cover the losses
(Article 45(3) EMIR). If this still has not covered the losses, the CCP
may use the default fund contributions of other, non-defaulting clearing
members, but not, however, their margins (Article 45(3) EMIR), as these
must remain untouched in case of risk arising from the non-defaulted
member.89 The CCP may be required to use its remaining capital once
the default fund is exhausted, despite this not being mentioned in the
regulation.90
Margin plays a central role in guaranteeing contractual fulfilment in
case the margin-providing clearing member defaults, as the member
margin acts as the first line of defence in the default procedure of the
CCP and this is a micro-prudential requirement.91 The default fund of the
CCP must be funded ex ante and cover any additional losses the collected
margin has not covered (Article 42(1) EMIR). While the margin takes
the portfolio of the clearing member into account (Article 41(2) EMIR),
the CCP collects an additional premium from the clearing members to
guarantee the default fund can sustain the default of the clearing member
with the biggest exposure, or the second and third members if their
combined exposure is greater than that of the largest member (Article
41(3) EMIR). 92 Each CCP must have at least one default fund, according
to Article 41(4) EMIR, but could have multiple funds for different types
of financial instruments.93
(2012) 18 The Columbia Journal of European Law 19, 23; Andre Alfes, ‘Die
Sicherungsmechanismen Der CCP’ in Rüdiger Wilhelmi and others (eds),
Handbuch EMIR (Erich Schmidt), 306–9. Discussion of default fund according
to EMIR at: ibid 299–301.
89
90
Ibid.
91
Ibid 6; Andre Alfes, ‘Die Sicherungsmechanismen Der CCP’ in Rüdiger
Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt), 317–8.
92
In comparison to the CPSS–IOSCO PFMI, EMIR is more demanding
with regard to close-out periods for certain products, rules for margins and
haircut practices aimed at reducing pro-cyclicality effects, and also has stricter
capital requirements in place. See also Lieven Hermans, Peter McGoldrick and
Heiko Schmiedel, ‘Central Counterparties and Systemic Risk’ (November 2013)
6, 6.
93
Andre Alfes, ‘Die Sicherungsmechanismen Der CCP’ in Rüdiger
Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt), 300, N 41–4.
EMIR shifts the collateral management supervision for risk stemming

from client clearing to the CCP member providing clearing service to
non-clearing members and, only upon request by the CCP, the clearing
member must provide information on arrangements with its clients.94
This is a contradiction to the transparency requirement.95 It can be
expected that CCP clearing members will charge a fee for client clearing
in addition to the collateral they should collect and that economic
incentives and competition to provide client clearing will play a role.
The CCP is directly responsible for its clearing members and must
ensure that they have sufficient financial resources and operational
capacity to meet the obligations corresponding to the participation
requirements of the CCP. If the obligations are no longer met, the CCP
may exclude the clearing member or suspend its membership.96
5.3.1.6 CCP default

The EU recognises the potential threat that CCPs pose to financial
stability and acknowledges that they are too-big-to-fail.97 Therefore, it
launched a consultation on possible recovery and resolution for CCPs.
This proposal will be discussed in the next chapter.98 CCPs are explicitly
exempt from the Bank Recovery and Resolution Directive99 and there are
no provisions within EMIR setting out a procedure to follow for CCP
default. Thus, the EU currently lacks regulations dealing with CCP
default, although Article 24 EMIR states the obligation of the CCP to
immediately inform ESMA, the college and the ESCB of any emergency
situations which could result in disturbances in the financial market or
liquidity shortages across clearing member states.100
5.3.1.7 Implementation timeframe

While EMIR was passed on 4 July 2012, the clearing obligation has been
pushed back several times. As of 21 June 2016, the clearing obligations
94
Article 37 (3) EMIR. See also, Christian Sigmundt, ‘Die Wohlverhaltens-
regeln Der EMIR’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich
Schmidt), 284–5, N 6–7.
95
Article 38 (1) EMIR.
96
Article 37 (1) and (4) EMIR.
97
European Commission, ‘Consultation on a Possible Framework for
the Recovery and Resolution of Financial Institutions Other than Banks’ (5
October 2012), 11–3 <ec.europa.eu/finance/consultations/2012/nonbanks/docs/
consultation-document_en.pdf> accessed 3 September 2017.
98
Chapter 6, Section 6.3.
99
Directive 2014/59/EU, Recital 12.
100
See Article 18 EMIR.
were being phased in, starting with counterparties of the first category,
pursuant to Article 3(1)(a) of the Commission Delegated Regulation.101
Phasing-in still continues today and will continue until at least the start of
the third quarter of 2019.102
5.3.2 Review
The EU differentiates between financial and non-financial counterparties.

While all financial counterparties are subject to the clearing mandate,
resulting from their size and market importance, non-financial counter-
parties are only subject to the clearing mandate, if they exceed the
clearing threshold, which is defined for each asset class of derivatives.
Once this threshold is exceeded, all derivatives of the non-financial
counterparty across all asset classes must be cleared, regardless of
whether those asset classes have met the threshold for clearing or not.
Those non-financial counterparties which do not exceed the clearing
threshold are referred to as ‘small non-financial counterparties’ and only
need to observe certain reporting and risk-mitigation requirements.
The financial requirements to establish a CCP are relatively low in the
EU and while CCPs are explicitly exempted from the Bank Recovery and
Resolution Directive, no other regulation has been established to define
the rules to deal with a failing CCP. Current regulation relies on the
efficiency and effectivity of the clearing members’ internal risk-
mitigation techniques and the internal control framework of the CCP to
deal with any market volatility and systemic shocks.
Finally, despite EMIR having been implemented in July 2012 as a
result of the 2007–2009 financial crisis, the regulation has yet to be
fully implemented, 10 years after the market event upending the
financial markets occurred. As such, while the main objectives of
the BCBS-IOSCO and Financial Stability Board (FSB) have been
101
Commission Delegated Regulation (EU) 2015/2205. See also European
Commission, ‘European Commission and the United States Commodity Futures
Commission: Common Approach for Transatlantic CCPs’ (10 February 2016).
102
European Commission, ‘Proposal for a Regulation of the European
Parliament and of the Council Amending Regulation (EU) No. 648/2012 as
Regards the Clearing Obligation, the Suspension of the Clearing Obligation, the
Reporting Requirements, the Risk-Mitigation Techniques for OTC Derivatives
Contracts Not Cleared by a Central Counterparty, the Registration and Super-
vision of Trade Repositories and the Requirements for Trade Repositories,
COM(2017) 208 final’, 8.
implemented, the EU’s regulatory framework lacks norms which trans-

pose the standards from the FSB’s Key Attributes of Effective Resolu-
tion Regimes for Financial Institutions.103
5.4 TRANSATLANTIC PERSPECTIVE
5.4.1 The American Approach
The United States has implemented stricter rules that have created
tension with the EU. While both jurisdictions permit access for foreign
CCPs and market participants, neither could agree to accept foreign
CCPs as sufficiently regulated.104 The United States and EU remained at
an impasse for nearly four years, unable to reach a consensus regarding
the equivalence of clearing rules, as the EU calls it, or substituted
compliance, as the United States calls it.105 The destructive course of
action was called the ‘new 21st century protectionism around regional
financial markets’106 by Commodity Futures Trading Commission
(CFTC) Commissioner Giancarlo and led to a significant decrease of
103
Institutions’ (n 402). ISDA remains an important player in the post-crisis
regulatory framework; however, it does not enjoy the same standing as before in
the absence of national regulation. For a discussion on how ISDA documentation
and EMIR go together, see Michael Huertas, ‘ISDA 2013 EMIR Portfolio
Reconciliation, Dispute Resolution and Disclosure Protocol (the ISDA PortRec
Protocol) and Other EMIR Relevant ISDA Documentation Solutions’ in Rüdiger
104
See Article 25 EMIR. ESMA, ‘ESMA Resumes US CCP Recognition
Process Following EU-US Agreement’ (10 February 2016) Press Release <https://
www.esma.europa.eu/press-news/esma-news/esma-resumes-us-ccp-recognition-
process-following-eu-us-agreement> accessed 3 September 2017; European
Commission, ‘European Commission and the United States Commodity Futures
Commission: Common Approach for Transatlantic CCPs’ (10 February 2016);
Shearman & Sterling, ‘Update on Third Country Equivalence Under EMIR’ (17
March 2016).
105
Shearman & Sterling, ‘Update on Third Country Equivalence Under
EMIR’ (17 March 2016).
106
Christopher J Giancarlo, ‘The Looming Cross-Atlantic Derivatives Trade
War: “A Return to Smoot–Hawley”’ (The Global Forum for Derivatives Markets,
35th Annual Burgenstock Conference, Geneva, September 2014).
cross-border trading activity and fragmentation of the formerly highly

integrated derivatives market.107
5.4.1.1 Introduction to Dodd-Frank

Immediately following the first impacts of the financial crisis in 2008, the
Democratic lawmakers who controlled both the US Senate and the House
of Representatives called for action, and on 21 July 2010, the Dodd-
Frank Act108 was signed into law by President Barack Obama. The
Dodd-Frank Act encompasses a vast array of new rules and regulations to
address the shortcomings of the years leading up to the financial crisis to
prevent a recurrence of such a crisis.109
5.4.1.2 Substituted compliance

The United States’ approach to substituted compliance traditionally
permitted non-US financial institutions to avoid registration with US
supervisors while being active in the US market as long as the home
country’s regulation was deemed to be ‘equivalent’ to the US regu-
lation.110 This approach changed with the introduction of the Dodd-Frank
Consumer Protection Act. Under Dodd-Frank, foreign-traded OTC
derivatives (‘swaps’111) activities are subject to US regulation if they
either ‘have direct and significant connections with activities in, or an
effect on, commerce of the USA’112 or contravene the rules of the CFTC
107
Ibid; Alexey Artamonov, ‘Cross-border Application of OTC Derivatives
Rules: Revisiting the Substituted Compliance Approach’ (2015) 1 Journal of
Financial Regulation 206, 206.
108
Dodd-Frank Wall Street Reform and Consumer Protection Act.
109
110
Regulation 206, 209. For an overview of the concept of substituted compliance,
see Howell E Jackson, ‘Substituted Compliance: The Emergence, Challenges,
and Evolution of a New Regulatory Paradigm’ (2015) 1 Journal of Financial
Regulation 169, 169–205.
111
Swaps refer to derivatives as per the definition of Section 721(a)(2) of
Title VII Dodd-Frank. For clarity, the author will continue to refer to said swaps
as OTC derivatives.
112
for regulatory arbitrage purposes.113 The new mandate requires those

derivatives contracts previously traded exclusively in the OTC market to
be traded on exchanges and cleared.114
The extraterritorial application of Dodd-Frank115 has meant that the
United States demands compliance with its national rules, no matter
where the trade takes place, unless explicitly stated otherwise.116 The
Securities and Exchanges Commission (SEC) and CFTC have different
procedures for deeming a foreign regulation compliant with US laws,
which has led to urges in the United States for the two agencies to work
together and find commonly acceptable terms.117 The US rules on
substituted compliance have been criticised heavily from within the
agencies, as there is no proof of them being more effective than foreign
regulation.118
Originally, the EU was worried about such extraterritorial application
of US legislation and admonished that this disregarded national sover-
eignty rules and globally mandated US trade practices.119 Eventually, it
became clear that the United States would not back down, so the
European Union decided to opt for extraterritorial application of Euro-
pean regulation120 as well, which was achieved through Article 13 EMIR
113
Ibid 210. See also Deborah North, Noah Baer and Dustin Plotnick, ‘The
Regulation of OTC Derivatives in the United States of America’ in Rüdiger
Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt), 619.
114
Section 723 Dodd-Frank for those swaps the CFTC and Section 763
Dodd-Frank for those swaps the SEC has jurisdiction over. Rena S Miller and
Kathleen Ann Ruane, ‘Dodd-Frank Wall Street Reform and Consumer Protection
Act: Title VII, Derivatives’ (November 2012) Congressional Research Service
R41298, 5.
115
Section 722 Dodd-Frank Act.
116
Regulation 206, 212; Deborah North, Noah Baer and Dustin Plotnick, ‘The
Regulation of OTC Derivatives in the United States of America’ in Rüdiger
117
118
Ibid 215.
119
John C Coffee Jr, ‘Extraterritorial Financial Regulation: Why E.T. Can’t
Come Home’ (2014) 99 Cornell Law Review 1259, 1259, 1264.
120
Article 4(1)(a)(v) EMIR extends the clearing requirement to ‘entities
established in one or more third countries that would be subject to the clearing
obligation if they were established in the Union, provided that the contract has a
and the ‘equivalence regime’ as defined above.121 The failure to find a

mutually acceptable solution led to a 77% drop in cleared Euro-
denominated interest rate swaps between the EU and the United States
between 2013 and 2014122 and continues to show a fragmentation of the
OTC derivatives market.123 This has led to a ring-fenced system that is
fragmented into different liquidity pools. Within these pools, the risk is
concentrated rather than spread globally, which was supposed to happen
with derivatives. It not only leads to increased risk, but it also compli-
cates the basic functions of derivatives, such as providing a liquid market
in which participants are able to hedge their risk. Furthermore, this
liquidity shortage can affect the underlying securities market and the
primary asset market.124 Today, the United States and the EU positions
are thawing and appear to finally be on their way to ending the persistent
impasse. The United States was quicker to implement reform in the
derivatives market and led many other jurisdictions to follow its lead in
order to maintain market access and to reduce compliance cost. The EU
proved unwilling to back down and let the United States take the lead in
this field. ESMA conducted its technical assessment of the compliance
between US and EU rules in 2013, in which it found the legal framework
of the United States to be generally equivalent to the standards required
for recognition and that the legally binding requirements for CCPs are
equivalent to EMIR.125 Nevertheless, ESMA found caveats with regard to
the longevity of some rules in the United States.126
direct, substantial and foreseeable effect within the Union […] to prevent the
evasion of any provisions of this Regulation’.
121
Section 5.3.1.7.
122
ISDA, ‘Cross-border Fragmentation of Global OTC Derivatives: An
Empirical Analysis’ (January 2014) ISDA Research Note <http://www2.isda.org/
search?headerSearch=1&keyword=cross+border+fragmentation> accessed 3 Sep-
tember 2017.
123
Ibid.
124
See also Alexey Artamonov, ‘Cross-border Application of OTC Deriva-
tives Rules: Revisiting the Substituted Compliance Approach’ (2015) 1 Journal of
Financial Regulation 206, 219; John C Coffee Jr, ‘Extraterritorial Financial
Regulation: Why E.T. Can’t Come Home’ (2014) 99 Cornell Law Review 1259,
1288.
125
ESMA, ‘Technical Advice on Third Country Regime Regulatory Equiva-
lence under EMIR-US’ (1 September 2013) Final Report, 18–9 <https://www.
esma.europa.eu/sites/default/files/library/2015/11/2013-1157_technical_advice_
on_third_country_regulatory_equivalence_under_emir_us.pdf> accessed 3 Sep-
tember 2017.
126
Ibid 21.
5.4.2 Comparing the Approaches
Although they share the objective of creating a globally harmonised

financial framework, many differences between the European and the
American approaches can be found. Some of these differences will be
analysed herein.
5.4.2.1 Counterparties affected

Every OTC derivative transaction, as well as each counterparty to such a
transaction, is subject to US entity-level and transaction-level regulation,
if the transaction either takes place in the United States or with a US
person, foreign branch or affiliate of an US person or with non-US
persons who have significant transactions with US persons.127 However,
non-financial counterparties and transactions with the sole purpose of
hedging are exempt from the clearing obligation.128 The United States
also differentiates between a swap dealer and a major swap dealer, with
stricter rules applying to the latter.129
5.4.2.2 Qualified derivatives

Title VII of the Dodd-Frank Act explicitly addresses OTC derivatives and
the deregulation of speculative usage of derivatives in the previous
years.130 In particular, the CFTC has been granted regulatory authority
over ‘swaps’ under Title VII of the Dodd-Frank Act.131 One exception is
127
128
Sections 723(a)(7) and 763 Dodd-Frank. For detailed discussion of
end-user exemption see Rena S Miller and Kathleen Ann Ruane, ‘Dodd-Frank
Wall Street Reform and Consumer Protection Act: Title VII, Derivatives’
(November 2012) Congressional Research Service R41298, 9–11; Deborah
North, Noah Baer and Dustin Plotnick, ‘The Regulation of OTC Derivatives in
the United States of America’ in Rüdiger Wilhelmi and others (eds), Handbuch
EMIR (Erich Schmidt), 634, N 48.
129
For an in depth discussion regarding the different requirements and
thresholds, see ibid 622–6.
130
See also Lynn A Stout, ‘Legal Origin of the 2008 Financial Crisis’ (2011)
1 Harvard Business Law Review 1, 33.
131
Deborah North, Noah Baer and Dustin Plotnick, ‘The Regulation of OTC
Derivatives in the United States of America’ in Rüdiger Wilhelmi and others
(eds), Handbuch EMIR (Erich Schmidt), 633, N 44.
made for security-based swaps, which are to be regulated by the SEC.132

Furthermore, the Secretary of the Treasury may exclude foreign exchange
products with physical delivery from the supervision of the CFTC.133
The United States, as the EU, employs a combination of bottom-up
and top-down approaches. OTC derivatives that fall within the scope of
mandatory clearing by a CCP (‘DCO’ which is supervised by the CFTC)
must report back to the CFTC and/or SEC respectively, depending on
which category of swap they wish to clear.134 The regulator then decides
if this falls within the scope of the clearing obligation based on liquidity,
notional exposure, and systemic risk (bottom-up approach). All deriva-
tives within the scope must be submitted for clearing with the DCO.135
Additionally, both the CFTC and the SEC have the ability to slate certain
derivatives for mandatory clearing, independently of a CCP’s initiative
(top-down approach).136 Clearing is mandated for all OTC derivatives;
without clearing, the contract between the counterparties is void.137
Dodd-Frank also mandates all speculative financial derivatives for clear-
ing as they were under the old requirements of the Commodity Exchange
Act (CEA).138
132
Legal Information Institute, ‘Dodd-Frank: Title VII – Wall Street Trans-
parency and Accountability’ (3 September 2017) <https://www.law.cornell.edu/
wex/dodd-frank_title_VII> accessed 3 September 2017.
133
Ibid; Deborah North, Noah Baer and Dustin Plotnick, ‘The Regulation of
OTC Derivatives in the United States of America’ in Rüdiger Wilhelmi and
others (eds), Handbuch EMIR (Erich Schmidt), 620–21, N 7.
134
Sections 721, 723(a), 725(c) Dodd-Frank. Considering the functions of
the DCOs it is apparent they are equivalent to what this book refers to as CCP.
Therefore the author will refer to them as CCPs for clarity. See also FINMA,
‘Finanzmarktinfrastrukturverordnung-FINMA Erläuterungsbericht’ (20 August
2015), 10 <https://www.admin.ch/ch/d/gg/pc/documents/2693/FinfraV-FINMA_
Erl.-Bericht_de.pdf> accessed 3 September 2017; Deborah North, Noah Baer and
Dustin Plotnick, ‘The Regulation of OTC Derivatives in the United States of
America’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich
Schmidt), 633, N 44.
135
(eds), Handbuch EMIR (Erich Schmidt), 633, N 44–6.
136
Ibid; Rena S Miller and Kathleen Ann Ruane, ‘Dodd-Frank Wall Street
Reform and Consumer Protection Act: Title VII, Derivatives’ (November 2012)
Congressional Research Service R41298, 6–7.
137
Section 723(a)(3) Dodd-Frank Act.
138
Section 723(a)(2) Dodd-Frank Act; see also Lynn A Stout, ‘Legal Origin
of the 2008 Financial Crisis’ (2011) 1 Harvard Business Law Review 1, 34.
The EU generally uses a stricter regulatory approach than the United

States. Owing to the maximum harmonisation approach, the Commis-
sion’s approval for most substantive regulatory changes is necessary.
Thus, despite a delegation to ESMA to create technical standards, the
regulation remains rigid and perhaps inflexible in adapting to market
changes swiftly.139 In contrast, the Dodd-Frank Act leaves more dis-
cretion to the regulatory bodies, the SEC and the CFTC.140
The OTC derivatives terminology is much broader in the United States
than it is in the EU. While the EU limits the concept of OTC derivatives
to financial instruments as defined by MiFID,141 the United States
subsumes any contract with financial, economic or commercial conse-
quence as a swap.142 EMIR has a comparatively narrow take on which
OTC derivatives are subjected to exchange trading (‘opt-in’), while the
United States subjects every agreement, contract, or transaction, which is
considered to be a ‘swap’ for mandatory clearing (‘opt-out’).143 In the
United States, hedging remains permissible in the non-cleared OTC
market, while purely speculative trading is confined to CCP clearing.144
Interestingly, foreign exchange swaps have been exempted from the
clearing obligation by the United States, which is an exemption that
ESMA did not follow.
139
243.
140
Ibid; Deborah North, Noah Baer and Dustin Plotnick, ‘The Regulation of
OTC Derivatives in the United States of America’ in Rüdiger Wilhelmi and
others (eds), Handbuch EMIR (Erich Schmidt), 633, N 46.
141
Article 2(5) and (7) EMIR.
142
(2012) 18 The Columbia Journal of European Law 19, 27.
143
244.
144
5.4.2.3 Establishing a CCP

In order to register as a CCP/DCO, an application must be submitted to
the CFTC in accordance with reformed CEA rules.145 The CFTC then
decides if sufficient capital has been provided, giving it more discretion
to vary capital adequacy.146 EMIR does not differentiate between sys-
temically important CCPs and regular CCPs, as does the US Dodd-Frank
Act in sections 805 et seqq. In the EU, financial market infrastructures,
particularly CPPs, are considered systemically important if their service
is indispensable to a smoothly functioning market.147 The CFTC, how-
ever, differentiates between DCOs and systemically important derivatives
clearing organisations (SIDCOs). SIDCOs are subject to more stringent
requirements with regard to financial resources and mechanisms to
ensure business continuity and recovery in case of turbulences,148 includ-
ing the default of the two clearing members to which the SIDCO has the
greatest exposure.149 This leads to friction with the EU, as EMIR requires
the exposure to the largest two counterparties to be covered by the default
fund. In the United States, this is only required for SIDCOs.150
5.4.2.4 CCP interoperability

Article 51 EMIR encourages CCPs to enter into interoperability agree-
ments with other CCPs, which Dodd-Frank does not.151 Such inter-
operability agreements could increase exposure to systemic risk, as will
be shown later.
145
Section 7(c) CEA.
146
Section 7 CEA; CFTC, Derivatives Clearing Organisation.
147
Counterparties and Systemic Risk’ (November 2013) 6, 7–8.
148
CFTC, ‘Derivatives Clearing Organisation’ (3 September 2017), 69335
<http://www.cftc.gov/IndustryOversight/ClearingOrganizations/index.htm> ac-
cessed 3 September 2017. CFTC, Derivatives Clearing Organisation.
149
Ibid 69352.
150
Shearman & Sterling, ‘EU–US Agreement on Regulation of Central
Counterparties-FIAFR-021616.pdf> accessed 3 September 2017), 3–4.
151
Shearman & Sterling, ‘Proposed US and EU Derivatives Regulations:
How They Compare’ (10 November 2010), 6 <http://www.shearman.com/~/
media/files/newsinsights/publications/2010/11/proposed-us-and-eu-derivatives-
regulations–how-__/files/view-full-memo-proposed-us-and-eu-derivatives-re__/
fileattachment/fia111010proposedusandeuderivativesregulations.pdf> accessed 3
September 2017.
5.4.2.5 Risk management

These differences largely relate to questions concerning collateral and
margin payments. Section 736 of the Dodd-Frank Act gives the CFTC
the authority to set margin requirements as necessary to maintain the
stability of the futures exchange.152 For one, the United States requires
higher initial margin payments as exchange-traded positions must be
liquidated within one day in case of counterparty default (‘minimum
liquidation period’), while the EU permits two days.153 ESMA offered a
new variation on the minimum liquidation period, which was met with
great scepticism.154 Both jurisdictions also disagree on appropriate
countercyclical buffers, which the United States do not implement,
requiring CCPs’ clients to post higher collateral.155 However, while
EMIR demands a confidence level of 99.5% for margin calculations, the
United States considers 99% sufficient.156 This could incentivise clear-
ing members to shift their place of incorporation to ensure lower costs
and undermine both providing for a harmonised and safe financial
market.
Furthermore, EMIR requires all derivative contracts, regardless of
whether they are traded on or off exchanges, to be disclosed to a trade
repository, while the United States and most other jurisdictions only
require OTC derivatives to be reported.157 This could undermine both
accessibility and transparency of the information collected.
Other important differences include the ‘push-out’ rule and the Volcker
Rule, as the EU has no such rules. The former restricts derivatives trades
by banks, while the latter prohibits banks from engaging in proprietary
152
Rena S Miller and Kathleen Ann Ruane, ‘Dodd-Frank Wall Street Reform
and Consumer Protection Act: Title VII, Derivatives’ (November 2012) Congres-
sional Research Service R41298, 17–8.
153
Rüdiger Wilhelmi, ‘Regulierung in Drittstaaten Und Resultierende Frik-
tionen’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich Schmidt),
554, N 13.
154
Shearman & Sterling, ‘EU-US Agreement on Regulation of Central
Counterparties-FIAFR-021616.pdf> accessed 3 September 2017), 2–3.
155
Ibid 3.
156
554, N 13.
157
Ibid 555, N 14.
trading of derivatives.158 However, this is hard to supervise and enforce

since the line between market-making and proprietary trading is very
thin.159
Regarding derivatives not submitted for clearing, strict margin require-
ments are imposed for both swap dealers and major swap dealers.160
These rules insure that sufficient risk-management practices are imposed,
despite the lack of a DCO/CCP.
5.4.2.6 CCP default

Finally, the United States prohibits federal assistance to swap entities to
prevent their liquidation161 and has created rules to wind-down system-
ically important financial institutions in Title II of the Dodd-Frank Act.
The Orderly Liquidation Authority is thereby intended ‘to provide the
necessary authority to liquidate failing financial companies that pose a
significant risk to the financial stability of the United States in a manner
that mitigates such risk and minimizes moral hazard’.162 CCPs are
considered too-big-to-fail and could therefore be subjected to Dodd-
Frank’s Title II by the Financial Stability Oversight Council.163 In such a
case, the receiver would likely be the Federal Deposit Insurance Corpor-
ation, who could transfer the CCP’s portfolio to a bridge financial
158
Section 716 Dodd-Frank. Clifford Chance and ISDA, ‘Regulation of OTC
Derivatives Markets: A Comparison of EU and US Initiatives’ (September 2012),
4 <www2.isda.org/attachment/NDc4Mw%3D%3D/CliffCh-ISDA%2520reg%252
0comparison%2520of%2520EU-US%2520initiatives%2520Sept%25202012.pd>
accessed 3 September 2017; Jan D Luettringhaus, ‘Regulating Over-the-Counter
Derivatives in the European Union – Transatlantic (Dis)Harmony After EMIR
and Dodd-Frank: The Impact on (Re)Insurance Companies and Occupational
Pension Funds’ (2012) 18 The Columbia Journal of European Law 19, 26–7.
159
SIFMA, ‘Volcker Rule Resource Center’ (3 September 2017) <http://
www2.sifma.org/volcker-rule/> accessed 3 September 2017; Ryan Tracy, ‘Vol-
cker Bank-risk Rule Set to Start with Little Fanfare’ The Wall Street Journal
(New York, 21 July 2015) <http://www.wsj.com/articles/volcker-bank-risk-rule-
set-to-start-with-little-fanfare-1437517061> accessed 3 September 2017.
160
(eds), Handbuch EMIR (Erich Schmidt), 642–3.
161
Section 716 Dodd-Frank. Rena S Miller and Kathleen Ann Ruane,
‘Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII,
Derivatives’ (November 2012) Congressional Research Service R41298, 20–21.
162
Section 204(a) Dodd-Frank, 12 U.S.C. Section 5384(a).
163
Section 804(a)(1) Dodd-Frank, 12 U.S.C. Section 5463(a)(1).
institution, where the portfolio would be further transferred to other

CCPs or auctioned off within two years.164
5.4.2.7 Implementation timeframe

Dodd-Frank was passed into law on 21 July 2010; however, despite the
United States’ head start, the implementation is ongoing and not all final
rules have been completed by the respective agencies.165
5.5 ISDA
Before the introduction of comprehensive legislation for derivatives,
ISDA was the international standard setting body. Despite the intro-
duction of the new rules, ISDA remains the main force on the OTC
derivatives market. ISDA reacted quickly to provide the industry with
boiler-plate agreements, covering the various regulatory requirements of
core jurisdictions, as well as certain smaller jurisdictions.166 As such,
today’s standard agreements include provisions that enable the counter-
parties to fulfil the regulatory requirements by signing the corresponding
master agreements, such as dispute resolution and portfolio reconcil-
iation, and margining requirements under EMIR.167 This is particularly
attractive for small and other non-financial counterparties, where the cost
of ensuring independent compliance with all regulation would be too
164
IMF, ‘United States Financial Sector Assessment Program: Review of The
Key Attributes of Effective Resolution Regimes for the Banking and Insurance
Sectors – Technical Note’ (July 2015) IMF Country Report No. 15/171, 21–5
<https://www.imf.org/external/pubs/ft/scr/2015/cr15171.pdf> accessed 3 Septem-
ber 2017.
165
Davis Polk, ‘Dodd-Frank Progress Report’ (19 July 2016) <https://
www.davispolk.com/files/2016-dodd-frank-six-year-anniversary-report.pdf> ac-
166
See e.g. ISDA, ‘European Market Infrastructure Regulation (EMIR)
Implementation Initiatives’ (3 September 2017) <http://www2.isda.org/emir/>
accessed 3 September 2017; ISDA, ‘ISDA Focus: Dodd-Frank’ (3 September
2017) <https://www2.isda.org/dodd-frank/> accessed 3 September 2017.
167
ISDA, ‘ISDA 2013, EMIR Portfolio Reconciliation, Dispute Resolution
and Disclosure Protocol’ (19 July 2013) <http://www2.isda.org/functional-areas/
protocol-management/protocol/15> accessed 3 September 2017; ISDA, ‘ISDA
2016 Variation Margin Protocol’ (16 August 2016) <http://www2.isda.org/
functional-areas/wgmr-implementation/isda-2016-variation-margin-protocol/> ac-
great. However, even for large financial counterparties, the ISDA Agree-
ments continue to be the most widely used agreements for OTC
derivative counterparties.
5.6 FIRST ANALYSIS

This chapter has shown that the global derivatives reform is far from
being completed or harmonised. Phasing-in of the clearing obligation in
the EU began in 2016, which is four years past the deadline set by the
G20 countries to implement the norms and almost 10 years after the
outbreak of the financial crisis.168 Both the EU and United States
implement multiple risk management mechanisms, such as prudent
collateral collection and margining practices; they require clearing mem-
bers to fulfil certain criteria before joining a CCP and derivatives to
comply with sufficient standardisation practices. These rules are in
accordance with the international standards provided.169 ESMA con-
ducted the first EU-wide CCP stress-test and the results showed that,
under the situation modelled, CCPs were able to cope with the counter-
party credit risk.170
The OTC derivatives reform hinges upon the smooth functioning of
FMIs, particularly CCPs, to ensure stable financial market conditions and
the reduction of systemic risk.171 CCPs are to act as a buffer between
counterparties against market externalities, using their risk mitigation
framework to achieve this. When identifying whether an institution
represents a threat to the financial system, its size, interconnectedness
and ability to substitute its services elsewhere on the market are
168
Review of implementation progress: FSB, ‘OTC Derivatives Market
Reforms: Tenth Progress Report on Implementation’ (4 November 2015),
2–3 and 8–11 <http://www.fsb.org/wp-content/uploads/OTC-Derivatives-10th-
Progress-Report.pdf> accessed 3 September 2017.
169
See ibid 8–14.
170
See generally ESMA, ‘EU-Wide CCP Stress Test 2015’ (16 April 2016)
<https://www.esma.europa.eu/sites/default/files/library/2016-658_ccp_stress_test_
report_2015.pdf> accessed 3 September 2017. The next results of the 2016 annual
stress-test are expected in the fourth quarter of 2017.
171
556, N 17.
considered.172 The function performed by a CCP is unique in that they

are highly interconnected and their exposure to counterparties is great.
Therefore, CCPs are considered a risk to financial stability and their
ability to function throughout systemic shocks pertinent. However, CCPs
have failed before.173 The clearing mandate can only fulfil its purpose if
the ultimate risk exposure, now concentrated within the CCPs which are
too-big-to-fail, is managed properly and a failing CCP can be efficiently
resolved. To quote CFTC Commissioner Giancarlo:
The scale and scope of several of the world’s major clearing houses and the
impact that the failure of any one would have on the global economy is too
great to not be a common concern. It will require flexibility and cooperation
among regulators on both sides of the Atlantic to strike the right regulatory
and supervisory balance.174
Unfortunately, the reform has not yet been completed. The EU lacks a
recovery and resolution framework for CCPs, despite having started the
consultation period for special resolution norms in 2012.175 Furthermore,
in the public consultation held by the European Commission between
May and August 2015, to gather stakeholder feedback regarding the
implementation of EMIR, a majority of respondents reported the desire
to have CCPs gain facilitated access to central bank liquidity.176 The
respondents believe that such liquidity access could not only counteract
172
European Commission, ‘Consultation on a Possible Framework for the
Recovery and Resolution of Financial Institutions Other than Banks’ (5 October
2012), 8.
173
For an overview of close-calls and CCP failures, see Jeremy C Kress,
‘Credit Default Swaps, Clearinghouses and Systemic Risk: Why Centralized
Counterparties Must Have Access to Central Bank Liquidity’ (2011) 48 Harvard
Journal on Legislation 49, 49–50; Paul Tucker, ‘Clearing Houses as System Risk
Managers’ (DTCC-CSFI Post Trade Fellowship Launch, London, 1 June 2011)
<http://www.bankofengland.co.uk/archive/Documents/historicpubs/speeches/2011/
speech501.pdf> accessed 3 September 2017, 4.
174
Christopher J Giancarlo, ‘The Looming Cross-Atlantic Derivatives Trade
War: “A Return to Smoot–Hawley”’ (The Global Forum for Derivatives Markets,
35th Annual Burgenstock Conference, Geneva, September 2014).
175
See also Tracy Alloway, ‘A Glimpse at Failed Central Counterparties’
Financial Times (London, 2 June 2011) <http://ftalphaville.ft.com/2011/06/02/
583116/a-glimpse-at-failed-central-counterparties/> accessed 3 September 2017.
176
European Commission, ‘EMIR Review, Public Consultation, 2015
Summary of Contributions’ (11 September 2015) <http://ec.europa.eu/finance/
consultations/2015/emir-revision/docs/summary-of-responses_en.pdf> accessed 3
September 2017.
CCPs’ exposure to commercial bank risks, but also decrease liquidity

risks, strengthen resilience and contribute to a level playing field.177
However, most public authorities and regulators opposed this request,
claiming it would undermine the independence and discretion of the
central banks and create moral hazard.178
The public consultation also generated feedback regarding pro-
cyclicality of the rules under EMIR: once again the opinions differed
between public authorities and market infrastructure operators, and
investment managers and industry associations. The first category consid-
ered the current requirements of EMIR to be adequate in limiting the
pro-cyclicality of the CCPs financial resources. While some still recog-
nised areas for improvement, particularly the second category suggested
more flexibility, either by adopting an outcome based approach or by
allowing additional tools. Some participants particularly expressed con-
cerns that the CCP could suddenly change its eligibility criteria and/or
margin levels, which could lead to a sudden and substantial increase in
initial margin payments or haircuts thereof.179 In some cases, the
discretion CCPs are given in setting haircuts and the eligibility of
collateral could increase pro-cyclicality if they require higher margins
than specified. Such pro-cyclicality could not only be caused by the CCP
itself, but also originate from client clearing agreements and brokers.180
As such, one suggestion is to subject client clearing to the rules of EMIR
and reduce the space for discretion on behalf of clearing members
performing client clearing.181 However, respondents were divided as to
whether this issue was better addressed through stronger interventions
from the regulator or if CCPs should remain responsible to define and
apply their risk management approach.182 Regarding the eligible collat-
eral, additional collateral categories were explicitly requested to be
permissible to post.183
Much critique was aimed towards the European Commission with
regard to the cross-border activities and the slow process regarding
equivalence assessments under EMIR. It took the transatlantic dialogue
177
Ibid 5.
178
Ibid. See also the author’s arguments on moral hazard in Chapter 7.
179
Ibid 7.
180
Ibid.
181
Ibid.
182
Ibid 8.
183
Ibid 7.
six years from the implementation of Dodd-Frank for the two juris-
dictions to find a way out of their protectionist approach to clearing,184
particularly since these slow implementations were leading to a frag-
mentation of liquidity and distorting the market, owing to the differences
in the various rules. It was also stated that the rules under EMIR were
creating disadvantages for EU entities over non-EU entities, as the EU
rules prove to be far more stringent in comparison with other country
regulations.185 These disadvantages could become even more apparent if
the United States opted to deregulate their market in the near future.186
This could cause further damage, not only to trade relationships, but
also by concentrating risk within the individual market instead of
spreading it across the global financial system.187 For the purpose of
returning the market to a cross-border flow of liquidity, it is desirable that
both jurisdictions slowly abandon their protectionist regulations as they
are complicated, costly, disruptive and do not comply with the original
G20 objectives of having a harmoniously reformed market for OTC
derivatives, where arbitrage is reduced.188 Quite the contrary, the greater
the chances are of inconsistencies being present in the implementation of
regulation, the more issues of overlapping regulation, duplication, con-
flicts and gaps increase, thus increasing chances of arbitrage.189 The
184
International Law Association, ‘Draft July 2016, Johannesburg Confer-
ence’, Twelfth Report (2016) <on file with author>, 4–6; European Commission,
European Commission, ‘EMIR Review, Public Consultation, 2015 Summary of
Contributions’ (11 September 2015), 10–11.
185
European Commission, ‘EMIR Review, Public Consultation, 2015 Sum-
mary of Contributions’ (11 September 2015), 11.
186
The US has been known to react to a crisis with highly stringent rules,
only to deregulate a few years later. President Trump has announced that he
intends to loosen regulation. Such discrepancies could further complicate cross-
border matters between the two core jurisdictions for derivatives trading. See also
the discussion in Claudia Aebersold Szalay, ‘Zehn Jahre Nach Der Finanzkrise:
Für Mehr Demut in Der Bankenregulierung’ Neue Zürcher Zeitung (Zurich, 13
July 2017) <https://www.nzz.ch/meinung/zehn-jahre-nach-der-finanzkrise-fuer-
mehr-demut-in-der-bankenregulierung-ld.1305673> accessed 3 September 2017.
187
See also Christopher J Giancarlo, ‘The Looming Cross-Atlantic Deriva-
tives Trade War: “A Return to Smoot–Hawley”’ (The Global Forum for Deriva-
tives Markets, 35th Annual Burgenstock Conference, Geneva, September 2014).
188
See also Alexey Artamonov, ‘Cross-border Application of OTC Deriva-
tives Rules: Revisiting the Substituted Compliance Approach’ (2015) 1 Journal of
Financial Regulation 206, 221.
189
Ibid 208; Rüdiger Wilhelmi, ‘Regulierung in Drittstaaten Und Resultier-
ende Friktionen’ in Rüdiger Wilhelmi and others (eds), Handbuch EMIR (Erich
Schmidt), 556–8.
financial market is highly mobile, particularly the OTC market, where its
bilateral nature allows for swift adaptation of contracts to profit from
jurisdictions with less stringent regulation, evade regulation and ultim-
ately the potential to undermine efforts for a secure financial market.190
In June 2016, ESMA and the CFTC signed a Memorandum of Under-
standing to cooperate on the regulation of CCPs, which is an important
step forward.191 To support this, the Chicago Mercantile Exchange Inc.
was the first US CCP to be recognised by ESMA on 13 June 2016.192
Overall, higher collateral requirements are the result of this meeting of
minds of regulators on both sides of the Atlantic.
Currently, the United States has rules in place for orderly liquidation of
systemically important institutions; however, CCPs are not explicitly
mentioned as targets thereof. Additionally, market conditions at a time
of a CCP default may be such that the ability to transfer the positions
to a bridge institution and, ultimately, to another CCP, may not be
successful.193
The objective of EMIR, which has been in force since August 2012, is
to require ‘CCPs to observe high prudential, organisational and conduct
of business standards’.194 The lessons of the 2007–2009 financial crisis
demonstrated that regular recovery and resolution proceedings may be
insufficient to ensure the ongoing functioning of critical functions of
financial institutions, thus preventing financial instabilities. EMIR did not
address these concerns with regard to CCPs, which is why in late 2016, a
new draft proposal was created titled: Proposal for a Regulation of the
European Parliament and of the Council on a framework for the recovery
and resolution of central counterparties and amending Regulations (EU)
No. 1095/2010, (EU) No. 648/2012, and (EU) 2015/2365. This draft
proposal aims to provide adequate tools to enable failing financial
190
191
ESMA, ‘ESMA and CFTC to Cooperate on CCPs’ (6 June 2016)
Press Release <https://www.esma.europa.eu/press-news/esma-news/esma-and-
cftc-cooperate-ccps> accessed 3 September 2017; International Law Association,
‘Draft July 2016, Johannesburg Conference’, Twelfth Report (2016) <on file with
author>, 4–6.
192
ESMA, List of third-country central counterparties recognised to offer
services and activities in the Union.
193
See discussion of current problems in the cross-border discourse here:
International Law Association, ‘Draft July 2016, Johannesburg Conference’,
Twelfth Report (2016) <on file with author>, 7–8 and 14–5.
194
Recital 4 CCPRRR.
institutions to preserve critical functions, promote cooperation and

coordination amongst various member state authorities, and ensure swift
and decisive action.195 The proposal should in future guarantee that the
CCP can recover from financial distress and maintain critical functions,
while winding down the remaining activities by means of regular
insolvency proceedings, all the while avoiding – or minimising – the
costs to taxpayers.196
195
Recitals 5–6 CCPRRR.
196
Recital 7 CCPRRR.
6. Reforming the reform
6.1 INTRODUCTION
Between 2015 and 2016, an extensive assessment of European Market
Infrastructure Regulation (EMIR) was carried out by the European
Commission, based on Article 85(1) EMIR. These assessments included
a public consultation and a public hearing on the review of EMIR.1 This
consultation showed that, while most aspects of EMIR were positively
received, some could not be implemented within the allocated timeframe,
yet others placed an undue burden on smaller counterparties in particu-
lar.2 The general report on EMIR was submitted to the European
Parliament and Council in November 2016 and was a part of the
Regulatory Fitness and Performance Programme (REFIT).3 All of these
findings were summarised in the ‘Report from the Commission to the
European Parliament and the Council under Article 85(1) of Regulation
(EU) No. 648/2012 of the European Parliament and of the Council of
4 July 2012 on OTC Derivatives, central counterparties, and trade
repositories’.4 The report found that, generally, EMIR as a framework has
performed well, but also identified certain areas within the framework
which could be improved upon.5
1
European Commission, ‘Inception Impact Assessment EMIR Amend-
ment’, 1 (21 November 2016) <http://ec.europa.eu/smart-regulation/roadmaps/
docs/ 2016_fisma_004_emir_amendment_en.pdf> accessed 3 September 2017.
2
Ibid; European Commission, ‘Report from the Commission to the Euro-
pean Parliament and the Council under Article 85(1) of Regulation (EU) No.
648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC
Derivatives, Central Counterparties and Trade Repositories’ COM(2016) 857
final, 6.
3
European Commission, ‘Questions and Answers on the Proposal to
Amend the European Market Infrastructure Regulation (EMIR)’, 1 (4 May 2017)
Press Release <http://europa.eu/rapid/press-release_MEMO-17-1145_en.htm?
locale=en> accessed 3 September 2017.
4
Amend the European Market Infrastructure Regulation (EMIR)’, 1.
5
124
Reforming the reform 125
During the REFIT process, the Commission assessed which policies

effectively met their target in an efficient and effective way. Where
disproportionate costs and burden were identified, or excessively com-
plex requirements were found, the report made recommendations to
increase financial stability in a more effective way.6
Following the feedback provided in these evaluations, the Commission
proposed amendments to EMIR in May 2017. The amendments target the
regulatory complexity surrounding over-the-counter (OTC) derivatives
and aim to reduce both burdens and costs for market participants, without
leading to compromises regarding financial stability. Multiple short-
comings have been identified by the European Commission, including
the heavy reliance on member state regulators, heavy interlinkages in the
financial system and the lack of a recovery and resolution system for
Central Counterparties (CCPs).7 The EU has identified that the risk
concentration within certain CCPs is greater than others, making some
CCPs increasingly important and significant to financial stability.8
The following will be subdivided to take into account two core
regulatory changes: the reform of EMIR and the creation of a recovery
and resolution framework for CCPs.
6.2 REFORMING EMIR

The November 2016 EMIR report found that no fundamental changes
should be made to the core requirements of the regulation, given its
importance for preventing systemic risk. While EMIR was found to be
effectively reducing such risk, while enhancing transparency, the pos-
sibility to make amendments to eliminate disproportionate costs and
simplify certain procedures was noted.9 Such was achieved by
Reporting Requirements, the Risk-mitigation Techniques for OTC Derivatives
COM(2017) 208 final’, 2.
6
Ibid 3–4.
7
See generally, European Commission, ‘Communication from the Com-
mission to the European Parliament, the Council and the European Central Bank,
Responding to Challenges for Critical Financial Market Infrastructures and
Further Developing the Capital Markets Union’ COM(2017) 225 final.
8
Ibid 2–3.
9
Amend the European Market Infrastructure Regulation (EMIR)’, 1; European
re-calibrating the application of certain requirements – most notably for

small financial counterparties, non-financial counterparties and pension
funds – reducing hurdles for CCP access and reducing the reporting
requirements.10 At the same time, compliance with other European
regulations, including the Capital Requirements Regulation, Market
Infrastructure Directive II (MiFID II), and the Proposal for a recovery
and resolution regime for CCPs needs to be maintained.11 These have
been implemented in the Commission’s proposal to amend EMIR.12
The EMIR reform focuses on key aspects, including compliance with
the clearing mandate for counterparties in the peripheral area of the
derivative trading network, transparency and access to clearing.13 The
objectives are to reduce the observed burden on small financial and
non-financial counterparties, while increasing access to clearing for
smaller institutions and streamlining the reporting process. These changes
are expected to reduce the likelihood of sudden shocks and business
disruptions by reducing the overall volatility.14
Commission, ‘Report from the Commission to the European Parliament and the
Council under Article 85(1) of Regulation (EU) No. 648/2012 of the European
Parliament and of the Council of 4 July 2012 on OTC Derivatives, Central
Counterparties and Trade Repositories’ COM(2016) 857 final, 6; European
Commission, ‘Proposal for a Regulation of the European Parliament and of the
Council Amending Regulation (EU) No. 648/2012 as Regards the Clearing
Obligation, the Suspension of the Clearing Obligation, the Reporting Require-
ments, the Risk-mitigation Techniques for OTC Derivatives Contracts Not
Cleared by a Central Counterparty, the Registration and Supervision of Trade
Repositories and the Requirements for Trade Repositories, COM(2017) 208
final’, 3–4.
10
COM(2017) 208 final’, 8.
11
Ibid 4 and 7.
12
Ibid 6.
13
Ibid 3–4.
14
6.2.1 Reform Overview
EMIR will be revised with regard to nine aspects. The reporting

obligations will be amended to reduce the burden for small non-financial
counterparties and intragroup transactions for OTC derivatives and for
exchange-traded derivatives the reporting obligation will be fulfilled by
the CCP on behalf of the counterparties.15 There are also planned
changes with regard to the quality of data reported to trade repositories,
meaning that the trade repositories will be required to verify the
completeness and accuracy of the data, particularly if the two sides of the
transaction report incongruent data. To this end Trade Repositories will
also be required to establish strong reconciliation processes to compare
data with other repositories, in case the other counterparty reported to a
separate repository.16
There will also be new rules regarding clearing for non-financial
counterparties. After implementation of the new EMIR regulation, non-
financial firms superseding a clearing threshold will only be obligated to
clear the class of derivatives which breaches the clearing threshold, while
those OTC derivatives used to hedge risks which relate back to the
hedging positions will not count towards the clearing threshold. The
calculation of the clearing threshold will also be simplified for these
non-financial counterparties, requiring them to only assess their situation
with regard to the clearing obligation on a yearly basis, based on their
average trading activity throughout the months of March, April and
May.17
The Commission also proposes to amend the clearing obligation, to
entice more – and particularly smaller – counterparties to clear their
trades. Evidence has shown that the clearing obligation places undue
burden upon small counterparties, particularly when they only have few
derivatives to trade in. As such, the amendments propose introducing a
clearing threshold for derivatives subject to the clearing obligation, below
15
Ibid.
16
Ibid 1–2.
17
Amend the European Market Infrastructure Regulation (EMIR)’, 2; Article 4a (1)
European Commission, ‘Proposal for a Regulation of the European Parliament
and of the Council amending Regulation (EU) No. 648/2012 as regards the
clearing obligation, the suspension of the clearing obligation, the reporting
requirements, the risk-mitigation techniques for OTC derivatives contracts not
cleared by a central counterparty, the registration and supervision of trade
repositories and the requirements for trade repositories, COM(2017) 208 final’,
4 May 2017 (herein EMIR II).
which derivatives are not subject to the clearing obligation, despite the
class of derivatives being subject to the clearing obligation.18 This is a
highly interesting dual-threshold concept and permits the regulator to
loosen or tighten the otherwise very stern clearing obligation. Highly
liquid derivatives can thus be subject to the clearing obligation to fulfil
the financial stability mandate. At the same time, the implications,
particularly for smaller counterparties, that the clearing obligation places
on these can be lessened by exempting them from the clearing obligation.
Not only is this able to reduce the strain on high-quality collateral, but it
can also minimise the implications from client clearing, particularly by
reducing costs and regulatory burden for said firms.
Additionally, CCPs will be required to provide their members with a
tool to predict future collateral requests, and the empowerment of the
regulator to implement additional risk mitigation techniques for non-
cleared OTC derivatives, as well as further segregation solutions to hold
the collateral.19
6.2.2 Reporting
Currently, EMIR requires two-sided reporting by both counterparties. The

redraft would change this for financial counterparties transacting with
non-financial counterparties, which are not subject to the clearing obliga-
tion, by only mandating the financial counterparty to report the trade on
behalf of both, reducing the burden for the small non-financial counter-
party.20 Intra-group transactions where at least one counterparty is a
non-financial counterparty will also benefit from an exemption from the
reporting obligation. Exchange-traded derivatives will be reported by the
18
Amend the European Market Infrastructure Regulation (EMIR)’, 2–3.
19
Ibid 2.
20
Article 9 EMIR II; European Commission, ‘Proposal for a Regulation of
the European Parliament and of the Council Amending Regulation (EU) No.
648/2012 as Regards the Clearing Obligation, the Suspension of the Clearing
Obligation, the Reporting Requirements, the Risk-mitigation Techniques for OTC
Derivatives Contracts Not Cleared by a Central Counterparty, the Registration
and Supervision of Trade Repositories and the Requirements for Trade Reposi-
tories, COM(2017) 208 final’, 16; European Commission, ‘Questions and
Answers on the Proposal to Amend the European Market Infrastructure Regu-
lation (EMIR)’, 2 and 7–8.
CCP on behalf of both counterparties, reducing the burden for counter-

parties.21 Finally, those trades entered into before the start of the
reporting obligation, which remain outstanding at the implementation
date of the reporting obligation, will not need to be reported.22 Fines for
trade repositories will also be increased, depending on the infringement,
to ensure that they are sufficiently dissuasive.23
6.2.3 Trade Reporting
The regulator has found the data reported to the trade repositories to be
subject to discrepancies when submitted by two separate counterparties.
Therefore, two changes are being recommended. First, the trade reposi-
tory is to implement a procedure by which to verify reported data for
both completeness and accuracy. This may be achieved through cross-
checking with other trade repositories to which the other counterparty
reported the trade (reconciliation).24 Second, procedures should be devel-
oped by trade repositories to fulfil customer requests regarding orderly
21
tories, COM(2017) 208 final’, 16.
22
Answers on the Proposal to Amend the European Market Infrastructure Regu-
lation (EMIR)’, 2.
23
24
Article 78, 81 EMIR II; European Commission, ‘Proposal for a Regu-
lation of the European Parliament and of the Council Amending Regulation (EU)
No. 648/2012 as Regards the Clearing Obligation, the Suspension of the Clearing
data transfers to another trade repository, e.g. if they wish to change trade
repository.25
The proposal also includes the new Article 76a EMIR, which will
enable third-country trade repositories to access data held in EU trade
repositories once an implementing act has been adopted ensuring that the
third-country trade repository is sufficiently authorised, supervised,
bound by professional secrecy and subject to immediate and direct data
exchange rules with the EU.26
6.2.4 Clearing Obligation
Current regulation prescribes that, once a counterparty exceeds the

clearing threshold for one class of derivatives, all derivatives across all
classes must be submitted for clearing. The reform suggests changing this
requirement to only mandate those derivatives for clearing within the
asset class that has breached the clearing threshold.27 Considering that
these non-financial counterparties will not have a great exposure on the
derivatives market, particularly not in those asset classes which have not
exceeded the clearing threshold, this re-regulation will greatly reduce the
financial and administrative burden for these counterparties.
Furthermore, the proposal for a recovery and resolution framework for
CCPs introduces a provision to enable the Commission to suspend the
clearing obligation temporarily for certain asset classes. While this new
provision for Article 6a EMIR is aimed primarily at situations where the

Answers on the proposal to amend the European Market Infrastructure Regu-
lation (EMIR)’, 2.
25
Ibid.
26
COM(2017) 208 final’, 17.
27
Amend the European Market Infrastructure Regulation (EMIR)’, 2–3; Recital 7
EMIR II.
CCP is in resolution, situations may arise where the Commission could

make use of this provision to prevent CCP failure.
The proposal also introduces a clearing threshold for ‘small financial
counterparties’ – which represent the majority of financial counterparties,
but not however the majority of risk – below which they will be
exempted from the clearing mandate.28 This is to pay respect to the fact
that it is not economically sustainable to mandate clearing for these
counterparties, given their limited usage of OTC derivatives.29 Similarly,
the deadline to implement mandatory clearing for pension funds and
small financial counterparties has been extended by two years until
2019.30
To aid clearing members assess their financial exposure towards the
CCP and increase predictability, CCPs will be required to provide a tool
to their members, which enables them to simulate the amount of
collateral which they will be requested to provide for future trades.31
Such plannability could decrease the pro-cyclicality of collateral contri-
butions, by providing some guidelines as to future cash-flows. At the
same time, all volatility could not be represented sufficiently by such a
model, making it a good tool in times of low volatility, but not for
stressed market conditions.
The new proposal furthermore introduces the option for the regulator
to suspend clearing in certain circumstances, particularly where a class of
OTC derivatives is likely to pose a serious threat to the stability of the
EU.32 This could be the case where the overall market volatility in a
certain asset classes causes underlying prices to act erratically, thus
increasing risks for CCPs and causing liquidity shortages from erratic
collateral requirements.
Finally, European Supervisory Authorities are given the power to
supervise the risk mitigation procedures in place by those counterparties,
not subject to the clearing obligation, by means of draft regulatory
technical standards.33 This will ensure that risk-management procedures
28
Recital 7 EMIR II.
29
30
Ibid.
31
Ibid.
32
Recital 10 EMIR II; Article 6b(1)(c) EMIR II.
33
are in place to ensure timely, accurate and appropriately segregated

exchange of collateral, and other significant shifts in the risk manage-
ment process.
6.3 CCP RECOVERY AND RESOLUTION

One of the core shortcomings of EMIR is the lack of a recovery and
resolution scheme for CCPs. EMIR remained silent regarding the worst-
case scenario of a CCP potentially defaulting. As such, it would have
been up the EU member states to enact their own recovery and resolution
scheme. Some member states enacted requirements for CCPs to prepare
contingency plans in case of home CCPs experiencing financial stress;
others covered CCP recovery and resolution as part of their broader
resolution regimes in the financial sector. However, none of the countries
developed a full recovery and resolution plan for CCPs that complies
with the rules of the FSB principles.34 Regarding those member states
who enacted such legislative changes, considerable differences regarding
the regulatory and administrative provisions can be found. Such substan-
tial differences would provide for undue burden, which runs directly
contrary to the objectives of EMIR to guarantee cross-border harmon-
isation, and creates additional hazards, costs and burdens when a CCP
faces financial distress. Furthermore, the varying oversight could lead to
competitive distortions and undermine the single market approach of
current regulatory projects within the EU, such as the Capital Markets
Union.35 Thus, the EU decided to create a framework at Union level, to
ensure maximum harmonisation, which benefits all national regulators
and the objective of the Single Market, as it prevents arbitrage, market
fragmentation and legal uncertainties.36

34
Parliament and of the Council on a Framework for the Recovery and Resolution
of Central Counterparties and Amending Regulations (EU) No. 1095/2010, (EU)
No. 648/2012, and (EU) 2015/2365, Brussels 28.11.2016, COM(2016) 856
final’, 5 (hereafter referred to as ‘CCPRRR’ when citing the legislative proposal);
Recital 8 CCPRRR.
35
Recital 8 CCPRRR.
36
The recovery and resolution framework for CCPs finds its legal basis
in Article 114 TFEU,37 and intends to close the current regulatory gap
and legal uncertainties regarding what measures the supervising author-
ities may take in case of CCP failure.38 As such, the objective of the
recovery and resolution framework can safeguard financial stability by
ensuring that critical functions are continuously performed, by protecting
them from the failing institution, while equally preventing the protection
performed at the cost of tax payers. As has been shown, CCPs – through
their size, market importance and interconnectedness – are considered
systemically relevant. The EU has now deemed all of its CCPs to be
systemically relevant.39 This draft regulation builds on the approach
created for the recovery and resolution of banks and tools created to
prepare the competent authorities to deal with CCP failure scenarios as a
result of either a clearing member failure or a non-default event with
significant systemic impact.40
6.3.1 The Draft Regulation
Recovery and resolution refer to two separate stages of a failing

institution and both pursue different objectives. The objective of recovery
mechanisms is to return long-term viability of the financial institution. In
the resolution process, the authorities generally separate the vital parts
and ensure continued functioning of these, while the non-viable parts are
placed in insolvency.41 Thus, an institution in the recovery phase requires

final’, 5.
37
Final’ (n 649). 5; Recital 3 CCPRRR.
38
final’, 1.
39
Ibid 2–3, with additional remarks in fn 2.
40
Recital 10 CCPRRR.
41
a certain policy environment to prevent a highly disruptive failure and

particular measures will be implemented to guide the CCP back to a
functioning state. If this is no longer possible, or these policy measures
fail, resolution is the only option. Resolution, contrary to recovery, does
not aim to prevent the failure of the institution, as the institution has
already become economically unviable. Its sole objective is to maintain
critical functions of the institution, while winding down the remaining
parts in an orderly manner and placing as much of the losses on the
CCP’s owners and creditors as possible.42 Despite the importance of
these measures, currently the tools to deal with a failing CCP are limited
to the CCP’s internal arrangement, with some guidance by national
regulators, where loose frameworks have been developed.43 This lack of a
harmonised approach implies that within the EU and between CCPs there
currently are divergent approaches by all involved, which could seriously
disrupt critical functions of the economy, fragment the internal market
and lead to wider financial instabilities.
The EU has proposed a Regulation to ensure harmonised implemen-
tation across all member states, just as it did with EMIR.44 The reasons
which could lead to CCP failure are believed to stem from situations such
as clearing member defaults or severe operational defaults, thus providing
regulators with tools to combat these shortcomings. Finally, CCPs –
contrary to banks – do not have complex cross-border branch and
subsidiary setups, but provide their services from one jurisdiction into
others directly, thus the uniform application of the Bank Recovery and
Resolution Directive is insufficient. This also supports a uniform
approach to applying decisions across the various member state juris-
dictions.45 According to the impact assessment of this draft Regulation,
the new Regulation should not only help ensure that the costs are borne
by the market participants associated with the CCP, but also bring
transparency to the resolution framework, by describing ex ante which
breaches of requirements could lead to public intervention.46 However,
these rules are not designed as constrained prescriptive triggers, as no
regulator could foresee all possible situations requiring intervention, nor
should the CCPs be able to game the system to their advantage and

final’, 3.
42
Ibid.
43
Ibid 6.
44
Ibid 7–8.
45
Ibid.
46
Ibid 9–10.
prevent the correct application of the resolution triggers. Thus, resolution

authorities will be given an encompassing tool-box, which is neither
exhaustive, nor prescriptive, but permits sufficient discretion to apply
the corresponding tool to the situation, always with the objective of
promoting market discipline, minimising all costs to the taxpayer and
distributing losses amongst CCP stakeholders in a fair manner.47 This is
the idea and concept behind the CCPRRR-Draft.
6.3.2 Resolution Authority
Pursuant to Article 3 CCPRRR, the member states must designate one or

more resolution authorities, which can be the national central bank,
competent ministries, public administrative authorities or other author-
ities which are entrusted with public administrative powers, given they
command the necessary expertise, resources and operational capacity
(Para 2). These designated authorities may then apply the resolution tools
and are empowered to apply the resolution proceedings, which are set out
in the Regulation (Article 3(1)).48 According to Article 4, a resolution
college must be established, consisting of members of both the resolution
and competent authorities of the CCP, as well as members of various
national or third-country members, depending on the interconnectedness
of the CCP,49 and finally the corresponding members of the European
System of Central Banks,50 central banks,51 other competent authorities,52
the European Securities Market Authority (ESMA)53 and the European
Banking Authority.54 This resolution college is to manage and chair a
resolution college to draw up a resolution plan for each CCP (Article 13)
in addition to the recovery plan drafted by the CCP itself (see Article 9),
assess the resolvability of the CCP in the absence of any extraordinary
public financial support, the emergency liquidity assistance of the central
bank or other central bank liquidity assistance (Article 16(1)), and finally,
address and remove any barriers to the resolvability of the CCP (Article
47
Ibid 10.
48
Article 3 CCPRRR.
49
Article 4(2)(c)–(f) CCPRRR in connection with Article 18(2)(c)–(f)
EMIR.
50
Article 4(2)(g) CCPRRR in connection with Article 18(2)(g) EMIR.
51
Article 4(2)(h) CCPRRR in connection with Article 18(2)(h) EMIR.
52
Article 4(2)(i)–(j) CCPRRR in connection with Article 8(4), 8(4)(a)
EMIR.
53
Article 4(2)(k) CCPRRR.
54
Article 4(2)(l) CCPRRR.
17). Article 4(4) CCPRRR introduces the possibility for third-country

resolution authorities to be invited as observers in the resolution college,
for those third countries implicated either through participation of a
clearing member, or if the CCP has entered into an interoperability
agreement with said CCP. Participation of such third countries would be
limited to certain cross-border enforcement issues, as outlined in Article
4(4)(a)–(e), which do not touch on core subjects of the resolution of the
foreign CCP. Furthermore, an ESMA resolution committee is to be
created as an internal committee of ESMA, pursuant to Article 41
Regulation (EU) No. 1095/2010, to make decisions regarding the devel-
opment and coordination of resolution plans, as well as develop resolu-
tion methods, for failing CCPs.55
Section II of the Draft Regulation considers the procedures for
decision-making in the various committees and colleges, stating which
factors must be taken into account generally (Article 7(a) CCPRRR),
which principles must be followed (Article 7(b)–(l) CCPRRR), and the
flow of information between all parties (Article 8 CCPRRR). The
principles include minimising the costs of early intervention (Article 7(b)
CCPRRR) and resolution (Article 7(k) CCPRRR), balancing of the
interests of all affected parties surrounding the CCP (Article 7(g)–(h)
CCPRRR) and mitigating any negative economic and social effects for
both the member state and any other affected third countries, where
services are provided by the CCP, particularly negative effects on
financial stability (Article 7(l) CCPRRR).
6.3.3 Recovery and Resolution Plan
CCPs are mandated to draw up and maintain a recovery and resolution

plan, in case of significant deterioration of their financial situation or the
risk of breaching their prudential requirements under EMIR.56 As such,
in the recovery plan, the situations must be identified by means of
indicators, where measures according to the recovery plan must be taken
and these indicators must be monitored on an ongoing basis, as well as
revised on a yearly basis. However, the CCP is not limited to these
situations in taking measures to intervene in the ongoing business.
Contrarily, it is up to the discretion of the CCP whether it takes measures
before any indicators are met, and even to refrain from taking action
55
Article 5 CCPRRR.
56
Article 9(1) CCPRRR.
despite a situation being identified which would require intervention from

the CCP, according to its own recovery plan.57 Should the CCP not take
action in the second case, it must report this ‘without delay’ to the
competent authority. In the situation where the CCP would like to
activate its own recovery plan, the ultimate decision regarding the
activation of the recovery plan lies with the competent authority, which
can veto the recovery depending on the overall situation of the economy
and the potentially adverse effects to the financial system.58
A resolution plan must be drawn up for every CCP by the resolution
authority, but must first consult the competent authority as well as the
resolution college. The plan itself must take into consideration the default
of one or more clearing members, other reasons for losses, particularly
from the investment activities and operations and broader financial
instabilities resulting from system wide event.59 However, the resolution
plan may not include extraordinary public funding or central bank
emergency liquidity assistance, the latter particularly not with non-
standard collateralisation, tenor and interest rates.60 Such emergency
bank liquidity should not be the primary recovery tool for the CCP.61
However, the author’s hypothesis is that should a EU-wide, highly
interconnected CCP be in need of activating its resolution plan, particu-
larly if the overall economic situation of the financial markets are
troubled, the usage of central bank emergency liquidity is highly likely.
Furthermore, this resolution plan requires the authority to take specific
circumstances and scenarios into account when drafting the plan, includ-
ing a demonstration of how the critical functions could be legally and
economically separated from the CCP to ensure their continuity, should
the CCP fail;62 an estimation of the timeframe to execute the planned
points;63 various resolution strategies, depending on the designated
timeframe and overall situation;64 and how to maintain the critical
functions of the CCP.65
57
Article 9(2)–(3) CCPRRR.
58
59
Article 13(1), (3) CCPRRR.
60
Article 13(4)(a)–(c) CCPRRR.
61
See Article 13(6)(i) CCPRRR.
62
Article 13(6)(b) CCPRRR.
63
Article 13(6)(d) CCPRRR.
64
Article 13(6)(j) CCPRRR.
65
Article 13(6)(l) CCPRRR. According to this article, the legislator consid-
ers the following six activities as critical functions which must be secured: access
The CCP is required to cooperate and provide all relevant data to

prevent information asymmetries and false assumptions when drafting
these resolution plans.66 In the hierarchy, the resolution authority out-
ranks the college. If the college does not reach a joint decision, the
resolution authority can ask ESMA to assist.67 Regardless, if the college
does not reach a decision within four months from the date of transmis-
sion of the resolution plan to ESMA, the final decision lies with the
resolution authority to finalise the decision.68
6.3.4 Early Intervention
Resolvability is given, if the resolution authority deems it feasible and

credible to either use normal insolvency proceedings to liquidate the CCP
or use resolution tools and powers to resolve it. However, the continuity
of the critical functions must be maintained, as well as avoidance of
adverse effects on the financial system, to the greatest possible extent.69
A CCP must be resolvable based on the same prerequisites as for
recovery:
(1) no extraordinary public financial support;

(2) no central bank emergency assistance;
(3) if central bank emergency assistance is necessary, it must be at
standard collateralisation and tenor and with standard interest rate
terms.70
To achieve this end, the resolution authority may propose far-reaching

requirements to alter the business practices of the CCP, including
measures such as requiring the CCP to divest from certain assets,
to payment and clearing services and similar infrastructures; settlement obliga-

tion to clearing members and all linked FMI; access of clearing members to their
securities and cash accounts of the CCP and the collateral that the CCP owes its
clearing members; continuity in any interoperability links; portability of clearing
member positions; and the preservation of the licences, authorisations, etc.,
necessary for the ongoing performance of the CCP of its critical functions and
ongoing participations in or with other FMI.
66
Article 15 CCPRRR.
67
68
Article 16 CCPRRR.
69
Article 16(2) CCPRRR. This wording shows clearly that the legislator is
highly aware that the resolution of a CCP cannot be considered as a non-
threatening process to financial stability.
70
Article 16(1)(a)–(c) CCPRRR.
preventing new or existing business lines or demanding changes to the

legal and operational structures of the CCP or any of the group entities.71
6.3.5 Resolution
When there are indications of an impending emergency crisis situation

that could affect the operations of the CCP or infringements have already
occurred, the competent authorities are permitted to intervene in the
operation of the CCP.72 Such intervention may include the implemen-
tation of appropriate measures according to the recovery plan;73 the
convening of a shareholder meeting and setting of the agenda;74 replacing
one or more members of the board or the senior management, if they are
found to be unfit to perform their duties;75 and even requiring the CCP to
refrain from implementing certain recovery measures, if those could have
adverse effects on financial stability.76 Should the implementation of the
CCPs recovery measures be necessary at this stage, this is only permis-
sible if such intervention is necessary to (i) maintain financial stability in
the EU, (ii) maintain the critical services of the CCP or (iii) to maintain
and enhance financial resilience of the CCP.77 Should the CCP have
already activated its waterfall default mechanism at this stage, the
authority is to be informed immediately, as well as any shortcomings or
weaknesses disclosed.78 If all these measures prove insufficient to return
the CCP to a healthy financial situation with sufficiently strong operating
rules, it will be possible for the authorities to remove some or all of the
board members and senior management, and replace them with new
members of their choice.79 Such powers could potentially limit the
willingness of the senior management and board to willingly and in a
timely manner disclose the true nature of the CCPs health and financial
situation, for fear of admitting their shortcomings and losing their
positions.
71
See Article 17(7) CCPRRR.
72
Article 19–20 CCPRRR.
73
74
Article 19(1)(d) CCPRRR.
75
Article 19(1)(e) CCPRRR in coordination with Article 27 EMIR.
76
Article 19(1)(j) CCPRRR.
77
Article 19(1)(i) CCPRRR in coordination with Article 19(4)(a)–(c)
CCPRRR.
78
Article 19(5) CCPRRR in coordination with Article 45 EMIR.
79
Article 20 CCPRRR in coordination with Article 27 EMIR.
When the objective of returning the CCP to a functioning state is

possible neither through early intervention nor the recovery mechanisms,
or if one or both of these approaches have not been successful, the final
approach/tool/choice is to resolve the CCP. Resolution action is taken
by the resolution authority when the following conditions are met
cumulatively:
(1) the nationally competent authority or the resolution authority, after

consulting with each other, determines that the CCP is failing or
likely to fail; and80
(2) after considering all circumstances, there is no alternative within a
reasonable timeframe through private sector measures or super-
visory action to prevent the CCP’s failure; and81
(3) the resolution is in the public’s interest and cannot be achieved
through regular insolvency procedures.82
The general principles, either individually or cumulatively, applied to

resolution tools are:
(1) the position and loss allocation tool;

(2) the write-down and conversion tool;
(3) the sale of business tool;
(4) the bridge CCP tool;
(5) any other resolution tools, consistent with Articles 21 and 23.83
These principles ensure that shareholders of the CCP are the first to bear
any losses, where contractual obligations can no longer be met, while
creditors will be second in line and in order of priority of their claims.84
The general principles regarding the resolution, which must be observed
by the resolution authority, can be viewed as a cascade, with regard to the
spread of losses. As a general rule, contractual obligations and other
arrangements, which are manifested in the recovery plan, should be
enforced in full or at least partially, if they have not yet been exhausted,
before the resolution tools are implemented.85 Furthermore, the share-
holders of the CCP must be the first to bear the losses in the cascade of
80
Article 22(1)(a)(i)–(ii) CCPRRR.
81
82
Article 22(1)(c) CCPRRR.
83
Article 27(1)(a)–(3) CCPRRR.
84
Article 23 CCPRRR.
85
Article 23(a) CCPRRR.
loss distribution resulting from the resolution. Next, creditors are to bear
the losses; this must relate in an equitable manner to creditors of the
same class. The loss is capped and must not exceed the losses the
creditors would have incurred had the resolution authority not taken any
resolution actions, or had the CCP been subjected to normal insolvency
proceedings.86 Additionally, if resolution proceedings become necessary,
the board and senior management of the CCP should be replaced, unless
keeping them in place is better for achieving the resolution objectives.87
Where the CCP is part of a group, the effects and impacts on other group
entities and the group as a whole must be taken into account.88
Resolution will be deemed to be in the public’s interest in most cases,
given that each CCP in the EU has been deemed to be too-big-to-fail. As
such, any CCP which finds itself in the unfortunate situation of no longer
being able to provide the critical functions will be subjected to the
resolution proceedings. The legislator determines five circumstances in
which a CCP will be considered ‘failing’:89
(1) the infringements of the CCP are grave enough to constitute

grounds to withdraw the CCPs authorisation, in accordance with
Article 20 EMIR;
(2) the CCP is unable to perform a critical function or will be unable to
do so in the immediate future;
(3) the CCP is unable to restore viability through a recovery plan or
will be unable to so in the immediate future;
(4) the CCP is unable to pay its debts or other liabilities or will be
unable to do so in the immediate future;
(5) extraordinary public funds are necessary to support the CCP.90
If any or a combination of multiple of this circumstances have set it, the

regulator will intervene and label the CCP as failing. Only in certain
cases will the provision of extraordinary public funds constitute sufficient
grounds to begin resolution proceedings. The legislation considers such
extraordinary public funds to constitute grounds for resolution only if
three requirements are provided for cumulatively:
86
Article 23(b)–(e) CCPRRR.
87
Article 23(f) CCPRRR.
88
Article 23(h) CCPRRR.
89
Article 22(2)(a)–(e) CCPRRR.
90
The legislation considers such extraordinary public funds to constitute
grounds for resolution only if three requirements are given cumulatively, deemed
a State guarantee by a central bank.
(1) a State guarantee provided by a central bank or newly issued

liability;
(2) this must be provided to a solvent CCP under the Union State aid
framework; and
(3) it must be required to counteract a serious economic disturbance in
a EU state and, as a consequence, preserve financial stability.91
Furthermore, if recovery mechanisms are considered to be too disruptive

to the financial system, they may be replaced by immediately applying
resolution mechanisms to the CCP, or in accordance with the ESMA
guidelines, which will be published at a later date.92
When resolving the CCP, it is pertinent to ensure the continuity of the
critical functions of the CCP, which must be identified in the recovery
plan, but must encompass the timely settlement of the clearing member’s
obligations and the continued access to the securities or cash accounts
with the obligations of both between the CCP and its members.93 Further
critical functions include substantial links with other financial market
infrastructure (FMI), preventing contagion in the financial system by any
means, minimising the reliance on public financial support and minim-
ising the cost of resolution for the stakeholders and the destruction of the
CCP’s value.94 Such can be achieved either through the sale of business
to a purchaser or the transferal of business to a bridge CCP.95 Where a
sale of business is chosen, the terms and conditions of the sale must be
based on commercial terms, and be in accordance with the Union States
aid framework and the profits of the sale are to benefit the ownership
instruments transferred in the sale, the CCP itself and non-defaulting
clearing members who suffered losses previously.96 If the resolution
authority opts to transfer instruments of ownership issued by or any
assets, rights, obligations or liabilities of the CCP under resolution to a
bridge CCP, this may take place without obtaining shareholder consent of
the CCP under resolution or any third party other than the bridge CCP.
The resolution authority may act outside of this very Directive, by being
91
Article 22(2)(e)(i)–(iii) CCPRRR.
92
Article 22(3)–(4) CCPRRR.
93
Article 21(1)(a)(i)–(ii) CCPRRR.
94
Article 21(1)(b)–(e) CCPRRR.
95
Articles 40 and 42 CCPRRR.
96
exempt from complying with any procedural requirements, except for

those stated in Article 43 CCPRRR.97
6.3.6 Additional Financial Resources
When the CCP is under resolution, the resolution authority is able to

enter into contracts to borrow additional forms of financial support, to
ensure effective usage of resolution tools.98 Government financial stabi-
lisation tools are foreseen if and where the following conditions are met:
(1) there is a necessity to achieve resolution objectives;

(2) it is a last resort after having assessed and exploited other resolu-
tion tools to the maximum extent practicable, while maintaining
financial stability;
(3) compliance with the Union States aid framework is necessary; and
(4) there is a mandate by the competent authority to the resolution
authority to provide such financial support.99
Such a state-funded bail-out is to be the last resort, and requires that any
of the following conditions are met:
(1) resolution tools are deemed insufficient to avoid significant impact

on the financial system;
(2) resolution tools are insufficient to protect public interests, if extra-
ordinary liquidity assistance has already been provided to the CCP
from the central bank;
(3) where the CCP has been transferred to temporary public ownership
and it has received public equity support, resolution tools are
considered to be insufficient.100
Considering that all European CCPs have been deemed systemically

relevant, it is hard to imagine a situation in which such a CCP could fail
97
Article 42(1) CCPRRR. For discussions regarding the requirements of a
legal person to become a bridge CCP, see Article 42(2) CCPRRR.
98
Article 44 CCPRRR.
99
Article 45(1)(a)–(d) CCPRRR.
100
Article 45(3)(a)–(c) CCPRRR. Such public equity support tools as
mentioned in Paragraph (iii) are granted with the objective of recapitalising the
CCP and should be sold to a private purchaser as soon as possible. See Article 46
CCPRRR.
without triggering government stabilisation tools and a government-

funded bail-out, given their highly interconnected nature and size. As
such, this Article undermines the very core objective of the G20 mandate,
to prevent future taxpayer-funded bail-outs for the derivatives market,
and undermines the overall objective of the financial market reform.
The CCPRRR also introduces mechanisms which for the purpose of
financial stability encroach on the rights of the clearing members and
could thus greatly undermine the objective of furthering the voluntary
clearing of non-mandatory derivatives. For example, the resolution
authorities may re-allocate losses by unilaterally reducing the value of
the CCP’s payment obligations to non-defaulting clearing members
resulting from gains in the variation margin or economically identical
payment.101 The resolution authority may also mandate additional cash
calls from non-defaulting members. While this contribution is capped at
the amount contributed to the default fund – or if multiple default funds
exist, to the amount contributed to the default fund for the affected asset
class – such cash calls may be made at any time, even before all lines of
defence have been depleted.102 Such a rule may severely undermine
financial stability by contributing to pro-cyclicality and creating further
liquidity drains to solvent entities. Furthermore, it contradicts the object-
ives of balancing moral hazard and ensuring that the CCP’s management
puts in place sufficiently strong risk management processes. Mandating
the clearing members to financially support a failing CCP, before it has
used all own financial lines of defence, could encourage CCPs not to
capitalise themselves sufficiently ex ante, trusting that the clearing
members will contribute further finances throughout a liquidity crisis.
The same applies for clearing members, as the non-defaulting clearing
members become responsible for financing the incurring losses of an
insufficiently prudent clearing member.
6.3.7 Third Countries
Title VI regulates the relations with third countries, where the third
country CCP either provides services or has subsidiaries in one or more
member states, or if a member state CCP provides services or has
subsidiaries in a third country.103 In light of Brexit, this Article becomes
particularly prominent given the UK’s core role in the clearing market.
Article 76 CCPRRR permits EU member states to disregard recognition
101
Article 29(1) and Article 30(1) CCPRRR.
102
103
Article 74 CCPRRR.
and enforcement of third-country resolution proceedings if such ‘would

have adverse effects on financial stability in their Member State’,104
which can be expected whenever further collateral calls would be made
at the expense of a third-country CCP. Cooperation agreements will be
concluded with relevant third-country authorities, until and unless an
international agreement is made between both jurisdictions.105 That these
cooperation agreements and recognitions have more of a political than
legal reasoning has been proven countless times in the last years,
particularly with regard to the equivalence decisions between the EU and
the United States, thus the political agenda could have severe impacts on
London-based CCPs once the UK exits the European Union.
6.4 OTHER CHALLENGES

6.4.1 The UK
On 23 June 2016 the UK voted in a referendum whether it should remain

in the EU or leave, and opted to leave. Article 50 TFEU was evoked on
29 May 2017 and, as such, the dissolution from the EU is expected to be
completed by 29 May 2019.106 With regard to the clearing of derivatives,
this impending departure of the UK from the EU following the referen-
dum will have an impact on London’s CCPs. LCH.Clearnet currently
processes financial products worth a notional amount of EUR850 billion
daily. While the EU has mentioned its intention to force all Euro-
denominated clearing back into the Eurozone, some observers consider
this to be highly unlikely to be achieved, while others expect the UK to
lose much of its attractiveness and business.107 Needless to say, such a
requirement would directly contradict all objectives of modern liberal
financial markets. With LCH.Clearnet being one of the most influential
104
Article 76(b) CCPRRR.
105
Article 77(1) in connection with Article 74 CCPRRR.
106
Alex Hunt and Brian Wheeler, ‘Brexit: All You Need to Know about the
UK Leaving the EU, BBC News’ BBC News (London, 13 July 2017) <http://
www.bbc.com/news/uk-politics-32810887> accessed 24 July 2017.
107
See Jim Brundsen and Alex Barker, ‘Brussels Set for Power Grab on
London’s Euro-clearing Market’ Financial Times (London, 1 May 2017) <https://
www.ft.com/content/b2c842a6-2b64-11e7-bc4b-5528796fe35c> accessed 3 Sep-
tember 2017; Samuel Agini, ‘Euronext Expects Euro-Clearing to Shift from
London’ Financial News London (London, 19 May 2017) <https://www.fn
london.com/articles/euronext-expects-euro-clearing-to-shift-from-london-20170519>
CCPs in the Eurozone, the EU has already announced its intentions to

increase its extraterritorial oversight over third-country CCPs with sys-
temic relevance within the EU. In his May speech, Dombrovskis stated
the following:
For third country CCPs which play a key systemic role for the EU, we are
looking in particular at two possibilities for enhanced supervision: We can ask
for enhanced supervisory powers for EU authorities over third country
entities. Or such CCPs of key systemic importance for the EU could be asked
to be located within the EU. We now need to look at these options in the
impact assessment.
While minimising the risk of market fragmentation, the EU needs to be able
to ensure supervisory oversight over such key CCPs.108
This statement was further solidified when the EU issued a Communi-

cation outlining its future approach to systemically relevant market
infrastructures providing Euro-denominated services, particularly CCPs,
which was published in May 2017. With currently up to 75% of all
Euro-denominated interest rate derivatives being cleared in the UK, the
EU is feeling threatened by the possibility of their dwindling influence
over the UK’s regulatory powers.109 To address these risks, the EU has
decided to enhance supervision and subject third-country CCPs to greater
scrutiny. The objective of enhanced supervision is to prevent a regulatory
race to the bottom, regulatory arbitrage and the acceleration of market
integration. Additionally, the EU intends to centralise supervision of all
critical capital markets functions, which must perform effectively and
soundly.110
These measures will probably lead to further regulatory burden and
unnecessary political stand-offs. The United States has already
announced its disdain for the EU’s plan in this area. Depending on the
approach the UK takes following its exit from the EU, it could possibly
108
Valdis Dombrovskis, ‘Speech by Vice-President Dombrovskis on EMIR
REFIT’ (Brussels, 4 May 2017) <http://europa.eu/rapid/press-release_SPEECH-
17-1225_en.htm> accessed 3 September 2017.
109
European Commission, ‘Communication from the Commission to the
European Parliament, the Council and the European Central Bank, Responding to
Challenges for Critical Financial Market Infrastructures and Further Developing
the Capital Markets Union’ COM(2017) 225 final, 3.
110
Ibid 3–4.
consider a similar approach to Switzerland. As a non-EU state, Switzer-

land chooses to voluntarily follow certain EU regulations, while adapting
these rules to the specific needs of the country.111
The separation of the UK from the EU will lead to more turbulence in
the financial market, which will not only test existing rules, but could
also create new market fragmentations and uncertainties regarding the
clearing of derivatives in the highly sophisticated and experienced setting
which LCH.Clearnet has been providing.
6.4.2 United States
Not only is Europe currently faced with great regulatory challenges, so is

the United States. While the United States led the charge to highly
stringent regulatory boundaries for derivatives after the crisis, the change
in Presidency has resulted in a review of procedure for existing policy.
On 3 February 2017, President Trump signed an executive order directing
the Secretary of Treasury to report back within 120 days whether current
governmental rules and policies promote or inhibit the order’s ‘Core
Principles for Financial Regulation’.112 While Dodd-Frank was not
explicitly mentioned in the order, President Trump explicitly stated that
he intended to largely cut back on regulations in Dodd-Frank.113 The
objective of this review of Dodd-Frank is to reduce the financial
oversight burden on banks and to enhance the flow of capital from banks
to corporations.114 Furthermore, regulatory oversight of systemically
significant institutions is to be reduced, as well as other client-business-
oriented tasks, such as inducements. This objective is being cemented
through President Trump’s selection of cabinet members.
Currently, there have been no explicit calls to reduce the regulatory
burden for derivatives or CCPs. However, in light of the intended
111
For details on the Swiss approach, see Alexandra Balmer, Clearing OTC
Derivatives: An Analysis of the Post-crisis Reform on Systemic Risk (Schulthess
Juristische Medien 2017), 122–43.
112
Robert C Pozen, ‘What Will Happen to Dodd-Frank under Trump’s
Executive Order?’ (9 March 2017) <https://www.brookings.edu/blog/up-front/
2017/02/06/what-will-happen-to-dodd-frank-under-trumps-executive-order/> ac-
cessed 9 March 2017.
113
Antoine Gara, ‘With a Stroke of the Pen, Donald Trump Will Wave
Goodbye to Dodd-Frank-Act’ Forbes (New York, 3 February 2017) <https://
www.forbes.com/sites/antoinegara/2017/02/03/with-a-stroke-of-the-pen-donald-
trump-will-wave-goodbye-to-the-dodd-frank-act/#52e8a55c1148>.
114
Robert C Pozen, ‘What Will Happen to Dodd-Frank under Trump’s
Executive Order?’ (9 March 2017).
appointment of Christopher Giancarlo as Chairman of the CFTC,

changes to the derivative framework are likely. Based on the Congres-
sional Review Act, the Senate and House of Representatives, together
with the President, can repeal agency regulations which are adopted
within the last 60 legislative business days of the previous government.115
As such, regulation of topical relevance within the 60 day timeframe
could include capital requirements for banks trading derivatives issued by
the banking agencies, which was accepted by the CFTC in late 2016.116
Contrarily, the industry has voiced concern at this prospect, stating that
this could undermine financial stability objectives which have proven to
be effective.117 This appears to be a highly unusual situation, with the
industry preferring higher regulatory measures while politicians are in
support of deregulation.
Should the United States opt towards a deregulatory trajectory, while
Europe continues to push for more stringent regulation, arbitrage and
regulatory mismatches could continue to grow. Furthermore, with the
United States openly threatening the EU with countermeasures should
they revoke the UK’s market access and domination of Euro-denoted
currency clearing, this could lead to further exacerbations in the already
raging transatlantic trade war.
6.5 SUMMARY
Overall, it can be said that the G20 objectives of 2008 are yet to be
implemented, nine years later. Mandatory clearing is still being phased in
for many derivatives categories. All the while, regulators have realised
that mandatory clearing without an ‘emergency brake’ may prove to be
counterproductive and are now preparing legislation which will introduce
the ability to suspend the clearing mandate temporarily. Furthermore,
with MiFID II/MiFIR only entering into force on 3 January 2018, the
trading obligation is yet to be implemented properly. Financial counter-
parties have yet to complete their licensing process to trade on the
regulated markets. Trade reporting has proven to be more difficult and
less reliable than the regulators had planned, which is now requiring
115
Ibid.
116
Ibid.
117
Joe Rennison and Phillip Stafford, ‘U.S. Derivatives Market Anticipates
Modest Dodd-Frank Changes’ Financial Times (London, 3 February
2017) <https://www.ft.com/content/1f6ccfbe-ed2e-11e6-ba01-119a44939bb6>
accessed 9 March 2017.
re-regulation to ensure that false, non- and double-reporting can be

eliminated or at least kept to a minimum. Most importantly, it took the
regulators four years after the implementation of EMIR to draft a
recovery and resolution Regulation for CCPs. Such a framework would
have been pertinent from the get-go, not only to ensure that the
systemically important institutions have all relevant measures in place to
guarantee the objective of financial stability, but it would have also been
more cost-efficient for the CCPs and national authorities to plan their
internal frameworks and supervisory bodies around the legal obligations,
now imposed. Finally, Brexit is looming on the horizon and, ignoring the
general importance of the London market for the EU, the importance of
the London market for clearing of Euro-denominated derivatives is
overwhelming. With the EU considering ordering all Euro-denominated
derivatives home or insisting on strong extraterritorial supervision of
foreign CCPs, many more bumps are ahead on the road regarding
clearing.
It is safe to say that even 10 years after the latest financial crisis, the
highly ambitious – and perhaps over-zealous – G20 objectives of
harmonising global derivatives regulation and particularly guaranteeing
the stability of the financial markets through CCPs are yet to be achieved.
CCPs remain ticking time-bombs with the potential to devastate the
financial markets. The push to regulate this market even further could
lead the regulations to become even more complicated, causing higher
costs for the market participants, and as such, ultimately causing them to
refrain from using the hedging benefits that derivatives enable and which
are their core function. Once again, a good intention could lead to an
unintended outcome and a new risk to the financial market.
EMIR, particularly the clearing obligation, is considered to have
achieved many of its designated objectives. For one, this is proven since
central clearing of interest rate derivatives has increased from 36 to 60%
since the implementation of the clearing obligation.118 Increasing manda-
tory clearing was one of the core objectives of the G20 in the crisis
aftermath. New challenges, particularly with regard to CCPs located
outside of the EU clearing EU-denominated derivatives, pose a new
threat to systemic risk. The fact that the EU has no regulatory powers
over derivatives located in foreign jurisdictions, however, scares the EU.
As such, it is planning to enhance its supervisory powers over third-
country entities, in particular over those that are of key systemic
118
Valdis Dombrovskis, ‘Speech by Vice-President Dombrovskis on EMIR
REFIT’ (Brussels, 4 May 2017).
importance for the EU. Regarding this second category, the EU currently
is considering a proposal to insist that they are located within the EU.119
This regulatory redraft has consequences for more than one legislation.
In particular, the refit of EMIR is planned to reduce the reporting
requirements for businesses, saving up to €1.1 billion in operational costs
and up to €5.3 billion in one-off costs.120 It should also give pension
funds three additional years to develop technical solutions to enable them
to partake in central clearing.121 The legislation under revision is the
following: the Second Company Law Directive to include CCPs; the
Bank Recovery and Resolution Directive, to exclude CCPs with banking
licences, to ensure they are only subject to the new recovery and
resolution Regulation for CCPs; EMIR, to temporarily suspend the
clearing obligation, as well as the enhanced role of the CCP risk
committee; and finally, the creation of an ESMA Board of Supervisors.122
LCH.Clearnet was used as an example in the crisis aftermath of why
clearing should be considered the antidote against systemic risk origin-
ating from OTC derivatives. While it is true that LCH.Clearnet success-
fully wound down Lehman Brothers’ exposure, they profited from four
unique circumstances:
(1) LCH.Clearnet was a seasoned CCP with many years of experience

and know-how from earlier clearing member defaults. Could other,
less experienced and new CCPs joining the market replicate the
success of LCH?
(2) LCH also demands higher margins than those required by regula-
tors.123 Considering the cost of collateral, will the regulatory
requirements for collateral be sufficient?
(3) Mandatory clearing and increased market competition remove the
ability of a CCP to select its members stringently. Could this result
119
Ibid.
120
Ibid.
121
Ibid.
122
See European Commission, ‘Proposal for a Regulation of the European
final’, 16–17, with further comments.
123
LCH.Clearnet, ‘CCP Risk Management Recovery & Resolution’
(3 September 2017) <http://www.lch.com/documents/731485/762448/ccprisk
management_whitepaper.pdf/4afc698a-2538-4f5b-b7fa-b8ade2dd594a> accessed
3 September 2017.
in an influx of less solvent clearing members and lead to increased

problems of moral hazard and adverse selection?
(4) Considering the importance of CCPs for the overall systemic risk
management, are improperly managed and insufficiently funded
CCPs themselves becoming a risk to financial stability?
Thus, it remains unclear whether LCH.Clearnet’s success could be

replicated by another CCP in the same position. The following chapter
will consider the implications of the new regulatory framework, particu-
larly with regard to the ability of CCPs to be the bulwark of financial
stability. To address the lack of regulatory proposals for an innovative
CCP recovery and resolution regime, this study will introduce the novel
concept of an ex ante capitalised CCP bail-out fund.
7. Regulatory analysis
7.1 OBJECTIVES OF THE REFORM
This study has comprehensively explained what derivatives are, how they
contributed to the financial crisis, why clearing is thought to be the cure
and how different jurisdictions are redesigning their financial market
legislation. Derivatives manage risk – market and credit risk – and allow
for such risk to be shifted to market participants willing to carry it. At the
same time, credit risk is being created in the form of counterparty credit
risk. Between the exchange-traded derivatives market and the over-the-
counter (OTC) derivatives market a symbiotic relationship evolved.
Liquid and standardised derivatives were traded on exchanges, while
exotic and bespoke products could be found on the OTC derivatives
market. At the same time, the OTC market relied upon the creditworthi-
ness of the counterparties trading with one another, as there was no
central counterparty (CCP) to assume counterparty credit risk. A counter-
party default or liquidity loss in the OTC market would cause the solvent
party to lose the protection potentially purchased at the moment it needed
it most. This risk acted as a natural selection process, preventing less
creditworthy counterparties from entering into the OTC derivatives
market.
The regulatory reforms we have seen are based on turning the clocks
back to the American pre-Commodity Futures Modernization Act regu-
lation. Could the crisis have therefore been prevented by keeping
prudent regulation in place? If so, what makes this new regulation so
extraordinary?
This chapter analyses the benefits and limitations of clearing and the
legal reform surrounding it. The OTC derivatives market is notoriously
opaque and benefits from increased reporting mandates originating from
the G20 initiative for clearing. Central clearing also reduces the likeli-
hood of counterparties underestimating and under-collateralising their
exposure to each other. However, CCPs face the problem of relying on
information provided to them by the counterparties to determine their
own risk exposure and collateral demands. This clashes with the incen-
tives of clearing members to reduce their costs originating primarily from
152
Regulatory analysis 153
the higher margins that represent the CCP’s greatest defence against
market externalities, counterparty default and systemic risk management.
At the same time, the CCP internalises great exposure to market risk
through its clearing members and concentrates this risk within. Despite
CCPs having become of systemic importance, regulators have failed to
pre-emptively regulate their recovery and resolution.1 Thus, this chapter
will also identify how CCPs impact financial stability and systemic risk,
according to the following hypothesis.
The derivatives reform was scripted by observing the obvious short-
comings before, during and after the financial crisis to cover the most
apparent problems. Alexander and Schwarcz refer to the post-crisis
reform as being ‘fuelled more by political and emotional reactions to the
financial crisis than by logic’.2 The less obvious linkages and regulatory
‘hotter’ topics have not been addressed. Thus, the current reform could be
summarised as too little, too late.
While exchange-traded derivatives provided transparency with regard
to pricing, volume, counterparties and positions, the bilateral OTC
derivatives market remained opaque. The bilateral nature of the privately
negotiated, bespoke contracts was not recorded centrally, permitting a
build-up of systemic risk of which regulators and market participants
were unaware.3 Additionally, the OTC market did not require the
counterparties to post collateral by law, leaving risk mitigation to the
parties bilaterally. As a result, contracts often lacked sufficiently prudent
risk mitigation techniques and were exposed to high levels of counter-
party credit risk while being highly leveraged, which can exacerbate
losses further if market value declines.4 The effects were seen when the
financial crisis hit and AIG needed to be bailed out.
Therefore, the objective of the derivatives reform is to enhance
transparency through central reporting to trade repositories and the
removal of counterparty credit risk from bilateral OTC trades. This is
1
See International Law Association, ‘Draft July 2016, Johannesburg Con-
ference’, Twelfth Report (2016) <on file with author>, 11, 14–16.
2
3
(2012) 18 The Columbia Journal of European Law 19, 20.
4
Ibid 20–21.
achieved by mandating certain derivatives for clearing by means of a

CCP. The CCP then, through novation, multilateral netting and margin
collection, reduces market exposure.5 Combining this with the globally
harmonised macro-prudential oversight of CCPs reduces systemic risk in
the financial system, making CCPs the bulwark of financial stability. This
is the intended outcome of the reform.
7.2 CLEARING AND FINANCIAL STABILITY

The regulatory framework for CCP risk mitigation was designed with the
objective of removing exposure from the OTC market. The following will
first analyse the implications of the reform on transparency, market
exposure and default management. Then, it will consider the macro-
prudential impact of the reform on financial stability. The study asserts that
the reform’s objectives have not been met, as CCPs are not only highly
exposed to market turmoil, but also pose a grave risk to the financial
system. Despite this, regulators have not provided CCPs with a new
toolbox to manage the risk, but expect them to assess and mitigate the risk
using the same techniques as were used before the crisis. Additionally,
CCPs are granted considerable discretion to manage their risk. Finally, it is
shown that major CCPs are too-big-to-fail, posing unsolvable problems
regarding their resolution under the current regulation.
7.2.1 The Impact of the Reform
The Financial Stability Board (FSB)’s ‘Twelfth Progress Report on

Implementation’ of the OTC derivatives market reform shows that, even
eight years after the fateful Pittsburgh G20 meeting, the global com-
munity has yet to implement the rules effectively and achieve the market
harmonisation which was so sought after.6 Out of the 24 FSB member
jurisdictions, only 14 have margin requirements for non-centrally cleared
derivatives – meaning those derivatives that rely on counterparties to
ensure they do not impact financial stability negatively. Most of those
5
ence’, Twelfth Report (2016) <on file with author>, 11.
6
FSB, ‘Review of OTC Derivative Market Reforms: Effectiveness and
Broader Effects of the Reforms’ (29 June 2017) <http://www.fsb.org/wp-content/
uploads/P290617-1.pdf> accessed 3 September 2017, 1.
14 implemented these measures in the last year.7 Most of the jurisdictions

(20/24) now have at least one CCP available to clear certain interest rate
derivatives, while most other classes of derivatives remain to be excluded
from CCP access.8 Across most jurisdictions, access to clearing remains
difficult, with only a few clearing members actively offering client
clearing services, particularly in the EU, which has led the European
Securities Market Authority (ESMA) to draft provisions to postpone
clearing for small financial counterparties for another two years.9 While
the FSB considers this progress to be a success, this goes to show that,
despite apparent regulatory progress and many new rules having been
enacted since the 2007/2008 financial crisis, many of them have yet to
take force or effectively be implemented.10 It remains rather unsettling to
read the following lines in a FSB Report:
The long-term economic effects of the reforms remain difficult to assess […]
and can only be fully ascertained over a longer period of time. […] This
review thus cannot be considered a final assessment of the effects and
effectiveness of reforms.11
This could be interpreted to read that the FSB is unsure whether all the
costs that have been created by the derivatives reform meet the objectives
that they set out to achieve, and that the reform could potentially lack any
effectiveness regarding the stability of the financial markets. The follow-
ing will detail specific areas of concern and areas for improvement
according to the current situation.
7.2.1.1 Transparency
Clearing reduces the opacity of the OTC derivatives market in two ways.
Joining a CCP as a clearing member is subject to certain prerequisites,
7
Ibid 20. FSB, ‘OTC Derivatives Market Reforms: Twelfth Progress
Report on Implementation’ (29 June 2017) <http://www.fsb.org/wp-content/
uploads/P290617-2.pdf> accessed 3 September 2017, 1–2, 12–29.
8
FSB, ‘OTC Derivatives Market Reforms: Twelfth Progress Report on
Implementation’ (29 June 2017), 17; FSB, ‘Review of OTC Derivative Market
Reforms: Effectiveness and Broader Effects of the Reforms’ (29 June 2017),
10–15.
9
Implementation’ (29 June 2017), 25.
10
Broader Effects of the Reforms’ (29 June 2017), 1–5.
11
Ibid 6.
particularly relating to the clearing members’ financial resources.12 Thus,

clearing members typically are large financial institutions, such as hedge
funds and global banks. Institutions not meeting these prerequisites can
only interact with a CCP through an existing clearing member.13 The
clearing structure provides insight into who qualifies as a clearing
member and who is dealing in derivatives. National regulation, however,
permits small counterparties, non-financial institutions and others to be
exempt from the clearing mandate, which could potentially result in
unidentified risks. The new EU rules are intended to further exempt small
financial counterparties from the clearing obligations, as they appear to
be unable to join a clearing venue.14
Novation is the second transparency-enhancing benefit from clearing.
Through novation, the CCP becomes the buyer to every seller and vice
versa, replacing the original contract with two new ones.15 Novation by
recording outstanding contracts allows for transparency and knowledge
of exposure through the publishing of data on pricing and trade volume.16
These records can be accessed by both regulators and the public to assess
the build-up of risk in the financial system.17 The impact of transparency
from clearing is, however, dwarfed by the obligation to report to trade
repositories. Even those contracts exempt from the clearing mandate will
be required to disclose their positions to trade repositories (TRs) that will
collect, store and disseminate all data to permit an early detection of
potential risk accumulation.18 Following the realisation that much data
reported to TRs contained errors, the EU will now reform the regulations
for TRs, to reduce the errors from reporting. The new rules will also
12
13
Journal 8, 8.
14
See Chapter 6, Section 6.2.4.
15
See Stacey Anderson, Jean-Philippe Dion and Hector Perez Saiz, ‘To
Link or Not to Link? Netting and Exposures Between Central Counterparties’
(March 2016) 6, 4.
16
17
7–8.
18
2012) 9.
introduce a new responsibility for CCPs, which is to report trades on

behalf of the counterparties’ cleared trades.
Supervisors depend on much of the information disseminated by
CCPs. The following example regarding the dependence of supervisory
bodies upon the risk management and assessment abilities of CCPs lends
itself well to analysis. According to Article 24 European Market Infra-
structure Regulation (EMIR), the CCP must immediately inform ESMA
and the European Systemic Risk Board (ESRB; among others) of any
emergency situation relating to a CCP. Thus, the supervisory bodies
depend strongly upon CCPs to inform them of any adverse developments
on the financial markets that could impact market liquidity or the stability
of the financial system. This information must be divulged to any
member state in which the CCP or any of its clearing members are
established.19 This demonstrates a strong reliance and trust in the ability
of CCPs to monitor all market risks across all jurisdictions in which their
clearing members are established. A failure to comply with such risk-
management practices could result in market insecurities. Based on the
extensive information every CCP will be faced with on a daily basis, the
inability of any supervisory authority to cope with this information in a
timely fashion is apparent. Therefore, the regulator must rely on the
information provided to it by the CCPs. Surprisingly, this dependency has
not been discussed in the literature.
7.2.1.2 Netting
Novation through CCPs provides further market benefits. By assuming
the counterparty’s position, the CCP can net the offsetting positions
between market participants, thereby reducing the overall market expo-
sure.20 An increase in clearing members joining a CCP leads to an
increase in netting opportunities for the CCP. This represents a key
incentive for clearing reform. By increasing netting opportunities, overall
portfolio exposure decreases. Such a decrease not only benefits clearing
members by reducing collateral requirements, it also reduces systemic
19
Article 24 EMIR.
20
Stacey Anderson, Jean-Philippe Dion and Hector Perez Saiz, ‘To Link or
Not to Link? Netting and Exposures Between Central Counterparties’ (March
2016) 6, 4; Jeremy C Kress, ‘Credit Default Swaps, Clearinghouses and
Bank Liquidity’ (2011) 48 Harvard Journal on Legislation 49, 54.
risk.21 This multilateral netting is further enhanced through a specialis-

ation of the CCP to a specific asset class, benefitting from the economies
of scale. Netting greatly impacts the exposure in the market created by
derivatives. In September 2017, the global OTC derivatives market had a
total outstanding notional value of nearly USD 500 trillion, but credit
exposure after offsetting claims through netting only amounted to
roughly USD 3 trillion.22
In the bilateral OTC market, collateral collection and management was
left to the counterparties and lacked any uniform approach, despite the
ISDA Master Agreements. Clearing changes this dynamic, as the CCP
becomes responsible for collecting and managing the collateral from its
clearing members. The CCP defines initial and variation margins to be
collected at regular intervals reflecting market development and risk
exposure. Additionally, the CCP commands an ex ante capitalised default
fund from its members to mutualise and neutralise any exposure that may
arise from counterparty default before it reaches the market.23
Findings by Duffie and Zhu demonstrate that fragmentation of clearing
across multiple CCPs increases collateral demand as it undermines the
ability to apply multilateral netting; not only does it reduce overall market
exposure, but reduced netting opportunities also increase margin and other
risk mitigation collateral requirements.24 To the benefit of economies of
scope, different asset types cleared by the same CCP continue to achieve
netting opportunities and should therefore be cleared by a single CCP.25
As, realistically, there was never only one CCP, collateral demands are
increased. To counterbalance this, different suggestions have been made.
CCPs can be linked or enter into interoperability agreements with one
21
22
See BIS, ‘International Banking and Financial Market Developments’
(September 2017) <http://www.bis.org/publ/qtrpdf/r_qt1709.htm> accessed 3
September 2017.
23
2016) 6, 4.
24
Darrell Duffie and Haoxiang Zhu, ‘Does a Central Clearing Counterparty
Reduce Counterparty Risk?’ (2011) 1 The Review of Asset Pricing Studies 74,
23; Manmohan Singh, ‘Velocity of Pledged Collateral: Analysis and Impli-
cations’ (November 2011) 256, 18.
25
Darrell Duffie and Haoxiang Zhu, ‘Does a Central Clearing Counterparty
Reduce Counterparty Risk?’ (2011) 1 The Review of Asset Pricing Studies 74,
23.
another to increase multilateral netting abilities.26 Another suggestion is to

re-use collateral to reduce the overall collateral demand.27 The increased
reliance on collateral could make the market more susceptible to market
turbulences and increase pro-cyclicality within.28
7.2.1.2.1 CCP interoperability agreements To understand how risk is

concentrated within CCPs and how interconnectedness affects the disper-
sion of risk across the new financial market structure, linkage risk must
be analysed. In great market turmoil, the risk of more than one large
counterparty default is real,29 especially in the interconnected and con-
centrated market in which they are active. The strain on the own
resources/pre-funded financial resources may be much greater than
calculated, particularly if there are multiple consecutive defaults and the
default fund contributions of other, not-defaulted, members have been
used to cover an earlier default.
CCP linkage or interoperability arrangements between CCPs permit
multilateral netting among all participants, thus reducing financial expo-
sure within the clearing system across the membership area. At the same
time, multiple markets can be accessed via a single CCP.30 By linking
CCPs, netting of exposure can be expanded between foreign and domes-
tic CCPs, thereby reducing the overall collateral requirements as a single
global CCP would allow exposure to be net across all market participants
26
See generally Stacey Anderson, Jean-Philippe Dion and Hector Perez
Saiz, ‘To Link or Not to Link? Netting and Exposures Between Central
Counterparties’ (March 2016) 6; Jürg Mägerle and Thomas Nellen, ‘Inter-
operability between Central Counterparties’ (August 2011) 12.
27
For in-depth discussion and calculations on feasibility, see Manmohan
Singh, ‘Velocity of Pledged Collateral: Analysis and Implications’ (November
2011) 256; Manmohan Singh, ‘Collateral Netting and Systemic Risk in the OTC
Derivatives Market’ (April 2010) 99.
28
See discussion in International Law Association, ‘Draft July 2016,
Johannesburg Conference’, Twelfth Report (2016) <on file with author>, 13.
29
245–6; Jeremy C Kress, ‘Credit Default Swaps, Clearinghouses and Systemic
Liquidity’ (2011) 48 Harvard Journal on Legislation 49, 52–3.
30
2016) 6, 4; Jürg Mägerle and Thomas Nellen, ‘Interoperability between Central
Counterparties’ (August 2011) 12, 1.
by the global CCP.31 Currently, the OTC derivatives clearing market is

dominated by a few large CCPs specialising in certain asset classes on a
global scale. To maximise netting abilities, smaller national CCPs could
enter into operability agreements with large international CCPs to profit
from increased netting abilities.32 However, such CCP linkage leads to
risks, as the CCPs thereby create credit exposure to one another. In the
case of a linked CCP defaulting, the surviving CCP would become
obliged to fulfil the contractual obligations of the defaulted CCP, which
could potentially be detrimental if the smaller national CCP would have
to fulfil the global CCP’s positions.33 One of the few cases where this has
been done is between LCH.Clearnet (LCH) and the Swiss CCP SIX
x-clear.34
However, empirical data shows that such linkage between a small
domestic and a large international CCP is not desirable. While the risk of
a CCP default is lower than the risk of a clearing member defaulting, the
higher exposure of the domestic CCP does not correlate beneficially to
the netting abilities, and if the domestic CCP only has a few members, it
increases the individual clearing member’s exposure in a non-beneficial
way.35 This is an expansion on Mägerle and Nellen’s work that also
analysed the effects of interoperability on systemic risk.36 They conclude
that interoperability agreements can reduce inefficiencies resulting from
multiple CCPs clearing the same asset classes by increasing multilateral
netting opportunities while reducing margin requirements, default fund
contributions and counterparty exposures.37 The European regulation
31
2016) 6, 2, 17.
32
Ibid 2 and 4.
33
Ibid 4.
34
Ibid 5; SIX x-clear and LCH.Clearnet, ‘Link Agreement Summary
between LCH.Clearnet Ltd. and SIX x-Clear AG’ (3 September 2017)
<https://www.six-securities-services.com/dam/downloads/clearing/about-us/inter
operability/clr-x-clear-lchcearnet-link-agreement-en.pdf> accessed 3 September
2017.
35
2016) 6, 24–5.
36
Jürg Mägerle and Thomas Nellen, ‘Interoperability between Central
37
Ibid 8–9, 22; Darrell Duffie and Haoxiang Zhu, ‘Does a Central Clearing
Counterparty Reduce Counterparty Risk?’ (2011) 1 The Review of Asset Pricing
Studies 74, 8–12, 20.
promotes interoperability agreements between CCPs. However, Mägerle

and Nellen show that such interoperability agreements often suffer
from under-collateralisation, thus increasing systemic risk concerns. To
counteract this tendency, additional collateral is required by regulators if
CCPs enter into such agreements, leading to a further increase in
collateral demands which results in higher costs for clearing members.38
7.2.1.2.2 Collateral demand The recent financial crisis has increased

demand for collateral on a global scale. This can be attributed to the
change in financial regulation in two separate areas. First, the lessons
from the financial crisis led to financial market reforms. Particularly in
Europe, multiple sources can be identified which have led to an increase
in collateral: trends in the private European repo market, the OTC
derivatives reform, EU Solvency II and CRD IV and the new Basel III
liquidity requirements.39 Additionally, non-standardised monetary policy,
such as quantitative easing, increased collateral demand, as did the
official sector for currency management purposes.40 Increased collateral
demand makes collateral more costly and scarce. To deal with the lack of
adequate collateral, the re-hypothecation of collateral is suggested.41 As
collateral generally has to be in cash or highly liquid securities, there is
only a limited supply. Banks generally re-use collateral posted to them,
despite not being the owners of the collateral.42 Large global banks are
most likely to feel the pressure from increased collateral demands from
central clearing as they are the most frequent clearing members. It could
also offer them new business opportunities that were previously un-
economic.43 While Anderson et al. believe that there will be a sufficient
supply of collateral to fulfil the regulatory requirements, the set-up of the
market infrastructures will immobilise the collateral and therefore may
lead to temporary shortages.44
38
Jürg Mägerle and Thomas Nellen, ‘Interoperability between Central
39
Ronald W Anderson and Karin Joeveer, ‘The Economics of Collateral’
(April 2014), 6.
40
Ibid.
41
Manmohan Singh, ‘Under-collateralisation and Rehypothecation in the
OTC Derivatives Market’ (2010) 14 Financial Stability Review 113, 114.
42
Ibid.
43
(April 2014), 23–4, 32.
44
Ibid 35. See also: International Law Association, ‘Draft July 2016,
Johannesburg Conference’, Twelfth Report (2016) <on file with author>, 13.
Thus, netting reduces exposure; however, it requires the use of costly

and scarce collateral to do so. Duffie and Zhu, Anderson and Joeveer, and
Mägerle and Nellen analysed the implications of clearing for collateral
and reached the following conclusion: while one single global CCP
would allow for optimal multilateral netting, the regulatory approach has
already fragmented the market too much to achieve this and a single
global CCP would also raise large questions regarding systemic risk
management. Therefore, market fragmentation currently exists, reducing
the benefits of multilateral netting and increasing collateral demand and
the costs thereof. In turn, regulators are attempting to promote linkage
and interoperability agreements between CCPs, but small domestic CCPs
with few members are at a disadvantage if they enter into such an
agreement with a large global CCP because of the potential cost of
default of the larger CCP. At the same time, any interoperability
agreement may increase the systemic risk of the linked CCPs because
there may be insufficient collateralisation, or if regulators actively
promote heavy collateralisation, over-collateralisation, and thereby
increase the collateral demand and cost artificially.45 Therefore, CCP
linkage can currently only be described as a lose–lose situation. Further-
more, non-cleared contracts are demanding higher collateral as well to
prevent risks and circumvention of mandatory clearing, which add-
itionally contributes to the collateral drain.46
7.2.1.3 Default management

The collection of collateral, initial and variation margins, as well as
default fund contributions, permits CCPs a different approach compared
with the bilateral market. This difference is particularly noticeable in the
case of counterparty default, where losses are mutualised among clearing
members.47
In the bilateral OTC market, counterparties are left to find a replace-
ment for a defaulted position by means of regular trading mechanisms.
Depending on the size of the positions that need to be filled, as was the
case in the wake of Lehman Brothers’ collapse, the sudden increase in
45
See also Jürg Mägerle and Thomas Nellen, ‘Interoperability between
Central Counterparties’ (August 2011) 12, 23.
46
See margin requirements for non-centrally cleared CCPs. See also Man-
mohan Singh, ‘Collateral Netting and Systemic Risk in the OTC Derivatives
Market’ (April 2010) 99, 9 and 11.
47
replacement transactions and fire sales can send the market spiralling.48
Not only can there be a shortage of potential counterparties, but there
may also be a sudden shortage of liquidity and distrust among market
participants.49 Such an event and the following necessity to replace a
large number of defaulted positions within a short amount of time, in a
market already stripped of liquidity, could increase price volatility. Such
price shocks could in turn lead to fire sales, resulting in substantial losses
and could ultimately threaten the solvency of other market participants as
well.50 Fears of such disruptive events have led to bail-outs by lenders of
last resort.51
Regarding financial resources, there are two main principles: the
defaulter-pays and the survivors-pay principles.52 While the defaulter-
pays principle requires clearing members to post collateral for their
current transactions in the form of margins, the survivors-pay principle
requires the existence of a pre-capitalised collective default fund. While
under the first system the CCP relies on the margins by the defaulted
party to cover losses arising from the member default, the second system
relies on the default fund to cover the losses.53 These two default systems
are generally implemented side by side, where the defaulter-pays margin
contributions are calculated to cover losses under normal market circum-
stances while the survivors-pay principle only comes into play if the
default occurs under highly volatile market conditions, or if there were
otherwise insufficient funds.54 Additionally, CCPs may have emergency
credit lines from domestic and international commercial banks, which
could, however, increase the moral hazard dilemma.55 Thus, it is pertinent
48
Journal, 8, 22.
49
Ibid.
50
Ibid.
51
Such as LTCM (1998), AIG (2008).
52
Philipp Haene and Andy Sturm, ‘Optimal Central Counterparty Risk
Management’ (June 2009) 8, 2.
53
Ibid.
54
See also Christian Chamorro-Courtland, ‘The Trillion Dollar Question:
Can a Central Bank Bail Out a Central Counterparty Clearing House Which is
“Too Big to Fail”?’ (2012) 6 Brooklyn Journal of Corporate, Financial &
Commercial Law 432, 449–50.
55
Ibid 450–451. For a discussion of moral hazard, see Chapter 1, Section
1.2 and Chapter 6, Section 6.2.2.2.
to ensure that survivors-pay funds are pre-funded sufficiently so no

additional funds are required.56
The default fund is another benefit of clearing by means of a CCP,
helping the CCP to provide market confidence while winding down,
closing out and transferring the defaulter’s positions to other solvent
clearing members.57 This was proven by LCH when it successfully
wound down Lehman Brothers’ USD 9 trillion exposure. The CCP has a
waterfall default mechanism where first the defaulter’s own collateral
contributions are used and, if these are insufficient, the surviving
members’ default contributions will be used followed by the CCP’s own
capital.58 The CCP’s own capital is referred to as ‘skin in the game’ and
is necessary to incentivise, particularly for-profit organised, CCPs to
adequately monitor their risks.59 Thus, the CCP’s capital is highly
relevant to the stability of the organisation and risk mitigation approach.
Whether the current ‘skin in the game’ is sufficient is another question.
7.2.1.3.1 Skin in the game The current regulatory framework enables

the CCP to shift the ultimate financial loss from its own balance sheet
onto its members, by first depleting all contributions of the clearing
members, then the clearing member funded default fund, as well as
requesting additional member contributions, before accessing its own
financial resources. While this serves overall financial stability by
shielding the CCP’s own financial resources from market movements, it
56
BlackRock, ‘Roundtable on Recovery of Derivatives Clearing Organ-
izations’ (27 April 2015) <https://www.blackrock.com/corporate/en-us/literature/
publication/cftc-recovery-of-derivatives-clearing-organizations-042715.pdf> ac-
cessed 3 September 2017, 1.
57
Christian Chamorro-Courtland, ‘The Trillion Dollar Question: Can a
Central Bank Bail Out a Central Counterparty Clearing House Which is “Too
Big to Fail”?’ (2012) 6 Brooklyn Journal of Corporate, Financial & Commercial
Law 432, 442–3.
58
Article 45 EMIR; Dietrich Domanski, Leonardo Gambacorta and Cristina
Picillo, ‘Central Clearing: Trends and Current Issues’ [2015] BIS Quarterly
Review 59, 61; Christian Chamorro-Courtland, ‘The Trillion Dollar Question:
Commercial Law 432, 443.
59
counter Derivatives Symposium, Chicago, 11 April 2014), 5; Robert Cox and
Robert Steigerwald, ‘Tensions at For-profit CCPs Could Put Them at Risk’ Risk
Magazine (New York, 18 February 2016) <http://www.risk.net/risk/opinion/
2447480/tensions-at-for-profit-ccps-could-put-them-at-risk> accessed 3 Septem-
ber 2017.
also reduces the CCP’s own interests in ensuring that it does all within its
powers, to ensure prudent risk management.60 In connection with the
ownership structure of the CCP,61 this process shields the investors from
insisting on prudent risk management.62 This lack of skin in the game
could incentivise shareholders and management of a CCP to clear
high-risk products at lower costs, to attract additional business and
maximise profits.63 Given the systemic role of the CCP, they inherently
assume public support in a situation of financial distress. This under-
mines the core objective and selling point of the original derivatives
reform, promising that the skin in the game of CCPs will be sufficiently
great to ensure they avoid moral hazard and support prudential oversight
over the markets.64
7.2.1.3.2 Valuation errors European regulation demands that the CCP

hold sufficient collateral to deal with the default of its largest member, or
second and third largest combined, if the exposure to them is greater.65
However, as new and more complex derivatives are deemed sufficiently
standardised for clearing, CCPs are facing a dilemma as they lack
experience in pricing risk exposure to these products. Errors in valuation
of contracts also negatively impact the structure and reliance of collateral.
Collateral is valuated either once or multiple times a day, pegging it to
the market value of the asset (‘mark-to-market’).66 As the selection of
collateral is decided between the parties, a sudden decrease in the market
value of an asset can lead to a distinctive loss in collateral and the CCP’s
safety cushion.67 Additionally, as more exotic and bespoke derivatives are
cleared, CCPs face a lack of historic values to find a benchmark
valuation.68 This could lead to incentives of adverse selection, as will be
60
See also Paolo Saguato, ‘The Ownership of Clearinghouses: When “Skin
in the Game” is Not Enough, the Remutualization of Clearinghouses’ (2017) 34
Yale Journal 601, 641.
61
See Section 7.2.2.4.2.
62
Paolo Saguato, ‘The Ownership of Clearinghouses: When “Skin in the
Game” is Not Enough, the Remutualization of Clearinghouses’ (2017) 34 Yale
Journal 601, 641.
63
Ibid 642–3.
64
Ibid 643.
65
Article 16 EMIR.
66
67
Ibid.
68
Ibid; International Law Association, ‘Draft July 2016, Johannesburg
Conference’, Twelfth Report (2016) <on file with author>, 13–14.
shown later. Complex instruments, traded in less liquid markets, increase

complexity to determine their fair market value. Price – and risk
calculations – thus require complex models to valuate. Big dealer firms
who have specialised in these types of trades over the past few years have
invested many resources to develop and test these models. Such models
are also necessary to adequately collect collateral from trade partners.69
This creates a great incentive for private dealers to optimise their models
and update them on a regular basis. In contrast, the model benefits all
members of a CCP, leading to the CCP’s model being considered a
public good, thus weakening members’ incentives to push (e.g. through
means of collective action) for better models to be created and imple-
mented.70 Not only do they allow the dealer firm to quantify price and
default risk better, but good models also allow for higher trading profits
by gaining an information advantage in valuing the different instru-
ments.71 Such trades are new for CCPs, leaving them at an information
disadvantage from the start in comparison with private dealer firms. A
second disadvantage can be found between CCP models and bank
models. Because banks continuously interact with their counterparties on
multiple dimensions, they have better insight into the risk stemming from
their counterparties and CCPs that only interact for derivatives trades,
putting them at a further disadvantage to effectively price their expo-
sure.72 It is important to state that the accuracy of loss estimates in a
default scenario is subject to the same errors and inaccuracies that
bilateral counterparties faced prior to the reform.73
With regard to credit-derivative trading, determining the adequate
collateral to protect the CCP from a potential default is even more
complicated than for other instruments. Additionally, the negative impact
of newly cleared products and a lack of previous experience with these
69
70
Journal 8, 15.
71
Ibid.
72
(April 2014), 18–19, 22; see also Craig Pirrong, ‘The Inefficiency of Clearing
Mandates’ (2010) 665 Cato Journal 8, 15.
73
See also International Law Association, ‘Draft July 2016, Johannesburg
instruments add to the difficulties related to marking them to market,

especially in the early days and as new subforms are created.74
7.2.1.3.3 Clearing of CDS As was shown in the second chapter,

credit default swaps (CDS) have been found to be particularly risky
derivatives because of their insurance-like promise in cases where a third
party experiences a credit event, particularly default or bankruptcy.75
Despite CDS being a newer addition to the OTC derivatives market, they
played a central role in the financial crisis of 2007–2009 and were the
reason AIG needed to be bailed out. This demonstrates their ability to
inflict great financial damage. CDS create a special risk in addition to
counterparty default risk, which is referred to as ‘jump-to-default’ risk.76
Jump-to-default risk goes beyond regular non-performance risk, because
unlike a swap, there is no gradual fluctuation over time, but there is a
sudden, rapid escalation of events once the credit event incurs, i.e. a
sudden jump to default by the reference entity. Such a credit event is
likely to occur in times of general market downturn, contributing
negatively to the pro-cyclicality of these derivatives, as opposed to
others.77 CDS also increase systemic risk resulting from overlapping
CDS exposure, particularly demonstrated by AIG, which was seen as a
threat to financial stability. Therefore, the EU and the United States have
mandated standardised CDS to be cleared by CCPs.78
With the risk from CDS being deflected upon CCPs as well, the
increase in inherent systemic risk to CCPs is colossal.79 Unlike other
derivatives contracts where mark-to-market margin collection can aid in
reducing systemic risk, the ability of a CDS to suddenly jump to maturity
makes these particularly hazardous to CCPs. Nevertheless, CCPs have
been given neither any options to manage the risk stemming from the
underlying nor other risk mitigation tools to specifically address the
jump-to-default risk from CDS. Yadav, Kress and Chamorro-Courtland
all share the author’s view and find CDS to be a particular threat to the
74
75
76
Ibid 56.
77
Ibid.
78
Ibid 57–60 and 69–70.
79
See International Law Association, ‘Draft July 2016, Johannesburg Con-
ference’, Twelfth Report (2016) <on file with author>, 11, 13–14.
stability of CCP, potentially making the margins and default contributions

evaporate instantaneously.80 Thus, the lack of experience with pricing
many derivatives contracts – and particularly the special nature of CDS –
together with the reliance on CCP client risk calculations, should
additionally increase the level of collateral held in case of miscalculations
and under-pricing of risk. The creation of new CCPs, the addition of
client clearing and the clearing mandate reduce the choosiness of CCPs
as to who can be affiliated,81 which is yet another argument for higher
capital requirements for CCPs (particularly in the early stages of manda-
tory clearing) while clearing requirements continue to be phased in.
Especially since the mandatory clearing will require many more OTC
contracts from many different counterparties and new clearing members
to be cleared, the need for qualitatively high-standing collateral in greater
quantities increases.82 It can also be expected, as mandatory clearing
continues to become more prevalent, that an ever growing amount of
CDS will be shifted from the bilateral to the cleared markets.83 As shown
earlier, CCPs lack any reliable source of information when a new product
is cleared for the first time. The risk for information asymmetries and
adverse selection is particularly great in the early stages, i.e. before the
CCP gains experience with the product. Standards and capital require-
ments can always be decreased if they prove to be unnecessarily
80
Georgia Journal of International and Comparative Law 161, 164; Jeremy C
Kress, ‘Credit Default Swaps, Clearinghouses and Systemic Risk: Why Central-
ized Counterparties Must Have Access to Central Bank Liquidity’ (2011) 48
Harvard Journal on Legislation 49, 79; Christian Chamorro-Courtland, ‘The
Trillion Dollar Question: Can a Central Bank Bail Out a Central Counterparty
Clearing House Which is “Too Big to Fail”?’ (2012) 6 Brooklyn Journal of
Corporate, Financial & Commercial Law 432, 456–8.
81
See the ‘non-discriminatory access’ to be granted to contracts needing
clearing (Article 7 (1) EMIR), the clear regulatory push to allow for trading
venue access to the CCP in most cases (Article 7 (3) EMIR: ‘[The] CCP may
refuse access to the CCP following a formal request by a trading venue only
where such access would threaten the smooth and orderly function of the markets
of adversely affect systemic risk’), and the competition between the individual
CCPs to provide access to clearing for economic reasons.
82
245.
83
Georgia Journal of International and Comparative Law 161, 164.
stringent. EMIR calls for regular stress-testing84 to ensure that it is

resilient ‘in extreme but plausible market conditions’ (Article 49 (1)
EMIR), but does not have any mandatory regulation for CCPs to take
into account their exposure to concentrated liquidity and market risk that
results from their interconnectedness in the market.85
7.2.2 Systemic Risk and CCPs
For the aforementioned reasons, the derivatives reform has led to risk
concentration within CCPs instead of the bilateral market.86 The State
regulators have turned a market participant – the CCP – into the primary
regulator of the derivatives market, despite the many risks inherent to this
market participant.87 CCPs could become insolvent for many reasons,
including risk concentration, operational risk, financial innovation, moral
hazard, adverse selection, linkage risk and interoperability agreements,
and liquidity shortages.88
Mandating clearing for OTC derivatives creates strong incentives to
game the system in one’s own favour, increasing the dangers of moral
hazard, adverse selection and information asymmetry. At the same time,
clearing pools multiple counterparties’ risks within the CCP, requiring
CCPs to have strong risk-management practices in place to counter-
balance any negative exposure and prevent failure. However, one of the
most important aspects for the stability of the financial system and the
84
Article 49 (1) EMIR.
85
The CPSS and IOSCO, ‘Principles for Financial Market Infrastructures’
(April 2012), however, require CCPs to have transparent rules and contingency
plans in case of uncovered liquidity shortfalls or multiple defaults. However,
such norms lack in the European recovery and resolution framework. See Lieven
Hermans, Peter McGoldrick and Heiko Schmiedel, ‘Central Counterparties and
Systemic Risk’ (November 2013) 6, 5.
86
See also Rüdiger Wilhelmi and Benjamin Bluhm, ‘Systemische Risiken
Im Zusammenhang Mit OTC Derivaten’ in Rüdiger Wilhelmi and others (eds),
Handbuch EMIR (Erich Schmidt Verlag), 51–6; International Law Association,
author>, 11.
87
See Yesha Yadav, ‘Clearinghouses and Regulation by Proxy’ (2014) 43
88
See also Christian Chamorro-Courtland, ‘The Trillion Dollar Question:
Commercial Law 432, 437.
trust towards a CCP concerns what happens if a CCP should fail. These
questions will be analysed and answered next.
7.2.2.1 Risk concentration

Clearing is supposed to reduce systemic risk by netting and mutualising
losses among clearing members. However, it also concentrates systemic
risk within CCPs, which undermines the intended distribution of risk
across the financial system.89 Kress offers the following fitting analogy:
‘while the failure of a bilateral dealer may have a domino effect, the
failure of a CCP would have a bulldozer effect’.90 In the introductory
chapter, the connection between systemic risk and macro-prudential
policy decisions was introduced. The importance of creating a buffer in
years of financial boom to sustain and protect from default after a
downturn was explained and it was shown that CCPs achieve this by
collecting collateral and having a default fund ready.
Two mechanisms of systemic risk in particular can potentially multiply
and interact with each other. One is a domino effect: one default may
trigger other participants to default within the same clearing scheme by
causing losses and ultimately sending a shockwave through the system.
Another can be triggered by risk-management practices related to clear-
ing, where even in the absence of a default a market scenario might lead
to a ‘run and deleveraging’ mechanism.91 As risk concentration within
CCPs among clearing members and between other financial institutions
and financial market infrastructures grows on both national and inter-
national levels, strong risk-management practices to keep these risks in
check are necessary.92 Membership overlaps across CCPs are to be
expected, particularly for global systemically important financial insti-
tutions. As CCPs are particularly vulnerable towards these institutions,
special interest needs to be paid to potential risk exposure here.93
89
See also Jeremy C Kress, ‘Credit Default Swaps, Clearinghouses and
Bank Liquidity’ (2011) 48 Harvard Journal on Legislation 49, 73; International
Law Association, ‘Draft July 2016, Johannesburg Conference’, Twelfth Report
(2016) <on file with author>, 11.
90
91
Clearing: Trends and Current Issues’ [2015] BIS Quarterly Review 59, 65, 68.
92
93
Ibid 9.
The likelihood of a domino effect hinges on the size of the shock and
the overall resources held by the CCP.94 Small shocks are likely to be
absorbed well by CCPs, particularly if the defaulting member provided
sufficient funds to cover all losses resulting from his own default. Once
the defaulter’s own resources are insufficient to cover the losses and other
participants are required to contribute, the same structure that makes the
regularly functioning system resilient may prove to exacerbate issues and
be a source of instability.95 There must be the realisation that small
shocks and defaults can be handled by CCPs. Larger, potentially systemic
shocks leading to multiple defaults, particularly if the CCP must access
its own liquidity and additional liquidity lines from banks, may prove to
be too big to handle. In particular, the liquidity access and liquidity lines
from banks may dry up if the bank themselves are suffering from
liquidity problems owing to a systemic shock, and may in fact lead to an
even stronger domino effect than in the absence of clearing structures.96
Domino effects can also be enhanced if the CCP finds itself in a
position where it must activate unfunded liquidity arrangements and
expect participants to make additional capital contributions, thereby
leading to additional stress for market participants and contributing to
further defaults.97 Ultimately, such a cascade of defaults can exhaust all
liquidity of the CCP, forcing it into resolution and failure. The failure of
a CCP can additionally strain the participants of the now failed CCP, as
they must close their trades differently in a generally unstable market
environment. As most participants participate in multiple clearing
arrangements and CCPs, the default of common counterparties can cause
similar troubles for multiple CCPs across jurisdictions simultaneously.98
It is important to recognise that CCPs – particularly their risk-
management practices – and the non-cleared market, underlying assets
and collateral remain tightly interwoven, giving any sudden price move-
ment the ability to have a dramatic impact on their further development.
94
95
Ibid; International Law Association, ‘Draft July 2016, Johannesburg
Conference’, Twelfth Report (2016) <on file with author>, 14.
96
Clearing: Trends and Current Issues’ [2015] BIS Quarterly Review 59, 68. See
also discussion in International Law Association, ‘Draft July 2016, Johannesburg
97
98
Ibid 68–9.
While only a few CCPs have failed in recent history, the near-failures do
show that public intervention was necessary. Those needing public
intervention include the Caisse de Liquidation in Paris in 1974 following
a sharp downturn in sugar futures, the Commodities Clearing House in
Kuala Lumpur in 1983 following a crash in palm oil futures and the
Hong Kong Futures Exchange in 1987 after the global stock market
crash.99
CCPs are generally owned by a for-profit group which directly
counteracts the objective of CCPs’ acting in a counter-cyclical way.
During times of market growth, CCPs can be expected to lower margins
to promote profit and growth, but to increase margin payments when
market deterioration is occurring, acting in a pro-cyclical way instead.100
Such pro-cyclicality directly impacts the CCP’s ability to deal with the
risk arising. Brunnermeier et al. identify three core reasons for why
liquidity spirals contribute to pro-cyclicality, including backwards-
looking risk measures, varying volatility and adverse selection.101 To
counteract this tendency, margin calls and haircuts should be chosen
carefully from the start, to reduce the urge of a CCP to immediately raise
margins and haircuts when market volatility strikes and to promote
information availability to counterbalance information asymmetry artifi-
cially shortening the available liquidity.102
7.2.2.2 Adverse selection and information asymmetry

If one side to a contract possesses more information regarding the
contract than the other, this is referred to as information asymmetry.
When the same situation occurs just prior to two or more parties entering
into a contract or trade, this is referred to as adverse selection.103 Akerlof
99
Counterparties and Systemic Risk’ (November 2013) 6, 9 fn 16.
100
counter Derivatives Symposium, Chicago, 11 April 2014), 7–8; Paolo Saguato,
‘The Ownership of Clearinghouses: When “Skin in the Game” is Not Enough,
the Remutualization of Clearinghouses’ (2017) 34 Yale Journal 601, 643.
101
cial Regulation’ (June 2009) 11, 22; see also: International Law Association,
author>, 13.
102
cial Regulation’ (June 2009) 11, 22.
103
Quy-Toan Do, ‘Asymmetric Information’, 1 (September 2003) <http://site
resources.worldbank.org/DEC/Resources/84797-1114437274304/Asymmetric_
Info_Sep2003.pdf> accessed 3 September 2017.
uses the market for used cars (‘lemons’ and ‘plums’) to describe how
information asymmetry and adverse selection play out on the market.104
A CCP is susceptible to adverse selection and information asymmetries
from two factors.
The basic structure of a CCP allows for losses from the default of a
clearing member to be divided among the remaining solvent members.
Yadav uses game theory (‘stag hunt’) to describe adverse incentive.105
She describes the following scenario: pay-off depends on the cooperation
between all participants. If the parties collaborate correctly by adhering
to the rules, they catch the stag, if they do not, because the parties veer
off to pursue their own gains, they catch ‘hares’. The optimal solution
would be all parties collaborating, but as it is hard to tell which purpose
the others are following, some might begin pursuing ‘hares’ instead,
veering from the original objective of catching the ‘stag’.106 Translating
this back to clearing, optimal risk mitigation is a goal that must be
pursued by all clearing members, clients and the CCP itself. Any lenience
and negligence could lead to high costs.
The second reason stems from how counterparties and CCPs calculate
their risk exposure.107 Both sides need to model the risk and the side
which has more accurate models has an advantage over the other. The
derivatives’ creator and seller benefits from a large pool of background
information, models and forecasts; the more bespoke the product is, the
stronger the chances are of one party taking advantage of the contract
partner’s ignorance.108 Such ‘ignorance or informational failure’ could be
the result of commercial innocence, documentary misunderstandings
and/or technical ignorance.109 Commercial innocence refers to non-
professional investors who lack an understanding of what they are
104
George A Akerlof, ‘The Market for “Lemons”: Quality Uncertainty and
the Market Mechanism’ (1970) 84 The Quarterly Journal of Economics 488,
489–90.
105
town Law Journal 387, 417–19.
106
Ibid 417–18.
107
These models may be subject to the same errors as bilateral counterpar-
ties prior to the financial crisis, see International Law Association, ‘Draft July
2016, Johannesburg Conference’, Twelfth Report (2016) <on file with author>,
14.
108
Michael AH Dempster, Elena A Medova and Julian Roberts, ‘Regulating
Complex Derivatives: Can the Opaque Be Made Transparent?’ in Kern Alexander
and Niamh Moloney (eds), Law Reform and Financial Markets (Edward Elgar
2011), 113.
109
Ibid.
purchasing, relying instead on the sales pitch delivered by financial

advisors. MiFID I began restricting market entry by subdividing partici-
pants into retail, professional and eligible counterparties, but the duty of
care is extremely abstract.110 Legal understanding is explained as the lack
of understanding of the depth and impact of complex structured financial
contracts. Misleading names, concealed subagreements and a multitude
of interlinked agreements can quickly obscure the true implication of a
bespoke product, particularly if the price is appealing and it is offered in
a convincing manner.111
Technical misunderstandings, particularly misunderstandings in the
valuation of structured products, are common. Statistical distribution for
the valuation can only be completed with highly complex models,
beyond the grasp of all non-mathematicians and too costly for average
client counterparties to banks.112 Additionally, the language used for
derivatives trading is not intuitive, so it is hard to understand what
exactly the buyer is purchasing. When claims made it to the German
courts, banks openly explained that they had attempted to get a fair
market value (the statistical distribution specifying the price of the
instrument in relation to the forward income stream and adjusting this for
risk) before moving the strike (the line dividing the two parties’ expected
returns) as far in favour of the banks as they could find counterparties
willing to go.113 Needless to say, the buyers had no idea what the fair
market price was, or how the banks had calculated it, relying entirely on
the information provided to them. While clearing members are all
professional clients, these dangers are less imminent amongst each other;
however, it goes to show that counterparties are willing to push the
boundaries as far as possible to their own advantage. These are the same
counterparties which CCPs must greatly rely on for information, accord-
ing to the reform. How can this guarantee their effectiveness? Clearing
members directly profit from providing lower risk implications, as lower
risk requires them to contribute less collateral. This directly leads to
problems of information asymmetries and adverse selection.
Underestimating third-party exposure related to client clearing is an
oversight of regulation and may be underestimated by CCPs. Depending
on the national framework, clearing members may not be required to
directly divulge the nature of the contract between themselves and the
non-clearing member to the CCP or only upon the request thereof. Such
110
Ibid 114.
111
Ibid 115–16.
112
Ibid 116.
113
With additional references: ibid 117.
indirect participation has increased, particularly by small banks and

financial intermediaries wishing to reduce fixed costs that are related to
participation, if they have limited activity in the derivatives market.114 So
even if the total number of clearing participants remains relatively small,
the number of direct participants providing client clearing services
increases, especially as a result of the clearing mandate.115 A lack of
disclosure of such exposure could lead to the accumulation of risk
exposure for a specific third party, without this being adequately consid-
ered by the CCPs or taken into consideration with risk weightings and
margin collections.
This information asymmetry can be translated from the market partici-
pants among each other to market participants interacting with the CCP.
Again, the models and forecasts, fair market value and strike prices can
be tipped in favour of one party in the contractual relationship between
the counterparties before the contract is cleared by the CCP. The CCP
must rely on the information it is receiving, as the flood of information
makes it impossible both financially and for resource reasons to do one’s
own calculations. Such blind spots and miscalculations of risk may leave
the CCP unprepared for shocks and distort the risk models, similar to
how the market was taken by surprise, which can wreak havoc in the
even more interconnected market and the global clearing system.
7.2.2.3 Moral hazard

By mandating central clearing, the natural selection process for the most
sound and financially reliable counterparty is removed because the CCP
novates the contract, ultimately becoming responsible for fulfilling the
counterparties’ contractual obligations to one another. Thus, having a
third party ultimately become liable for the fulfilment of the contract
increases the risk taking of the individual – ergo moral hazard.116 CCPs
are heavily exposed to the moral hazard of their clearing members.
In order to counteract this moral hazard, CCPs collect margin and
collateral payments from their clearing members.117 Generally, CCPs do
not vary risk pricing and set collateral levels in accordance with the
member’s portfolio of cleared products and/or credit ratings, with regard
114
115
Ibid 62 and 64–5.
116
Kevin Dowd, ‘Moral Hazard and the Financial Crisis’ (2009) 29 Cato
Journal 141, 142.
117
counter Derivatives Symposium, Chicago, 11 April 2014), 5.
to their overall balance-sheet risk.118 Large and influential members may

be incentivised to influence the respective CCP to favourably price their
risk positions to decrease their overall collateral requirement. Pirrong
predicts too little margin to be the more frequent problem, leaving the
CCP exposed to greater default losses than predicted by its models.119
However, the incentives of both clearing members and the CCP itself
should ultimately be to control such recklessness, as it leads to higher
risk and a greater chance of needing to contribute further capital in case
of a member default.120
It is necessary to fully explore the regulatory risks by concentrating
systemic risk within the CCP. It is the author’s opinion that regulators
have not considered the heterogeneous group that clearing members
represent and the distortion of incentives some of the members and the
owners of the CCP may pursue under the current regulation.121 Infor-
mation asymmetry and the cost of moral hazard have not been adequately
explored. CCPs, because of their function as guarantors, may increase
motivation to externalise costs for reckless lending, maximising company
profits for their shareholders while shifting the majority of the risk onto
the CCP members.122 Risky contracts among counterparties are likelier to
occur if guaranteed returns exist. CCPs do just this: to avoid contagion in
the market, they guarantee that they will step in and return losses in case
of counterparty default. Not only do incentives to monitor the under-
writings diminish further, but counterparty due diligence also decreases
as there is always a third party to step in and reimburse the counterparty
of the defaulting party.123 So, if one member enters into contracts that
prove to be too risky, other clearing members must bear the cost through
118
Journal, 8, 17.
119
Ibid 16.
120
Ibid.
121
Similar opinion: Yesha Yadav, ‘Clearinghouses in Complex Markets’
(2013) 101 Georgetown Law Journal 387, 416–20; Paolo Saguato, ‘The Owner-
ship of Clearinghouses: When “Skin in the Game” is Not Enough, the Remutual-
ization of Clearinghouses’ (2017) 34 Yale Journal 601, 637–40.
122
Journal 601, 643.
123
Same opinion: Rüdiger Wilhelmi and Benjamin Bluhm, ‘Systemische
Risiken Im Zusammenhang Mit OTC Derivaten’ in Rüdiger Wilhelmi and others
(eds), Handbuch EMIR (Erich Schmidt), 51–2, N 9–10.
mutualisation.124 This encourages parties to discover ways to exploit the

risk-sharing features of the CCP for their own profit. This feature is not
addressed sufficiently by regulation. In return, the CCP is left without
adequate tools to detect and protect itself against such strategies. This
information asymmetry also encourages other parties to exploit the CCP
as they become aware that they are being ‘played’ by other members and
therefore decide to join the game.
Moreover, if a CCP considers itself to be systemically important and
thus too-big-to-fail, this might further increase its risk taking by the
owners and shareholders because the members of the CCP or public
funding would be used in case it experiences liquidity shortages or
default owing to excessive risk taking or insufficient risk-management
practices.125 Thus, new risks may be created by permitting CCPs to have
access to emergency credit lines provided by commercial banks or even
central banks.126
7.2.2.4 CCP authorisation requirements

Market entry levels for CCPs according to EMIR are very low. Art-
icle 16(1) EMIR requires CCPs to have a permanent minimum capital
level of EUR 7.5 million. In Europe, Article 16(3) EMIR advises the
European Banking Authority, European System of Central Banks and
ESMA to find technical standards to ensure that the capital, retained
earnings and reserves of the CCP are in proportion to the risk of the
124
Craig Pirrong, ‘The Economics of Clearing in Derivatives Markets
Netting, Asymmetric Information and the Sharing of Default Risks Through a
Central Counterparty’, 15 and 49.
125
Liquidity’ (2011) 48 Harvard Journal on Legislation 49, 73; Christian Chamorro-
Courtland, ‘The Trillion Dollar Question: Can a Central Bank Bail Out a Central
Counterparty Clearing House Which is “Too Big to Fail”?’ (2012) 6 Brooklyn
Journal of Corporate, Financial & Commercial Law 432, 438–40.
126
Law 432, 450. The argument for strong ties between the CCP and the central
bank has been made by other author’s earlier, see Stephan G Cecchetti, Jacob
Gyntelberg and Marc Hollanders, ‘Central Counterparties for Over-the-Counter
Derivatives’ [2009] BIS Quarterly Review 45, 45–55; Jeremy C Kress, ‘Credit
Default Swaps, Clearinghouses and Systemic Risk: Why Centralized Counter-
parties Must Have Access to Central Bank Liquidity’ (2011) 48 Harvard Journal
on Legislation 49, 49–79.
activities. However, even if they find higher capital allocations necessary

for the overall smooth functioning of the financial system, this will
require the long process of changing the regulation.127 The author does
not believe EUR 7.5 million to be sufficiently high for a systemically
important CCP.128 To ensure the ability of CCPs to successfully maintain
their obligation to the market, higher capital contributions by the CCP
and its members should be considered. LCH’s higher margin require-
ments resulted in its success dealing with Lehman Brothers’ collapse
without accessing its default fund. However, regulatory minimums are
lower than what LCH demanded.129 Initial and variation margins need to
be sufficiently high that a CCP never has to access its default fund. It is
unclear whether new CCPs will demand sufficiently high collateral from
their members, considering that they lack the experience that LCH had
and the competitive pressure from its members and the market may be
counterproductive.
EMIR does foresee additional capital to be held proportionate to the
risk of the CCP. However, this is the same risk that none of the market
participants were willing or able to assess in the time before 2007/2008.
Keeping in mind that, between 2007 and 2009, global stocks resulted in
losses of EUR 16 trillion, and in the same period, banks and insurance
companies were forced to write off over EUR 1 trillion,130 the prescribed
base capital for CCPs in the EU of EUR 7.5 million appears to be a drop
in the ocean.
7.2.2.4.1 Stress testing To determine whether the CCP has imple-

mented sufficient risk-management practices, regular stress testing is
mandated. Stress-testing models to determine exposure and weaknesses
cannot account for every possibility in extreme but plausible markets.
Even if a CCP attempts to prepare for a very large shock, there comes a
127
244.
128
Same opinion: ibid. Similar opinion: International Law Association,
author>, 14, stating that the CCPs own skin in the game must be sufficiently
high, to provide for a robust capital and incentives to monitor risk taking.
129
LCH.Clearnet, SA Derivatives, which demands 99.7% and Article 41
EMIR, which only demands 99 and 99.5% with the US being even lower at 99%.
See Chapter 5, Sections 5.3–5.4.
130
vision in the EU Report’ (25 February 2009), 6.
point where, from an ex ante perspective, insurance becomes too costly,

as the probability of this event occurring is too remote.131 Stress testing
cannot achieve absolute certainty that the financial institution can
weather every potential disaster in every constellation. Rather, the
ultimate goal of stress testing is to eliminate basic flaws in the system,
provide emergency training to all involved and optimise speed and
awareness of emergency procedures.132
Through stress testing, the ability of the CCP to withstand default of its
largest member, or its second and third largest members, if this is
exposure is greater, is tested. The first stress test results in Europe were
very positive.133 However, on Black Monday, 19 October 1987, a credit
crisis threatened the two largest US clearinghouses when more than a
dozen clearing members suddenly no longer fulfilled the capital require-
ments and half a dozen would have had to comply with margin calls that
exceeded their capital.134 It remains to be seen whether CCPs today could
weather such a crisis, but this study concludes that the CCP authorisation
requirements need to be more stringent. CCPs must hold higher capital
and the default fund should be able to sustain more potential defaults
than the regulation is currently anticipating.
7.2.2.4.2 CCP ownership There must also be unified provisions for

CCP ownership. As has been shown, the ownership structure of a central
counterparty has a measureable impact upon the risk that a CCP is
willing to take. Yet regulators have not defined a CCP ownership model
to prevent for-profit CCPs.135 Clearing members are already voicing
concerns that, despite providing the CCP with collateral to manage the
risk, they do not feel that they have received sufficient risk-monitoring
powers over the CCP.136 While the mutual CCP is owned and operated by
its clearing members, the demutualised CCP is operated for-profit. Both
131
Ben S Bernanke, ‘Clearing and Settlement during the Crash’ (1990) 3 The
Review of Financial Studies 133, 143–4.
132
(May 2011) 1, 24–6.
133
For details, see ESMA, ‘EU-Wide CCP Stress Test 2015’ (16 April 2016)
<https://www.esma.europa.eu/sites/default/files/library/2016-658_ccp_stress_test_
report_2015.pdf> accessed 3 September 2017.
134
135
E.g., Article 30 EMIR.
136
Robert Cox and Robert Steigerwald, ‘Tensions at For-profit CCPs Could
Put Them at Risk’ Risk Magazine (New York, 18 February 2016) <http://
mutualise losses among clearing members, but while the mutual CCP’s
risk management lies with the clearing members, the for-profit CCP has
risk-management practices spread between the CCP and clearing mem-
bers, thus reducing the say of the clearing members.137 The historic
excursus showed that originally all CCPs were mutually owned associ-
ations by the clearing members. This kept the clearing members’
incentives aligned and the fact that they would ultimately be responsible
for the losses resulting from a defaulted member by means of their ‘skin
in the game’ insured prudential risk management and CCP stability. It
was only in the last 20 years, following the boom of the OTC derivatives
market, that the business model shifted away from mutual associations to
for-profit corporations.138
While in both the EU and United States most CCPs are owned by
exchanges and operate on a for-profit shareholder-ownership model,139
the Bank of England suggests that user-owned, not-for-profit CCPs to
have stronger incentives to more closely monitor their own and their
members’ risk taking.140 The shareholder ownership increases incentives
to maximise profit, while limited liability decreases such incentives, as
negative externalities for members increase in case of failure since the
individual shareholder ultimately carries the risk. The economic lust for
profit is likely to blind for-profit organised CCPs towards the actual risk
they are taking on, as the incentive to increase revenue by attracting
additional clearing business from OTC derivatives to the CCP may be
www.risk.net/risk/opinion/2447480/tensions-at-for-profit-ccps-could-put-them-at-
risk> accessed 3 September 2017.
137
Ibid; Yesha Yadav, ‘Clearinghouses and Regulation by Proxy’ (2014) 43
Georgia Journal of International and Comparative Law 161 172–3; Paolo
Saguato, ‘The Ownership of Clearinghouses: When “Skin in the Game” is Not
Enough, the Remutualization of Clearinghouses’ (2017) 34 Yale Journal 601,
627.
138
3 April 2006), 37–9; Paolo Saguato, ‘The Ownership of Clearinghouses: When
“Skin in the Game” is Not Enough, the Remutualization of Clearinghouses’
(2017) 34 Yale Journal 601, 627.
139
250.
140
Bank of England, ‘Financial Stability Report’, 57 (December 2010) 28
<http://www.bankofengland.co.uk/publications/documents/fsr/2010/fsrfull1012.
pdf> accessed 3 September 2017.
faster than regulation to manage risk effectively. CCPs must find new
business by clearing new products. Herein lies the ultimate risk: if a
for-profit CCP lowers its standards for clearing membership, counterparty
credit risk is created, increasing the likelihood that other clearing
members will have to bear the costs of the CCP’s unsuccessful risk-
management practices.141 Such additional costs and collateral calls sud-
denly placed on clearing members could lead to the opposite of having
the CCP internalise the costs of failure and exacerbate the situation
further.142 Additionally, the necessity of creating new business can also
involve the CCP using the bottom-up clearing mechanism, which sug-
gests new products for clearing, despite them being riskier. To prevent
this from happening, clearing members are demanding greater say in
the risk-management practices of for-profit CCPs.143 As pointed out in
the introductory comments to this chapter, the hindsight approach to the
current regulatory reform cannot be ignored. Cox and Steigerwald point
out that, while legislators and regulators are attempting to pre-empt all
potential risks through regulation and stress testing ex ante, nobody can
envision every scenario. In case of a CCP experiencing liquidity short-
ages, it is essential to have a sound, trusting relationship between clearing
members and the CCP as they must work together to overcome it. 144
The CCP faces difficult choices in its day-to-day business, which is the
direct result of its complicated internal structure. In a demutualised CCP,
the shareholder’s interests may directly oppose those of the members.
This rift is further complicated as the financial interests also diverge.
Shareholders provide the equity capital and are interested in maximising
their profits, while having only a limited exposure to the losses of the
141
Journal 601, 631–2.
142
Ibid 632.
143
risk> accessed 3 September 2017; Paolo Saguato, ‘The Ownership of
Clearinghouses: When “Skin in the Game” is Not Enough, the Remutualization
of Clearinghouses’ (2017) 34 Yale Journal 601, 632–4.
144
risk> accessed 3 September 2017; Paolo Saguato, ‘The Ownership of
Clearinghouses: When “Skin in the Game” is Not Enough, the Remutualization
of Clearinghouses’ (2017) 34 Yale Journal 601, 632–4.
CCP. At the same time members provide the resources of the CCP’s
guarantee fund and may become subject to additional financial contribu-
tions and losses should the pre-funded mechanisms be insufficient.
Therefore, while the shareholders may prefer a high-risk, high-profit
strategy, the members would bear the consequences of this strategy,
making them oppose it more strongly.145 Saguato thus coins the phrase
that CCPs are ‘multi-stakeholder firms’, which must balance the interests
of shareholders, management and members.146 Therefore, while members
are the most committed towards pursuing a strategy that ensures financial
security, they are left without voting rights, while the management board
is responsible primarily to the company’s shareholders.
Yet a member-owned CCP may also bear risks, as the members may be
interested in promoting higher-risk clearing to generate higher returns.147
However, the fact that the CCP shares more information and simplifies
member communication may promote the development of rational strat-
egies to reduce risky trading and the pursuit of individual rewards.148 To
this end, the information must be comprehensible as to the other parties’
strategies and the information must be used to achieve an optimal
strategy.149
Finally, the dual role of the CCP in the market as both overseer and
market participant contains much potential for conflict. In particular, the
necessity to balance the business interests of generating profits through
sufficient volumes and services for a fee, while also investing heavily in
solid risk-management practices, places a highly unusual combination of
moral and business decision upon CCPs.150 The significant influence and
power the CCPs have been given in this new regulatory environment
should not to be underestimated. The regulators have left CCPs with a
difficult trade-off: cost versus risk. Thorough risk management will
increase costs relating to the use of the CCP for traders and market
participants, through increased collateral, other contributions and fees.
Considering that many traders and clearing members will react price
145
Journal 601, 633–44.
146
Ibid 637.
147
148
Ibid 420–21.
149
Ibid 421.
150
Georgia Journal of International and Comparative Law 161, 165–6.
sensitively and are likely to shift their business elsewhere if such

promises lower costs, the CCP is forced to make a trade-off, between
attracting more business at the cost of lowering its own risk-management
practices, or maintaining high risk-management standards without attract-
ing business and thus not fulfilling their shareholders’, or owners’,
objectives.151 These conflicting priorities of a CCP have been entirely
neglected in the legislative process.
7.2.2.5 Regulatory fragmentation

The comparison between the EU and the United States showed that,
despite their many similarities, the core G20 objective of creating a
globally harmonised approach to prevent regulatory arbitrage and higher
compliance costs has not been successful.152 This lack of regulatory
harmonisation cannot be solely blamed on nationalism and protectionism,
but also on the lack of innovative approaches by international standard-
setters, such as the FSB. While the FSB did not provide ideological
building blocks for how macro-prudential supervision and guidelines
should be constructed to implement the OTC derivatives market reform,
it is waiting to see which rules develop best and which are ineffective.153
This increases the fragmentation of rules and approaches, resulting in
incoherent and incompatible rules as well as the potential for regulatory
arbitrage.
The legislative process also missed an opportunity with regard to the
cross-border operations of CCPs. The CCP has the advantage of experi-
ences, expertise and proximity to the markets which no regulator
possesses at this time. The regulators aim to capitalise on this, by placing
much of their responsibility to oversee the market on these financial
market institutions, by mandating the CCPs to collect margins based on
their models, and in future even maintain their own recovery and
resolution plans. As such, CCPs will fulfil a gatekeeper function in the
financial markets, which is not without risk.154 However, the regulators
151
Ibid 173–4.
152
See Chapter 5, Sections 5.3–5.4; International Law Association, ‘Draft
July 2016, Johannesburg Conference’, Twelfth Report (2016) <on file with
author>, 4–6.
153
and its Regulation (Cambridge University Press 2016), 132–4.
154
have not managed to provide CCPs with sufficient tools to maximise

their cross-border insight and market powers, by maintaining heavily
fragmented regulatory frameworks. Potentially, a CCP could perceive a
market threat from its cross-border dealings, but not be able to react upon
it, owing to regulatory constraints and a lack of tools to combat the
situation.
7.2.2.6 Linkage risk

Linkage risk is based on how different players come together as CCP
participants and how this interconnection affects the market, especially
the linkage between CCPs and banks. There is an extraordinary level of
vulnerability of CCPs towards banks, as the two financial institutions
interact on four key levels.
Banks, regardless of size and systemic importance, are CCP partici-
pants, as they are end-users of derivatives and as such rely on the services
provided to clear their contracts. Larger and systemically relevant banks
are clearing members of multiple CCPs across various jurisdictions.155
Participation in various clearing schemes multiplies the interlinkages
between the two. Depending on how many other direct participants are
permitted to join, different levels of creditworthiness among clearing
participants are the result, potentially increasing risk exposure to a
decrease in credit quality in a specific financial segment.156 Thus, the first
linkage between banks and CCPs is the participation of banks as clearing
members. Next, owing to the participation of banks as clearing members,
they contribute financial resources to the CCP by providing both margins
and default fund contributions. Additionally, banks provide CCPs with
backup liquidity or lending facilities in case of the central counterparty
defaulting, so a failure to meet these liquidity lines in cases of market
turbulence will expose CCPs to liquidity risk.157 Such interconnectedness
was also identified by market participants as potentially increasing
pro-cyclicality in the EMIR review that was conducted.158
Risk-management prices, particularly additional contributions in the
form of variation margins, have been constructed with reliance on market
155
156
Ibid.
157
Ibid 62–3.
158
European Commission, ‘EMIR Review, Public Consultation, 2015
Summary of Contributions’ (11 September 2015) <http://ec.europa.eu/finance/
consultations/2015/emir-revision/docs/summary-of-responses_en.pdf> accessed
3 September 2017, 7.
prices to determine when additional contributions are necessary. Such

margin models based on value-at-risk have the potential to underestimate
the risk in times of calm, but aggravate risk when market stress has risen,
as the decline in collateral value would reduce the value of the initial
margin. This would trigger mechanisms within the CCP to post extra
collateral which could force members to deleverage and resort to fire
sales, amplifying the adverse market conditions.159 In reaction to this
finding, the European Commission is proposing to tackle this by man-
dating CCPs to divulge models to their clearing members, based on
which they can calculate their future margin contributions.160
Sudden shifts leading to liquidity shortages, collateral value falls and
CCPs’ risk management policies being scrutinised may increase doubts
over market stability and contravene the objectives of regulators to
increase user confidence in CCPs to prevent runs.161 CCPs must ensure
that they have accounted for the potential for abrupt price changes by
means of adequate haircuts. Finally, CCPs cannot be regarded as ring-
fenced entities that do not affect general market principles. Unexpected
asset freezing in financial markets directly impacts the ability of the CCP
to fulfil its default management procedures by preventing the sale of
non-cash collateral to cover losses. Vice versa, the close-out or transfer of
positions from a defaulting participant within the CCP can directly lead
to a loss of confidence in the rest of the market.162 Third, CCPs rely on
banks to provide them with financial services, such as the management of
cash margins or to deposit the financial instruments collected as collateral
for margins and default fund contributions.163 Lastly, banks are owners
of numerous CCPs.164 This ownership model potentially impacts risk
behaviour as user-owned CCPs have greater incentives to maintain a
159
160
161
See also Lynton Jones, ‘Current Issues Affecting the OTC Derivatives
Market and Its Importance to London’ (April 2009) <http://bourse-consult.com/
wp-content/uploads/2014/03/OTCDerivativesReportv21.pdf> accessed 3 Septem-
ber 2017, 19.
162
163
Ibid 63.
164
In 2006 stock exchanges owned 55%, while banks owned 35% of central
counterparties. In 2014 stock exchanges increased their ownership of CCPs to
83%, leaving banks with 14%, but still the second largest ownership group and
of the higher risk category of non-user-owned CCPs. See ibid 62–3.
homogeneous, high-quality participation base to help reduce costs and

risk for their users. A non-user-owned CCP’s primary objective is to
increase participation and therefore its profits, which negatively affects
risk management.165
Banks can be seen as CCPs’ primary financiers, but also the source of
their greatest risk. While banks provide a steady business to the CCPs
in which they participate, their interconnectedness with other riskier
counterparties and transactions have the potential to jeopardise the
clearing system.
7.2.2.7 Too-big-to-fail
It is paramount to realise that CCPs do not eliminate counterparty risk, as
they might fail themselves, if they do not have access to the necessary
resources in order to meet the costs to complete the contractual obliga-
tions for which they must stand.166 Considering the importance of CCPs
in the post-crisis financial system, the ultimate question to ask is, are they
just too-big-to-fail? If they are of such systemic importance, public funds
would be used to rescue CCPs if necessary. Demutualised CCPs have
been around since the 1990s and yet clearing members were not worried
about this ownership model until recently. The reason for this is that
CCPs were considered systemically important and clearing members and
CCP operators relied upon the notion of public funds being used to
rescue CCPs. However, since the clearing reforms, governments have
refrained from using public funds to do so, ultimately shifting the losses
to clearing members themselves.167
Yet at the same time, CCPs are being compared with central banks.
CCPs, like central banks, provide liquidity and insurance to the market,
thereby making financial markets more stable. Like central banks, they
assume a market position through novation and netting while protecting
themselves by collecting collateral. If the collateral fails or a large
counterparty fails, they are left with the exposure and the likelihood that
another counterparty may fail. However, whereas a central bank cannot
fail because it is guaranteed by the state, CCPs do not have such
165
Ibid 63.
166
town Law Journal 387, 410; International Law Association, ‘Draft July 2016,
Johannesburg Conference’, Twelfth Report (2016) <on file with author>, 11–12.
167
risk> accessed 3 September 2017.
protection as the ultimate risk, as shown above, lies with the clearing
members. While it is unlikely that multiple large clearing members would
fail simultaneously, it is not a given that just such a thing would never
happen, leaving CCPs that clear globally traded products, in particular,
unprotected.168 Herein lies a large discrepancy between what is being
communicated and what is effectively happening in the market. An
institution fulfilling a core public policy objective, just as the CCP is
performing, cannot be left to fail because the negative externalities for
the overall market and the clearing members, mostly key player global
financial firms, would be disastrous if a super-systemic CCP failed.169
Recent history has a lesson to prove this: when the Hong Kong Futures
Exchange failed during the stock market crash in 1987, it led to the entire
securities market shutting down, affecting all market participants, irres-
pective of whether they had been involved in the futures market or not.170
The G20 mandate to clear all OTC derivatives emphasises the CCPs’
importance in promoting globally sound financial markets and preventing
systemic risk, ultimately contributing to moral hazard. If clearing mem-
bers and the CCP’s board of governors believe that they are too important
to fail, they increase their willingness to sacrifice sound risk-management
practices because the state backstop is perceived as available.171 A CCP
does not magically eliminate the risk from counterparties, but instead
mutualises this credit and market risk that would otherwise remain with
the individual counterparties and effectively holds the exposure to all
clearing members on its balance sheet.172 In turn, it is up to the regulator
and the CCP risk management team to determine proper risk manage-
ment by collecting the right quality and quantity of equity capital through
168
counter Derivatives Symposium, Chicago, 11 April 2014), 1–2.
169
Ibid 2.
170
For more details see generally Hong Kong Securities Review Committee,
‘The Operation and Regulation of the Hong Kong Securities Industry’ (27 May
1988) Report of the Hong Kong Securities Review Committee <http://
www.fstb.gov.hk/fsb/ppr/report/doc/DAVISON_E.PDF> accessed 3 September
2017.
171
counter Derivatives Symposium, Chicago, 11 April 2014), 5–6.
172
45, 50; Dietrich Domanski, Leonardo Gambacorta and Cristina Picillo, ‘Central
International Law Association, ‘Draft July 2016, Johannesburg Conference’,
Twelfth Report (2016) <on file with author>, 11.
margins and collateral, and marking the positions to the market.173 CCPs
are regulated on a micro-prudential scale, but both create macro-
prudential impact and can be impacted by macro-prudential market
shifts.174
CCP resolution is now becoming a topic in the European regulation,
with the proposal for a recovery and resolution regulation for CCPs. Yet
this framework does not address any of the core problems, such as the
ownership structure of CCPs or how to best deal with moral hazard
arising from clearing. Contrarily, the author would like to argue that this
new regulation is effectively undermining all prior efforts to contain risks
from derivatives trades in CCPs. By including provisions which promise
public funds to save a failing institution to prevent further systemic
shocks, effectively this would be necessary in every situation a system-
ically relevant CCP encounters liquidity shortages. Moreover, most of the
measures the CCPRRR introduces are at the discretion of the corres-
ponding resolution authority and national competent authority.175
As a consequence, this opinion is heavily subjected to perception and
likely to be tarnished more by political sentiments than by financial
stability concerns. While the EU has foreseen certain safeguards, such as
the ‘no creditor worse off principle’176 and other safeguards for stake-
holders, should a trade-off situation arise, where overall financial stability
is weighed against the safeguards for those parties outlined, the public
interest in financial stability will most likely always outweigh private
interests.177 Furthermore, regulatory bias could lead to hasty regulatory
intervention of a still salvageable CCP for fear of the impact this highly
interconnected institution could have on the greater economic stability.
The consequence of such hasty intervention could be the destruction of
value for the share- and stakeholders of the CCP and a disruption of the
173
See also Stephan G Cecchetti, Jacob Gyntelberg and Marc Hollanders,
‘Central Counterparties for Over-the-Counter Derivatives’ [2009] BIS Quarterly
Review 45, 50.
174
175
The powers of the resolution authority are very far reaching and outlined
in Articles 48–59 CCPRRR. Hidden, in Article 52 CCPRRR, is a provision
giving Member State authorities the power ensure, other EU Member States must
follow their direction and implement the same means and measures, as the
Member State in which the CCP under resolution. It will be interesting to see if
the EU will expand this provision to third countries in the time of crisis.
176
See Articles 60–67 CCPRRR.
177
Ibid.
market, combined with fear of similar treatment of other CCPs. Alter-

natively, waiting too long to intervene could lead to unintended conse-
quences for financial stability, including contagion and possibly system-
wide knock-on effects.
Thus, the new regulation does not remove the risk of a CCP requiring
public financial support. Contrarily, it promotes the use of such liquidity
in specific cases, even if the CCP itself still has own funds. This
promotes moral hazard directly and undermines all of the objectives of
the derivatives market reform. With the EU legislation explicitly mention-
ing the option of using public funds to bail out a CCP, the core claim of
the entire reform, which promised to never use taxpayer money to bail
out a private institution owing to failings in the derivatives market again,
has been undermined. Furthermore, should public funds be necessary to
stabilise or support a CCP in the EU, it is likely that other market
participants will require similar support. As such, the G20 commitment to
ensure that no public funds will be necessary in the future to support the
economy – at least with regard to derivatives – has been undermined.
7.3 ALTERNATIVE SOLUTION TO MANAGING CCP

SYSTEMIC RISK
7.3.1 Best Current Suggestion
The US model with transferal of a CCP to a bridge institution is the only

viable suggestion currently in force and is currently pursued in the EU as
well.178 Here, however, the author questions whether clearing members
would not seize payment of margins to the CCP immediately if they
believed it might fail. Therefore, there might not be any viable assets to
transfer to a bridge institution. The EU has recognised that the current
framework is insufficient to ensure that third countries come together and
cooperate in a resolution crisis, ensuring assistance to enforce each
other’s resolution actions regarding the relevant actors, assets and liabil-
ities, which are located in the third-country jurisdiction.179
178
See also discussion of problems surrounding recovery and resolution of a
CCP under current law at: International Law Association, ‘Draft July 2016,
Johannesburg Conference’, Twelfth Report (2016) <on file with author>, 14–16.
For EU discussion, see Chapter 6, Section 6.3.
179
of Central Counterparties and Amending Regulations (EU) No 1095/2010, (EU)
The author would like to present an alternative solution for CCPs.

Considering that most CCPs are too-big-to-fail, resolution should be the
last option for them. The primary objective of the supervisory authorities
should be to return the CCP to a liquid state and permit it to continue its
business objective or to be wound down. Thus, a solution must be found
for how to grant the CCP access to liquidity without burdening the tax-
payer with the cost thereof.
The author believes that the most innovative current suggestion for
CCP resolution is shared by Cecchetti, Gyntelberg and Hollanders,
Chamorro-Courtland, and Kress, who suggest counterbalancing systemic
risk from CCPs by granting the CCP access to central bank liquidity as a
form of lender of last resort (LOLR). In their new post-crisis role, central
banks have become willing to provide systemically relevant financial
institutions with liquidity if they are insolvent and considered too big
and/or too interconnected to fail.180 However, Chamorro-Courtland points
out that CCPs will never pass through the stage of ‘illiquidity’, which
would be necessary for central bank intervention according to current
guidelines.181 CCPs would pass directly from being liquid to insolvent,
thus not complying with the first pillar of the prerequisites for LOLR
assistance, which mandates illiquidity, but solvency.182 As the CCP
receives margins from its members and possesses a default fund, a CCP
is liquid until all the resources of the waterfall default procedure are used
up, at which point it loses solvency and enters default.183 This does not
comply with LOLR protocol and if a CCP enters default, it can only
No 648/2012, and (EU) 2015/2365, Brussels 28.11.2016, COM(2016) 856 Final’

(n 649). 16.
180
Law 432, 451–2.
181
Ibid 451–7. For an in depth discussion of the abilities of central banks as
LOLRs for banks in the EU, see Seraina N Grünewald, The Resolution of
Cross-Border Banking Crisis in the European Union (Kluwer Law International
2014), 32–5 and 183–9.
182
Law 432, 455.
183
blame its own lack of risk management.184 The regulation in both the EU
and United States is inconsistent and it is unclear whether such central
bank intervention might be directly prohibited by current legislation.185
Should the EU introduce the CCPRRR in its current state, such would be
explicitly permitted in the future.186
This idea presents two additional shortcomings in addition to the legal
uncertainty surrounding its permissibility. Not only does having guaran-
teed access to central bank liquidity directly increase the too-big-to-fail
problem of moral hazard and undermine the objective of regulators to
have highly successful risk mitigation techniques in place by CCPs, it
also does not change the fact that public funds are implicated in bailing
out private institutions.187 The problematics of moral hazard have been
discussed extensively in this study. Providing CCPs with either explicit or
implicit access to public funds would undermine the objective of
regulators and the entire derivatives reform of forcing the defaulter-pays
mentality. Also, if central bank funds are used to bail out a CCP, it is the
taxpayer that ultimately shoulders the cost. Thus, this idea does not
address the underlying problematics of shifting the ultimate cost of
excessive risk taking back to those who engaged in the risk, but permits
them to skim off the profits and pass the losses on to others.
7.3.2 A New Approach
What is necessary is an approach that not only allows the derivatives and
clearing users to profit from the system, but also mandates them and not
184
Same opinion, Christian Chamorro-Courtland, ‘The Trillion Dollar Ques-
tion: Can a Central Bank Bail Out a Central Counterparty Clearing House Which
is “Too Big to Fail”?’ (2012) 6 Brooklyn Journal of Corporate, Financial &
Commercial Law 432, 456–9.
185
See discussion at Jeremy C Kress, ‘Credit Default Swaps, Clearinghouses
and Systemic Risk: Why Centralized Counterparties Must Have Access to
Central Bank Liquidity’ (2011) 48 Harvard Journal on Legislation 49, 84–92;
Christian Chamorro-Courtland, ‘The Trillion Dollar Question: Can a Central
Bank Bail Out a Central Counterparty Clearing House Which is “Too Big to
Fail”?’ (2012) 6 Brooklyn Journal of Corporate, Financial & Commercial Law
432, 461–79.
186
See discussion in Chapter 6, Section 6.3.6.
187
Same problem as with moral hazard suggestions for public fund access
discussed in Craig Pirrong, ‘The Inefficiency of Clearing Mandates’ (2010) 665
Cato Journal 8; Craig Pirrong, ‘The Economics of Central Clearing: Theory and
Practice’ (May 2011) 1; and Yesha Yadav, ‘Clearinghouses in Complex Markets’
(2013) 101 Georgetown Law Journal 387.
the taxpayer to be held responsible for any negative fall-out. The

international aspect of clearing and cross-border activities of CCPs also
need to be taken into consideration. At the same time, the too-big-to-fail
problematic of CCP resolution needs to be addressed. The objective is to
prevent any state intervention and bail-outs, by having a system in place
that ultimately holds the CCPs and derivative market participants
accountable, thus removing the incentive for clearing members to put
their own interests first. It must also be recognised that the size of the
derivatives market which has been shifted to clearing causes externalities
for the overall financial markets, which could not be rectified by any
single country. As such, the solution to dealing with a CCP failure should
not be attempted at a national level, but should take the international and
interconnected nature of clearing into consideration.188 To this end, the
author is able to make an original contribution to the discussion that
provides defaulted CCPs with new funds, provided by CCP users, and
prevents moral hazard.189
7.3.2.1 A CCP default fund

These benefits can all be combined by creating a global ‘CCP default
fund’. Such a fund would be capitalised through continuous contributions
by market participants using a CCP, either through client clearing or as a
direct clearing member.190 Continuous funding provides for an ex ante
funded insurance scheme while acting in a counter-cyclical manner. It
also maintains low contribution levels; therefore it does not create
additional risk through the sudden necessity to contribute funds in times
of financial turmoil. Situating the fund on a global scale accounts for the
reality that clearing is not contained within borders and most clearing
members are members of multiple CCPs. Thus, instead of CCPs needing
to contribute to independent funds in each country, contributions are
188
Conference’, Twelfth Report (2016) <on file with author>, 14–15, stating that a
cross-border recovery mechanism is necessary and that all current propositions
ultimately impose on taxpayers; Yesha Yadav, ‘Clearinghouses and Regulation by
Proxy’ (2014) 43 Georgia Journal of International and Comparative Law 161,
184.
189
This idea was first introduced by the author in her PhD thesis: see
Alexandra Balmer, Clearing OTC Derivatives: An Analysis of the Post-crisis
Reform on Systemic Risk (Schulthess Juristische Medien 2017), 196–7. The
author is unaware of any other contributions that have indicated any similar
approach.
190
These contributions would be in addition to margins and other capital
contributions.
harmonised, which reduces the overall collateral amount necessary for

such a project. The global nature allows a non-discriminatory access in
times of excessive volatility and turmoil, and compensates for the fact
that no country could stem the financial burden of bailing out a CCP on
its own.
7.3.2.2 The benefits

This proposal is able to counteract all negative externalities of the current
regulation. By ensuring that the ultimate financial burden is placed on the
market participants, it becomes secondary how successfully the indi-
vidual CCPs manage their risk and which ownership model they follow.
Such a default fund would mandate every counterparty and every CCP to
contribute to the global default fund, placing the ultimate skin in the
game back on the players of the derivative market. Each and every
counterparty to a derivative trade, whether large or small, would be
mandated to contribute a percentile of the value of the contract to the
global CCP default fund, if the contract is being cleared.
Not only does this reduce moral hazard, but the remaining amount of
moral hazard is passed right back to the market. The socio-economic
costs of excessive risk taking are directly passed back to those who
profit the most from clearing. Having an insurance fund has proven
itself to be a powerful tool for deposit-taking banks in the form of the
deposit guarantee schemes that the EU has recently extended
jurisdiction-wide.191
Such a global default fund would not hamper the benefits of netting or
other risk-reducing measures of the CCPs, nor would it require any
substantial changes to the existing regulation. The proposal would
achieve what the ongoing regulatory reform has not: a harmonised,
global approach to eliminate the risks from derivatives, by means of a
central counterparty. Furthermore, it also eliminates the risk of a default-
ing CCP, which is too-big-to-fail and too interconnected to fail, without
disrupting the financial stability of the global financial markets. All of
these benefits could be achieved without the additional risk of requiring
taxpayer dollars in the event of a crisis.
191
European Commission, ‘European Deposit Insurance Scheme’ (3 Septem-
ber 2017) <https://ec.europa.eu/info/business-economy-euro/banking-and-finance/
banking-union/european-deposit-insurance-scheme_en> accessed 3 September
2017; Jan Strupczewski, ‘European Commission Unveils Scheme for EU Deposit
Guarantees’ Reuters (London, 24 November 2015) <http://www.reuters.com/
article/eu-banks-deposits-guarantee-idUSL8N13J2DC20151124> accessed 3 Sep-
tember 2017.
7.3.2.3 Possible implementation

Membership in the CCP insurance fund should be mandatory for all
systemically relevant CCPs to ensure that no taxpayer funds are neces-
sary, if internal risk-management practices prove unsuccessful. Each CCP
would then be required to contribute a reasonable amount of capital to
the global fund, based on the size, interconnectedness, internal risk
control measures and types of contracts cleared. Such gradual contribu-
tions ensure reasonability and fairness amongst CCPs.
All direct and indirect clearing members of such a CCP would also be
required to provide a certain amount to the fund for each trade they clear
through a CCP. Such a contribution could either be structured as a tax or
an additional contribution, as the margin and default fund contributions to
the individual CCPs are today. While these additional contributions
increase the strain on liquidity, the benefits of having sufficient liquidity
in the markets in case of a CCP failure outweigh the additional costs for
counterparties in the short term. This may also incentivise CCPs share-
holders to pursue strong risk-management procedures over short-sighted
profitability if this leads to a reduction in their contributions to the global
fund. While higher contributions for riskier products may at first hamper
the introduction of clearing for certain new products, it could also
incentivise CCPs to ensure adequate risk management prior to the
introduction of clearing for these products. As such, no long-term
negative implications to innovation are expected from the introduction of
such a fund.
Currently, the EU has a similar tax in the form of the Financial
Transaction Tax, which can be paid on a voluntary basis, to return the
cost of failure to the financial sector.192 The Financial Transaction Tax
imposes a minimum tax of 0.01% on derivatives trades, but leaves
discretion to the member states to impose higher taxes.193 Taking this
figure as a starting point, it could be used to determine contribution
levels, or lowered even further, if applied globally.
In case a systemically relevant CCP loses liquidity and exhausts its
own financial reserves, it could immediately request funding from the
insurance fund to guarantee its obligations and reassure the market. As
192
European Commission, ‘Financial Transaction Tax: Making the Financial
Sector Pay Its Fair Share’ (28 September 2011) Press Release <http://europa.eu/
rapid/press-release_IP-11-1085_en.htm?locale=en> accessed 3 September 2017.
193
Thomas Hemmelgarn and others, ‘Financial Transaction Taxes in the
European Union’ (January 2016) No 62-2015 <http://ec.europa.eu/taxation_
customs/resources/documents/taxation/gen_info/economic_analysis/tax_papers/
taxation_paper_62.pdf> accessed 3 September 2017, 11.
the clearing members are financing this, they have an increased incentive
to monitor the CCPs they join, whose financial risk they ultimately carry,
and not to put their own interests first.
7.4 SUMMARY
Only if the clearing members work hand-in-hand with the CCP to create
strong and sound risk-management practices can the interests of both be
aligned, thereby preventing adverse selection and moral hazard from
within the interest of each and every clearing member while also
significantly reducing the risk of CCP failure. In 2006, Kroszner pro-
vided evidence that, while CCPs had been successfully clearing
exchange-traded derivatives contracts, the incentives of all market partici-
pants were aligned to ensure effective risk-management practices. He
remarked that, as CCPs begin venturing into more complex and less
liquid products – not of classic exchange-traded origin – the risk assumed
by CCPs increases. At the same time, increased regulatory intervention
impedes the individual CCP’s ability to quantitate risk-management
practices and even increases moral hazard. This could act counter-
intuitively and ultimately undermine the very stability of the CCPs it
intended to strengthen.194
CCPs have not been provided with any new tools to manage their
exposure any differently from the counterparties before the crisis. While
it is true that systemic risk is reduced through multilateral netting, the
OTC market does become more transparent and the CCP default water-
fall mechanism and fund may help contain exposure, there has been no
innovation to guarantee the effectiveness of CCP risk management. Quite
the contrary, regulators appear to have passed the ball to the privately
owned and operated CCPs to come up with sufficiently adequate risk-
management practices, as LCH proved it was capable of. Yet CCPs
provide a public policy objective to the market. Therefore, the author
finds that the clearing obligation undermines the objective of making the
derivatives market safer. In fact, the greatest result of the reform has been
to impose public policy objectives upon a privately owned institution and
concentrate market risk within CCPs. Thus, the failure of a CCP would
be far more detrimental to the financial system than the failure of AIG
194
3 April 2006), 37.
would have been. CCPs are systemically important institutions and their
inability to perform could pose a great risk to financial stability.
The regulation has completely disregarded linkage risk, particularly if
asset segregation fails and the bank holding the collateral or operating the
CCP fails. While technical standards may eventually address some of the
issues raised, CCPs are largely left to their own devices. In the EU,
supervision and authorisation of a new CCP are left up to the authorities
in the member state where it is registered. Although the European
Commission and Parliament intend to harmonise oversight at the EU
level, this may contribute to different levels of oversight and risk
management.
Much of the regulation gives great discretion to the CCP, particularly
with regard to its primary risk management tool: margin collection and
default fund size. This contradicts the macro-prudential regulatory
approach as it leaves room for arbitrary choices and could create
systemic risk in the process. In conclusion, the author finds that the
regulator has not sufficiently utilised its power to ensure sufficiently
prudent risk-management practices and that too much discretion is given
to CCPs. Additionally, the lack of a resolution plan for CCPs –
particularly systemically important ones and the EU’s plan to introduce
explicit taxpayer bail-outs in the EU – leads the author to believe that,
without a new approach, taxpayers would be forced to once again
intervene to prevent financial Armageddon. To solve this conundrum, the
author presents a novel option in the form of a two-step approach to
making CCPs more systemically sound. First, CCP risk-management
practices should be increased by restrictively permitting market access to
new CCPs, thus increasing their minimum capital and default fund size.
All CCPs should also be mutually owned by their members. Second, a
global CCP insurance fund should be created for systemically relevant
CCPs. The funding must be ex ante and contributed by all direct and
indirect clearing members of systemically relevant CCPs. In the event
that a CCP faces liquidity troubles, this fund could be accessed instead of
risking a governmental bail-out. Such a fund reduces moral hazard
problems and ensures that the costs are contained within the market
segment that uses derivatives and clearing. Therefore, this proposal
addresses all of the shortcomings of the current derivatives reform while
being financeable and implementable. All that is necessary is global
cooperation and a market readiness to accept full responsibility for one’s
actions.
8. Summary of findings and outlook
The problems that exist in the world today cannot be solved by
the level of thinking that created them. (Albert Einstein)
8.1 FINDINGS
This study set out to determine the past, present, and future regulation of
financial derivatives, particularly with regard to clearing by means of a
central counterparty. The primary objective was to determine whether or
not central counterparties (CCPs) have been equipped with the tools to
face the challenges that mass clearing of over-the-counter (OTC) deriva-
tives will present them with. The study also set out to determine whether
the risk to the financial markets that were identified in the aftermath of
the latest financial crisis have been efficiently dealt with and minimised
to a non-systemic level.
What the study found is fragmented regulation at various stages of
implementation across the main jurisdictions without a clear and unified
direction for the future. This unsatisfactory regulatory approach provides
market participants with high implementation costs, legal uncertainties
and the requirement to adhere to multiple, non-harmonised regulatory
requirements if they wish to continue trading in the derivatives market on
a global scale. It requires CCPs to fulfil a public policy objective, despite
a plethora of regulations not yet implemented or enacted, and the
application of these rules is greatly left to the discretion of the super-
visory bodies. The following provides an overview of the key findings of
this book.
8.2 KEY FINDINGS

8.2.1 The New Bulwark of Financial Stability
The main purpose for derivatives is to permit market participants to shift

risk from themselves and their books to other market participants willing
to carry the risk. OTC derivatives allow a party to create a bespoke tool
197
to address their specific needs; in turn, this bespoke nature leads to a lack
of broad interest, making them of little value to third parties and
therefore virtually illiquid. In the past, OTC derivatives were notoriously
opaque and under-collateralised, as the counterparties were permitted to
bilaterally negotiate the terms and conditions of each contract. Their
bilateral nature permitted the trades to take place beyond the regulatory
scope and the lack of public records permitted risk-pools to arise. Thus,
although derivatives themselves can fulfil socially ‘desirable’ purposes,
e.g. hedging, their speculative usage can lead to social costs. The line
between the two is flexible, as was shown using the example of AIG and
its excessive exposure to credit default swaps (CDS). In 2008, the OTC
derivative market peaked at USD 670 trillion, making AIG’s exposure to
CDS contracts systemically important and its failure a threat to the
financial system. Thus, AIG was bailed out with USD 180 billion and
OTC derivatives were branded as the culprit. However, LCH.Clearnet
(LCH), as a central counterparty, had managed to wind-down its USD 9
trillion exposure to Lehman Brothers within a short period of time. CCPs
were henceforth considered the solution to unidentified systemic risk
build-up, containment of OTC derivative counterparty default and pru-
dent risk management. Following the lead by regulators and policymak-
ers in the aftermath of the crisis, the risk-management practices of CCPs
to counteract systemic risk exposure, particularly their ability to net
offsetting positions and collect margin and default fund contributions,
were analysed.
At the 2009 G20 meeting in Pittsburgh, four commitments were agreed
upon to stabilise the markets and prevent a similar occurrence in the
future by implementing mandatory clearing for standardised OTC deriva-
tives contracts. The commitments were to be implemented on a national
level by the end of 2012 and provide for a strong risk management
framework and macro-prudential oversight. To this end, international
standard-setters provided soft law guidelines on how to implement the
commitments and reform the financial system. They profited from their
ability to address the challenges of the financial markets in a timely
fashion, thus contributing to the rising importance of soft law in financial
regulation. These soft laws include guidelines for determining OTC
derivatives suitable for clearing, the setting of margins for non-cleared
OTC derivatives, the setting of standards for financial market infrastruc-
tures and guidance regarding the recovery and resolution of market
infrastructures.
The implementation of the OTC derivatives reform into national
regulation proved to be more difficult and time-consuming than expected.
The United States was the first jurisdiction to implement the derivatives
Summary of findings and outlook 199
reform in 2010 with Dodd-Frank. However, the United States had had a
strict regulation of derivatives in place until the 1990s. The earlier
regulation banned speculative trading of derivatives outside of the
controlling walls of exchanges. With time, and through lobbying, OTC
derivatives were exempted from strict regulation against the advice of
Brooksley Born, the CFTC Commissioner from 1996 to 1999. After her
resignation, the CFMA was enacted in 2000, liberalising the OTC
derivatives market and exempting it from supervision. Thus, Dodd-Frank
turns back the clock by restricting the speculative usage of derivatives
and mandating clearing for most.
The EU has taken longer to comply with the international standards
and the G20 commitments. European Market Infrastructure Regulation
(EMIR) mandates clearing for certain standardised OTC derivatives and
is currently being phased in. Despite the EU having enacted its
regulation after the United States, the rules are not equivalent, which led
to a long-lasting, politically motivated stalemate between the two
jurisdictions.
CCPs rely on certain risk management tools. These include selecting
their clearing members prudently, netting offsetting positions among
clearing members to reduce exposure to market risk, collecting initial and
variation margins to hold collateral against market risk and shifts in
valuation of collateral, demanding clearing members contribute to the
default fund to contain any losses in case of member default and having
strict and stress-tested protocols in place to identify how the CCP is to
proceed in case of clearing member default. Clearing alters many of the
basic linkages between CCPs and their members.
First, competitive distortions arise as more CCPs enter the market to
offer their services. This may undermine prudent risk-management
practices as margins and other contributions are lowered and fewer
capitalised counterparties are accepted as direct clearing members. Add-
itionally, products which are less suited for clearing may be accepted by
a CCP. LCH benefitted from greater flexibility in the absence of a
clearing mandate. Additionally, previous experience with default proced-
ures following the default of a clearing member permitted LCH a level of
sophistication and experience that newly established CCPs may lack. The
expectation of regulators that all CCPs will manage clearing members
equally efficiently and successfully may thus not be met. The addition of
newer and more exotic derivatives products to clearing, such as the
clearing of CDS contracts, increases the risks to CCPs as they are more
complicated to value and can jump to default – causing derivative
maturity – without warning.
Second, a CCP may lack experience in pricing a product it has been

mandated to clear. The counterparties to the original contract thus have
more experience and possibly better abilities to define the risk parameters
of the contract. Such an advantage may be based on more accurate
models or greater experience and more frequent interaction with the
counterparty. This exposes the CCP to adverse selection from infor-
mation asymmetries, as it is more beneficial for the counterparties to
down-play the contractual risk, as lower risk requires less collateral,
which has become even more costly and scarce since the financial crisis.
Thus, problems surrounding the adequate risk pricing of products under-
mine the CCP’s risk management abilities.
Third, mutualisation of loss among clearing members through CCP
default procedures increases the risk of moral hazard, thus tempting
clearing members to achieve the maximum amount of profit and accept
that other clearing members may need to contribute more funds in case
of excessive risk taking. This is further exacerbated through demutual-
isation of the CCP ownership structure. The lower the penalties imposed
upon clearing members taking unreasonably high risk are, the more likely
they are to chase elusive profits in economic boom years. The objective
of macro-prudential oversight in reducing systemic risk and promoting
financial stability is precisely the opposite. The first chapter showed that
buffers should be created in times of financial surplus to cushion and act
in a counter-cyclical way. Thus, not defining mutualised ownership for
CCPs and forbidding any for-profit activity contradicts the objective of
stabilising financial markets through CCPs. Such a structure of de-
mutualisation also discourages clearing members from keeping one
another in check and decreases their ability to intervene if they believe
that the CCP’s managers and shareholders are taking excessive risks.
Moral hazard could also be increased if clearing members use their
influence to reduce collateral contributions. The main difference between
bilateral and cleared markets is the centrally governed collateral buffer.
Any reduction thereof could decrease the CCP’s ability to withstand a
financial shock.
Fourth, in the EU, the minimum CCP capital is set at EUR 7.5 million,
while the United States leaves it up to discretion of the supervisor. Yet it
is the CCP’s own capital – its skin in the game – which ensures that the
incentives of the CCP’s management and shareholders are aligned with
those of the clearing members. Comparing the overall size of the
derivatives market with such a minimal capital, it is questionable whether
it will suffice as an incentive for the CCP. While the first EU-wide
stress-test proved to be a success, it did not test the ability of EU-based
CCPs to deal with subsequent defaults beyond the legal requirements.
Historical data shows that, when the largest or two largest clearing
members are unable to meet their collateral requirements, others simul-
taneously experience the same difficulties, thus bringing the ability of
systemically relevant CCPs to manage a financial Armageddon into
question. Once again, a regulatory oversight is identified. Should the
margins of the defaulted clearing member be insufficient to contain the
losses – contrary to the case of LCH and Lehman Brothers – the default
fund and the CCP’s own capital are all that stand between market
contagion and containment. While it must be the objective, through
sufficiently high margins, never to tap into the default fund or the CCP’s
own capital, as a last resort they must both be sufficiently high to
withstand more defaults than are currently expected.
Finally, CCPs have morphed into institutions of high systemic risk and
many will be considered too systemically relevant to fail. While the
United States differentiates between regulation and oversight of such
systemically important CCPs, the EU does not – despite having classified
all EU-domiciled CCPs as systemically relevant. Systemically important
financial institutions and global systemically important financial insti-
tutions pose even greater risks to the stability of the financial system as
they are highly interconnected and their failure would lead to contagion
and other defaults. Specialised regulation is necessary to address their
market importance, which could include higher capital requirements and
collateral contributions. Systemically relevant institutions create moral
hazard problems because those CCPs will expect to be bailed out if their
risk-management practices fail. Such is the direct dichotomy in ensuring
prudent risk-management practices by CCPs and their enforcement of
following such rules by their members. Additionally, questions remain
concerning CCP insolvency, particularly a sound recovery and resolution
framework, where either long-term viability of the CCP is restored or, if
this is no longer possible, the vital parts are separated and continued
service is ensured, while the non-vital parts are placed in insolvency.
Therefore, despite the immediate action to redesign a global frame-
work to make OTC derivatives less of a threat to objectives of the
financial system and make CCPs the bulwark of the financial system, the
systemic risk itself has not been addressed. Contrarily, instead of having
the risk spread across multiple, large global firms, it is now concentrated
and even increased within CCPs. As such, the author finds that the
objective of the derivatives reform has not been achieved and the current
regulation has neither decisively followed through nor created a better
situation. In fact, systemic risk is more concentrated and – in some ways
– less regulated than before.
8.2.2 Managing Expectations
8.2.2.1 The CCP’s burden of risk management

The regulator has efficiently delegated much of the power regarding
risk-management practices to the CCPs. Keeping in mind that the CCP is
a privately owned institution, this fulfilment of public policy objectives
without the guarantee of a state – such as a central bank enjoys – is
remarkable. Specifically, the discussion of the origin of clearing and
clearinghouses showed that they evolved from market necessity in the
absence of state authority. Eventually, central banks took over from bank
clearinghouses, but there never was the same nascence for exchange
clearinghouses. Even after the mandate of clearing, modern CCPs remain
private institutions. The lack of clarity regarding their ownership struc-
ture could further adversely affect the achievement of the policy object-
ives. As such, the hybrid status of CCPs could further impact
problematics of moral hazard through implicit state guarantees, which
have been heightened further by the EU proposal for a CCP recovery and
resolution regulation.
Nevertheless, regulation delegates independent monitoring of risk
exposure to all counterparties to collect adequate collateral as margin and
default fund contributions. To that end, the CCP must devise intricate risk
management models which are considered a public good. Such models
need to be funded by the clearing members and their willingness to
contribute additional funds to create such models may not be a given.
Conversely, the counterparties, especially the large financial institutions,
are already in possession of highly sophisticated models as these enabled
them to achieve profits and hedge their risks in the bilateral markets prior
to the clearing obligation. These private models are likely to be of higher
quality in comparison with those considered as a public good, enabling at
least one clearing member to profit at the cost of others and choose the
CCP which falsely calculated the risk exposure. In doing so, it thereby
leverages the risk-management practices of the CCP for private gain and
undermines the objective of stability through information asymmetries
and adverse selection. Regulators have not provided CCPs with any tools
to take countermeasures against such adverse behaviour.
The CCPs’ models are the basis for the contribution calculations of
initial and variation margins, as well as default fund contributions. While
the initial margin should assess the overall risk exposure of the counter-
party and contract to the CCP, the variation margin addresses shifts in
collateral value and exposure. Sufficient margins are pertinent to the
efficiency of the CCP’s own default waterfall mechanism, as the counter-
parties’ contributions are used as a first dyke in case of its default.
Default fund contributions are equally important as they would be

liquidated to avoid exposure prior to contamination of the financial
markets beyond the CCP. While the regulator does prescribe that margins
must achieve a 99–99.5% level of confidence, LCH nevertheless requires
higher margins. Higher margin requirements decrease the likelihood of
requiring access to the default fund. As such, if a seasoned CCP requires
margin contributions higher than the minimum, the question is raised
whether less collateral could achieve the same benefit and whether other
CCPs competing for a share in the market will impose sufficiently
prudent margins. Imposing higher margin requirements would not only
help to contravene cases of adverse selection through additional buffers,
but also improve the risk management abilities of CCPs. As pressure
from clearing members is to be expected to push CCPs to lower their
margins to the regulatory minimum, increasing the minimum from the
onset could prevent adjustments later on if the minimum is found to be
too low after all.
Under EMIR, the CCP’s default fund must be sufficient to sustain the
default of either the largest member or the second and third largest
members, if their exposure is greater. Such may be insufficient to truly
sustain a CCP if multiple large clearing members default simultaneously,
which is not beyond the realm of possibility in extreme, but plausible,
market conditions. Considering the low capital requirement of the CCP,
an increase in the default fund size would not only reduce moral hazard
among clearing members but also increase the ability of the CCP to
sustain clearing member defaults. Once again, the CCP is given dis-
cretion to determine its risk exposure to the counterparties and could
become the casualty of adverse selection.
Finally, as the authorisation and primary supervision of EU CCPs is
delegated to the national authority in the member state where the CCP is
established, it is conceivable that there may be great differences between
member states despite the maximum harmonisation approach of EMIR.
Such differences may further contribute to adverse selection opportunities
for both CCPs (in opting where to establish themselves) and clearing
members (in deciding where to have their trades cleared).
8.2.2.2 The regulators’ (over-)reliance on CCPs

The extensive discretion entrusted to CCPs by the regulator is not met
with stringent supervision. While the EU CCP must have a supervisory
college with representatives of the European Securities Market Authority
and the member state authorities present at the founding of the CCP, it is
conceivable that, later on, the supervision authorities will need to rely on
the data supplied to them by the CCP. Not only would the flood of data
and information overwhelm the national- and EU-level supervisors, but

they would also probably lack the ability to disseminate and assess the
information in a timely manner. They would also face the same difficul-
ties creating models to convey a portrayal of the market and the risk
location. The models to be created by the CCP to monitor and assess
each clearing member and each derivative contract are of the utmost
importance to the stability of the financial market, and yet they are
relinquished to the CCPs. In order to grasp all exposure and market
developments, and to fulfil their obligation of overseeing the financial
markets, the supervisory authorities must rely on the CCP providing them
with timely, correct and complete information. However, more import-
antly, the regulator has to trust that the CCP will react to all market
changes immediately and impose penalties on members that become
non-compliant with the prerequisites before they themselves can react.
Considering the importance of the clearing of OTC derivatives in the
context of post-crisis financial regulation, the delegation of the creation
of market models and blind trust in their validity is striking.
Therefore, the author concludes that there is an excessive dependence
upon the ability of CCPs to assess and mitigate their risks holistically, in
a timely manner and prudently. With the regulatory objective of making
CCPs a bulwark against all negative market externalities and shocks, but
faced with the realisation that CCPs themselves represent one of the
greatest current risks to financial stability, this over-reliance on CCPs’
own abilities extends beyond the boundaries of prudent risk management.
To the author’s surprise, this over-reliance on the data provided by CCPs
has not been addressed in the literature.
This CCP overreliance appears to diminish in the context of the EU’s
recovery and resolution framework. However, here the recovery and
resolution bodies, as well as national supervisors are given more discre-
tion than should be expected from a maximally harmonising regulation,
and based on legal foreseeability, and could lead to fragmented approach
throughout the Union. Furthermore, many of the proposed rules appear to
directly undermine the very objectives intended by the G20, particularly
by permitting public funds to be provided to CCPs, in specific circum-
stances. The EU is facing additional challenges in the near future,
particularly in light of Brexit and the location of the most important
EU-CPPs at this time.
8.3 THEORETICAL IMPLICATIONS

The exploration of the post-crisis framework of OTC derivatives clearing
brought multiple limitations of the reform to attention. First, there is a
lack of harmonisation across the two most important jurisdictions for
derivatives trading, the EU and the United States. This disharmony led to
a downturn in the trade of derivatives and fragmented a formerly highly
integrated market. Second, progress regarding the implementation of the
reform at a global level is very slow. Third, systemic risk has not been
reduced, but shifted from the bilateral market to the CCP. The CCP
concentrates this risk and, should the CCP fail, the market externalities
would be much greater than anything experienced during the last
financial crisis. Consequently, rigorous risk-management practices must
be in place to ensure its ability to weather any externalities in extreme,
but plausible, markets. However, fourth, regulator-mandated margin con-
tributions do not match those imposed by LCH, with the United States
requiring even lower margin confidence than the EU. As such, it is
possible that CCPs following the regulatory minimum would be unable to
sustain the same exposure as was successfully managed by LCH.
Therefore, higher collateral levels are necessary. Finally, with the pos-
sibility looming that a CCP could fail and present a great risk to financial
stability, a coherent recovery and resolution framework is necessary. This
framework needs to take its potential influence on moral hazard into
account. The EU’s proposal for a recovery and resolution framework
could directly lead to an increase in moral hazard, as it allows for public
funds to be used to rescue a CCP instead of explicitly forbidding it.
Therefore, the author proposes to increase the global harmonisation of
regulation and supervision to ensure linear application with little possibil-
ity of regulatory arbitrage. Macro-prudential oversight of CCPs needs to
be harmonised to avoid arbitrage possibilities. Risk management prac-
tices on a micro-prudential level for CCPs need to be improved to ensure
that they are able to sustain a financial crisis explicitly through higher
collateral contributions in the form of initial and variation margins and
default fund contributions. The CCP’s own capital must also be raised
and there needs to be differentiation between those that are systemically
relevant and those that are not. Finally, a recovery and resolution
framework must be determined and internationally harmonised. The
author’s proposal to create a global CCP default fund is a possible way to
achieve this end.
8.4 OUTLOOK
8.4.1 Strengthening CCPs
The tendencies of the current reform need to be reassessed and reformed,

as it is based on hindsight and excessive burdens being placed on most
market participants, without clear gains. Currently, there is no better
proposal regarding how to deal with bilateral exposure from OTC
derivatives than clearing. Nevertheless, the author does not consider
clearing – the way it is currently structured – to be a panacea in the quest
for sustainable financial markets. Trust in the triangle formed between
market participants, supervisors and the CCP is a core necessity, as no
regulation can ever be comprehensive or pre-empt every possibility.
Equally, it is the CCP itself that needs to ensure that it has put all dykes
in place to manage multiple clearing member defaults, as only the CCP
has timely and inclusive access to the most information concerning its
members. However, there is ample opportunity to consider the worst-case
scenario if the CCP, particularly a systemically relevant CCP, itself
defaults.
At the moment, the most innovative proposition is to provide central
bank liquidity to a CCP, if necessary. This notion deals with the
continuity and containment of systemic risk, but does not sufficiently
address the resulting social costs and moral hazard. Such an addition of
liquidity would undermine the objective of increasing the direct respons-
ibility of clearing members, CCP owners and shareholders to manage
their risk exposure. It also creates social costs and does not indemnify
that the costs of a CCP default are allocated according to the causal
principle.
Therefore, the author proposes to create a global CCP default fund. Its
capital would be contributed by all direct and indirect clearing members
with every derivative trade. Membership should be compulsory for all
systemically important CCPs. Thus, one fund would be sufficient and
take into account the fact that clearing members can access a CCP
irrespective of their place of incorporation. It also increases rule harmon-
isation to prevent arbitrage. Most importantly, it does not create moral
hazard or additional social costs as the ultimate responsibility and costs
are attributed according to the causative principle. A global fund, in
comparison to a domestic fund, would also decrease the overall cost of
collateral, as only one fund would be demanding contributions, thus
reducing the additional strain on collateral.
8.4.2 Join the Discussion
While the regulators grant much discretion to the CCP, the author is
unsure whether this is the result of actual trust or the lack of a better
alternative. After completing this extensive study, the author is unable to
determine whether regulators have chosen to play a game of ‘hot potato’
or have actually fully contemplated all aspects of this regulation, as the
new regulation appears to shift their regulatory and supervisory obliga-
tion onto the CCPs, hoping that they comply with the rules proposed and
further improve upon them. Should they fail to do so, the patsy has
already been found and additional time has been gained to search for a
more sustainable approach. The study also found that systemic risk has
been concentrated within CCPs, thus shifting the risk away from the
bilateral market but without eliminating it. The risk-management prac-
tices in place to counterbalance these risks to achieve financial stability
have been found to be insufficient. Therefore, the author concludes that,
despite having good intentions when devising the derivatives regulatory
reform – which, in the United States at least, is more of a hindsight
re-instatement of regulation – its full potential has not been realised. To
fully mitigate the threat to systemic risk stemming from CCPs clearing
OTC derivatives, more should be done.
Derivatives have caused losses ever since their inception and CCPs
have defaulted in the past. Thus, following this discourse, it is now up to
you to answer the following question: have we achieved the policy
objectives we set out to accomplish, to prevent systemic risk from
financial derivatives through clearing, by means of a central counter-
party? Regardless of your answer, it is important that the discussion
remains alive and new ideas be heard on the subject.
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Index
accountability 76, 192 Basel Committee on Banking
adverse selection 55, 151, 165–6, 195, Supervision (BCBS) 65, 71, 82
203 Basel II 31
information asymmetry and 168, Basel III 161
169, 172–5, 200, 202 margin requirements 52
AIG 28–9, 32, 33–4, 37, 153, 167, Bear Stearns 33
198 Black Monday (19 October 1987) 179
AIG Financial Products (AIGFP) 33, Bloomberg 67
34 Born, Brooksley 70, 199
arbitrage 20 Bretton Woods System 66–7
regulatory 52, 78, 82, 86, 90, 109, Brexit 144–7, 148, 149
121–2, 132, 146, 148, 183, Buffett, Warren 2
205, 206 Bush, George W. 76
Aristotle 15
asymmetry, information 55, 168, 172, Caisse de Liquidation (Paris) 172
176, 177 call options 25
adverse selection and 168, 169, capital reserves 31, 34
172–5, 200, 202 CCP default fund 191–3, 196, 205,
CCP resolution plan 138 206
benefits 193
bail-outs 33, 34, 35, 36, 37, 70, possible implementation 194–5
143–4, 153, 163, 167, 189, 192, central banks 75–6, 84, 102, 119–20,
196, 198, 201 135, 137, 138, 142, 143, 177,
Bank of England 180 190–191, 202, 206
Bank for International Settlements Bank of England 180
(BIS) 78 European System of (ESCB) 101,
bank(s) 115–16, 147, 148, 166, 171, 105, 135, 177–8, 200
177 Federal Reserve 31, 34, 35
central see separate entry central securities depositories (CSDs)
clearing members 44, 55, 156, 184 80–81
clearinghouses 57, 60 Chicago Board of Trade (CBOT) 58
collateral demand 161 Clearing Corporation 58–9
deposit guarantee schemes 193 Chicago Eggs and Butter Board (later
fair market value 174 Chicago Mercantile Exchange)
financial crisis (2007–2009) 31, 33, 59, 122
178 Chicago’s International Monetary
licence 101, 150 Market 67
linkage risk 184, 185–6 clearing 38–64, 148–51, 205, 206
Barings Bank 34–5 auctions 47, 53, 55–6, 62, 74, 117
223
central counterparty or CCP default 105, 106, 122–3,

clearinghouse 38–41 125, 130–131, 132–45, 149,
collateral collection 47–53, 63, 186, 188–9, 191, 196, 202, 204,
188, 200, 202–3, 205 205
default fund 51, 53, 54–5, 59, 62, CCP interoperability 101–2,
64, 102, 104, 114, 144, 162, 160–161
163–4, 170, 178, 184, 190, CCPs: systemically
196, 198, 199, 201, 202, important/relevant 95, 114,
203, 205 133, 141, 143–4, 178, 188,
EU reform 101–5, 120, 122, 128, 196, 201
counterparties affected 96–9
131, 144, 203
establishing CCP 100–101, 106
initial margin 48, 49, 51, 54, 59,
impact of reform 155, 156–7,
63–4, 101–2, 158, 162, 178, 160–161
185, 199, 202, 205 implementation timeframe 105–6,
margin and derivatives 51–3 118
segregation 48–9, 54, 102, 128 initial margin 101–2
US reform 115, 122 minimum CCP capital 101, 177,
variation margin 46, 48, 49–50, 178, 200
53, 54, 59, 63–4, 144, 158, qualified derivatives 99–100
162, 178, 184–5, 199, 202, reforming EMIR 125–32
205 risk management 94–5, 101–5,
default resolution 53–6 144, 157
waterfall mechanism 54–5, small non-financial counterparties
103–4, 164, 190, 202 97, 106, 126, 127, 128
definition 39–40 reform in United States 107–17,
financial stability see clearing and 118, 120–122
financial stability CCP default 116–17, 122
for-profit CCPs 61, 164, 172, CCP interoperability 114
179–83, 200 counterparties affected 111
international reform agenda 77, establishing CCP 114
80–81, 82, 83–4, 86 implementation timeframe 117
clearing eligibility 78–80, 85 qualified derivatives 111–13
LCH.Clearnet (LCH) 36, 37, 40, risk management 115–16
54, 61–3, 150–151, 164, 195, regulators’ (over-)reliance on CCPs
198, 199 203–4
Brexit 145–6, 147 specifics of 43, 199, 202–3
margins 178, 203, 205 collateral collection see above
SwapClear 41–2 default resolution 53–6, 103–4
Swiss CCP SIX x-clear 160 exchange-traded versus bilateral
origins of 57, 202 derivatives 43–4
derivative clearinghouses 58–60 member selection 44
recent developments 60–61 netting 40, 45, 46–7, 55, 59, 83,
ownership, CCP 165, 179–83, 200, 157–62, 186, 193, 195, 198,
202 199
reform in European Union 90–91, novation 39, 44–6, 58, 63, 156,
93–110, 113, 118–23, 148–51, 186
203 review 57
Index 225
standardisation 47 contagion 53, 54, 55, 100, 142, 176,

transparency and reporting 56–7, 189
105 corporate governance 34
strengthening CCPs 206 counterparty risk 35–6, 39–40, 41, 43,
summary 63–4 44
clearing and financial stability 152–4, CDS without clearing 45–6
195–6 central counterparty (CCP) 45, 48,
alternative solution 189–95 61, 186
best current solution 189–91 for-profit CCPs 181
new approach 191–5, 196 post-crisis reform: EU 95, 98, 118
default management 162–9
credit default swaps (CDS) 27–30,
clearing of CDS 167–9
32–4, 37, 70, 198
skin in the game 164–5, 180
valuation errors 165–7 clearing of 167–9, 199
impact of reform 154–5 counterparty risk without clearing
default management 162–9 45–6
netting 157–62 ISDA 73–4
transparency 155–7 credit derivatives 26–30, 67
netting 157–62 credit rating agencies 23, 58
CCP interoperability agreements European Union 92
159–61 financial crisis (2007–2009) 32
collateral demand 161–2 credit risk 16, 17–18, 26, 29, 33, 48,
systemic risk and CCPs 169–70 58
adverse selection and information ISDA 73
asymmetry 172–5, 200 currency derivatives 67
alternative solution 189–95
CCP authorisation requirements defaulter-pays principle 53, 163,
177–83 191
linkage risk 184–6, 196 definitions
moral hazard 175–7 central counterparty and
ownership, CCP 179–83 clearinghouse 40–41
regulatory fragmentation 183–4 derivative 13–14
risk concentration 170–172, 195
democratic legitimacy 66, 76
shareholders vs clearing members
deregulation 67, 70–71, 74, 79, 111,
181–2
stress-testing 178–9 121, 147–8, 199
too-big-to-fail 177, 186–9 difference contracts 25, 68
client clearing 44, 49, 54, 61, 105 domino effect 170–171
collateralised debt obligations (CDO) due diligence 98, 176
32 Durbin, M 28
Committee on Payments and Market
Infrastructures (CPMI, formerly economies of scale 58, 158
CPSS) 40–41, 65, 77, 82 economies of scope 58, 158
financial market infrastructures European Banking Authority (EBA)
80–81 93, 135, 177–8
Commodities Clearing House (Kuala European Insurance and
Lumpur) 172 Occupational Pensions Authority
commodity traders 97 (EIOPA) 93
European Securities and Market ownership, CCP 180

Association (ESMA) 90, 92–4, post-crisis regulation 88–92, 94–5,
96, 99, 100, 101, 103, 105, 110, 107–10, 113, 118–23,
113, 115, 118, 122, 155, 157, 130–132, 148–51
203 BRRD 105, 106, 134, 150
Board of Supervisors 150 CCP default 105, 106, 122–3,
capital, retained earnings and 125, 130–131, 132–45, 149,
reserves of CCP 177–8 202
CCP recovery and resolution 135, CCP interoperability 101–2
136, 138, 142 CCPs: systemically important
European System of Central Banks
institutions 95, 114, 133,
(ESCB) 101, 105, 135, 177–8,
141, 143–4, 149
200
European Union 76, 86, 89–90, 189, counterparties affected 96–9
196 EMIR 89, 90–91, 92, 93, 95–107,
Brexit 144–7, 148, 149 109–10, 113, 114, 115, 117,
CCP default 105, 106, 122–3, 125, 119–20, 121, 122, 124–32,
130–131, 132–45, 149, 188–9, 136, 149, 150, 157, 169,
191, 196, 202, 204, 205 177–8, 184, 199, 203
additional financial resources establishing CCP 100–101, 106
143–4 implementation timeframe 105–6,
cascade of loss distribution 118
140–141 MiFID II 91–2, 99, 126, 148
draft Regulation 133–5 MiFIR 92, 148
early intervention 138–9 qualified derivatives 99–100
‘failing’ CCP 141 risk management 94–5, 101–5,
recovery and resolution plan 135, 131–2, 144, 157
136–8 small non-financial counterparties
resolution 139–43 97, 106
Resolution Authority 135–6 supervision 90, 92–4, 101, 105,
state-funded bail-out 143–4 118, 122, 131–2, 146, 157,
third countries 144–5, 149–50 203–4
Commission 77, 86, 94, 113, pre-crisis regulation 71–2, 74
119–20, 124–5, 127, 130–131, reforming the reform 124–5, 156
185 CCP recovery and resolution
credit default swaps (CDS) 167 132–45, 191, 196, 202, 204,
definition: central counterparty and 205
clearinghouse 41 EMIR 125–32
deposit guarantee schemes 193 regulations: directly applicable
ESMA see European Securities and 91
Market Association Second Company Law Directive
European Systemic Risk Board 150
(ESRB) 88, 93, 157 State aid 142, 143
Financial Transaction Tax 194 United States 89, 107–10, 113,
MiFID I 72, 91–2, 174 120–122, 145, 146, 148, 183,
minimum CCP capital 101, 177, 199, 205
178, 200 exchange-traded derivatives 21–2, 23,
national differences 203 36, 37, 68, 152, 153, 195
Index 227
clearing: bilateral derivatives versus Freddy Mac 32

43–4 futures clearinghouses 57
European Union 127, 128–9
MiFID I 72 G7 75
futures contracts 25 G10 41
options 25 G20 65, 75–7, 78, 85, 86, 88, 89, 90,
exchanges 58–9 118, 121, 144, 148, 149, 183,
origin of 58 187, 189, 198, 204
recent developments 60–61 game theory 173
extraterritoriality 1, 98, 108–10, 146, Giancarlo, CJ 107, 119, 148
149 global systemically important
financial institutions (G-SIFIs)
fair-value accounting/mark-to-market 83, 170
50, 51–2, 165–7 gold standard 66
Fannie Mae 32 Goldman Sachs 33
Federal Reserve System 34, 35 Greenspan, Alan 70
interest rates 31
financial crisis (2007–2009) 28–33, haircuts 53, 84, 103, 120, 172, 185
53–4, 63, 71, 74, 85, 153, 178 hedge funds 44, 156
AIG 28–9, 32, 33–4, 37 hedging 16–17, 19–20, 36, 58, 80,
G-SIFIs 83 149, 198
LCH.Clearnet (LCH) 36, 37, 40, credit default swaps (CDS) 29
54, 61–3, 150–151, 164, 198 credit risk 16, 17–18
lessons from 34–6, 37, 122 forward contracts 24
see also international reform market risk 16, 17, 18
agenda risks from 18
financial derivatives 24–6 Hong Kong Futures Exchange 172,
forwards/futures 24–5, 29 187
options 24, 25–6
swaps 24, 26 in the money 17
financial stability see clearing and incorporation, place of 115
financial stability information 115, 203–4
Financial Stability Board (FSB) 65, asymmetry 55, 168, 172, 176, 177
73–4, 132 adverse selection and 168, 169,
international reform agenda 75, 172–5, 200, 202
77–8, 83–4, 183 CCP resolution plan 138
progress report 154–5 CCP resolution and recovery 138,
post-crisis reform: EU 106–7 139
Financial Transaction Tax (EU) 194 clearing 56–7, 157, 168, 182
fines 129 exchanges 21–2
for-profit CCPs 61, 164, 172, 179–83, over-the-counter 23
200 insolvency 16, 17–18, 27
foreign exchange forwards 24 central counterparty (CCP) 45, 123,
forwards/futures 24–5, 29 133, 140, 169, 190, 201
fragmentation 110, 121, 132, 134, insurance companies 178
146, 158, 162, 183–4, 197, 204, insurance fund, CCP 193–4, 196
205 benefits 193
possible implementation 194–5 key findings 197–204

insurance regulators 28, 32
interconnectedness 4–5, 6, 7, 90, Lamfalussy Report (2001) 71
118–19, 133, 135, 137, 144, 159, Larosière Report (2009) 90
169, 175, 184–6, 188, 190, 192, LCH.Clearnet (LCH) 36, 37, 40,
193, 194, 201 41–2, 54, 61–3, 150–151, 164,
interest rate swaps 22, 26, 29, 67, 110 195, 198, 199
LCH.Clearnet (LCH) 54, 62 Brexit 145–6, 147
interest rates 31 margins 178, 203, 205
International Monetary Fund (IMF) Swiss CCP SIX x-clear 160
51, 76, 77 legal risk 40
International Organisation of ISDA 73
Securities Commissions (IOSCO) Lehman Brothers 33, 34, 36, 37, 38,
65, 77, 78 40, 54, 61–3, 150, 162–3, 164,
determining clearing eligibility 178, 198
78–80 liquidity 18–19, 20, 21, 22, 23, 28, 36
financial market infrastructures central counterparty (CCP) 45, 47,
80–81 55, 61, 171, 172, 181, 184,
margin requirements 52 186, 190
non-centrally cleared OTC insurance fund 194, 196
derivatives 81–2 financial crisis (2007–2009) 29, 34
international reform agenda 75, 85–7 international reform agenda 79
first results 77–8 post-crisis reform 163, 206
determining clearing eligibility EU 95, 102, 103, 105, 110,
78–80 119–20, 121, 131, 135, 137,
financial market infrastructures 143, 144, 157, 161, 169, 189
80–81, 86 US 110, 112, 121
further developments 81–3 spiral 53
margin requirements 84–5 long party 24, 25
national regulators 84 Long Term Capital Management
recovery and resolution 83–4 34–5, 70
G20 65, 75–7, 78, 85, 86, 88, 89,
90, 118, 121, 144, 148, 149, margin(s) 48, 59, 62, 163, 172, 176,
183, 187, 189, 198, 204 184, 188, 190, 196, 198, 199,
origin 75–7 201, 202, 203, 205
International Swaps and Derivatives call 50
Association (ISDA) 28, 65, 67, derivatives and 51–3
76 EU reform 101–2, 103–4
‘Big Bang Protocol’ 74 initial 34, 48, 49, 51, 54, 59, 63–4,
Codes 72 83, 84, 85, 101–2, 158, 162,
Master Agreements 72–3, 74–5, 178, 185, 199, 202, 205
117–18, 158 international reform agenda 77,
intra-group transactions 80, 96, 98, 82–3, 84–5
127, 128 US reform 115, 116
Irwin v. Williar 68 variation 46, 48, 49–50, 53, 54, 59,
63–4, 83, 84, 144, 158, 162,
jump-to-default risk 167, 199 178, 184–5, 199, 202, 205
Index 229
mark-to-market 50, 51–2, 165–7 over-the-counter derivatives 22–3,

market abuse 57 36–7, 38, 66, 69
market risk 16, 17, 18, 23, 29, 58, 60 AIG 33
clearing 39–40, 48 clearing: exchange-traded versus
hedging 16, 17, 18 43–4
Merrill Lynch 33, 34 credit derivatives 28
Metallgesellschaft 34–5 forward contracts 24
moral hazard 55, 195, 200, 201, 202, opacity 35–6
205, 206 options 25
CCP default fund 192, 193, 196 swaps 26
emergency credit lines to CCPs see also clearing; pre-crisis
163, 177 regulation; reform agenda,
EU 188, 189, 205 international
CCP under resolution 144 ownership, CCP 165, 179–83, 200,
CCPs and access to central bank 202
liquidity 120
default fund 203 pension funds 34, 96, 98, 126, 131,
mandating central clearing 169, 150
175–7 pre-crisis regulation 65–7
margin collection 52 European Union 71–2, 74
selection of CCP members 151 national 67–8
skin in the game 165 United States 68–71, 74, 85
too-big-to-fail 187, 191 non-governmental 72–5
US priority
CCP default 116 creditor 47
Morgan Stanley 33 pro-cyclicality 52, 85, 103, 120, 131,
mortgage-backed securities (MBS) 32 144, 159, 167, 172, 184
proportionality 97, 125, 178
nationalism 183 protectionism 107, 121, 183
netting 40, 45, 46–7, 55, 59, 83, purpose of derivatives 15–16
157–62, 186, 193, 195, 198, 199
arbitrage 20
bilateral 43
hedging 16–17, 19–20, 36, 58, 80,
ISDA 73
New York International Commercial 149, 198
Exchange 67 credit default swaps (CDS) 29
Nixon, Richard 66 credit risk 16, 17–18
novation 39, 44–6, 58, 63, 156, 186 forward contracts 24
market risk 16, 17, 18
Obama, Barack 108 risks from 18
operational risk 16, 29 speculation 18–20
banks 31 put options 25
clearing 39–40, 48
options 24, 25–6, 29 quantitative easing 161
Orange County Pension Fund 34–5
OTC Derivatives Supervisors Group reference entity 17
(ODSG) 78 reform agenda, international 75, 85–7
out of the money 17 first results 77–8
determining clearing eligibility securities differentiated from

78–80 derivatives 14
financial market infrastructures securities settlement systems (SSSs)
80–81, 86 80–81
further developments 81–3 securitisation 31–2
margin requirements 84–5 settlement risk 39–40
national regulators 84 short party 24, 25
recovery and resolution 83–4 size of market 13, 22, 23, 28, 30, 64,
G20 65, 75–7, 78, 85, 86, 88, 89, 71, 75, 158
90, 118, 121, 144, 148, 149, subprime mortgages 31
soft law 65–6, 85, 93, 198
183, 187, 189, 198, 204
speculation 2–3, 18–20, 36, 65, 66,
origin 75–7
80, 198
regulatory analysis credit default swaps (CDS) 29
clearing and financial stability see credit derivatives 28
separate entry forward contracts 24
objectives of reform 152–4 United States 68, 74, 112, 113, 199
regulatory arbitrage 52, 78, 82, 86, spill-over effects 8, 52
90, 109, 121–2, 132, 146, 148, standardisation 47, 52, 58, 65, 67, 82
183, 205, 206 Chicago Board of Trade (CBOT) 58
reporting 56–7, 74, 77, 78 European Union 99
EU 90, 98, 106, 126, 128–30, exchange-traded derivatives 21, 36
148–9, 150, 156–7 Financial Stability Board (FSB)
Reuters 67 77–8
risk management 4, 8–9, 23, 34, 62, IOSCO 79
78, 80, 191, 195, 201, 204, 205, ISDA Master Agreements 72–3
207 State aid 142, 143
AIG 29, 34 stress-testing 51, 118, 169, 178–9,
CCP insurance fund 194 199, 200
CCP’s burden of 202–3 subprime lending 30–33
clearing: techniques of 38, 41–57, Summers, Larry 70
170, 187–8, 196, 198, 199, survivors-pay principle 163–4
SwapClear 41–2
202, 205
swaps 24, 26, 29, 70
cost vs risk 182–3
currency 67
default management 165 foreign exchange 113
for-profit corporations 61, interest rate 22, 26, 29
180–181 Sweden 41
linkage risk 184–6 Switzerland 147
post-crisis reform 169 CCP SIX x-clear 160
EU 94–5, 101–5, 131–2, 144, systemic risk 2, 4, 36, 38–9, 42, 46,
157 63, 64, 87, 153–4, 200, 201, 205,
US 115–16 206
purpose of derivatives 15 CCPs and 169–70, 190, 198, 201,
too-big-to-fail 187–8 207
Roman law 44–5 adverse selection and information
Rubin, Robert 70 asymmetry 172–5, 200
Russia 31 alternative solution 189–95
Index 231
CCP authorisation requirements MiFID II 91

177–83 impact of reform 155–7
linkage risk 184–6, 196 price 47, 68
moral hazard 175–7 Trump, Donald 147–8
regulatory fragmentation 183–4 types of derivatives 24
risk concentration 170–172, 195 comparative summary 29–30
too-big-to-fail 177, 186–9 credit 26–30
credit default swaps (CDS) 167–8 financial 24–6
default resolution 55 forwards/futures 24–5, 29
European Union 88, 93, 94, 96, 97, options 24, 25–6, 29
114, 125, 149 swaps 24, 26, 29
interoperability agreements
160–161 underlying assets 14, 15, 68
Financial Stability Board (FSB) 77 United Kingdom 71
G20 76 Brexit 144–7, 148, 149
interoperability agreements United States 25, 64, 189, 191, 201,
160–161, 162 207
macro-prudential policy and 6–10, Black Monday (19 October 1987)
170 179
margins 52, 53, 198 Chicago Board of Trade (CBOT)
netting 157–8, 195, 198 58
origins of clearing 60 Clearing Corporation 58–9
post-crisis soft law standards 66, 85 Chicago Eggs and Butter Board
United States 70–71, 88, 112, 114 (later Chicago Mercantile
Exchange) 59, 122
taxation Chicago’s International Monetary
EU: Financial Transaction Tax 194 Market 67
Telekurs 67 Commodity Exchange Act (CEA)
time horizon and counterparty risk 35 69, 71, 112, 114
too-big-to-fail 77, 83, 96, 105, 116, Commodity Futures Modernization
119, 141, 177, 186–9, 190, 191, Act (CFMA) 65, 68, 70–71,
192, 193 199
trade repositories (TRs) 56–7, 77, 78, Commodity Futures Trading
81, 156 Commission (CFTC) 69, 70,
European Union 90, 92–3, 100, 71, 107, 108–9, 111–12, 113,
115, 127, 129–30, 156–7 114, 115, 119, 122, 148, 199
trading derivatives 20–21 credit default swaps (CDS) 167
exchange-traded derivatives 21–2, Dodd-Frank Act 2010 26, 108–9,
23, 25, 36, 37 111–13, 114, 115, 116, 117,
over-the-counter derivatives see 121, 147, 198–9
separate entry European Union 89, 107–10, 113,
transaction costs 59, 73 120–122, 145, 146, 148, 183,
transparency 36, 115 199, 205
central counterparty (CCP) 40, 47, Federal Deposit Insurance
56–7 Corporation 116–17
European Union 134, 156–7 Financial Stability Oversight
EMIR 90, 105, 115, 125, 126 Council 88, 116
gold standard 66 risk management 115–16

New York International Commercial SIDCOs 114
Exchange 67 pre-crisis regulation 68–71, 74, 85
over-the-counter derivatives 22, 26, Securities and Exchange
37 Commission (SEC) 71, 109,
ownership, CCP 180 112, 113
post-crisis order 75, 85, 86, 89,
107–17, 118, 120–122, 147–8 valuation 61, 82, 174, 175, 200
CCP default 116–17, 122 errors 165–7
CCP interoperability 114 mark-to-market 50, 51–2, 165–7
counterparties affected 111 Volcker Rule 115–16
establishing CCP 114
implementation timeframe 117 weather derivatives 67, 69
qualified derivatives 111–13 World Bank 76

Alexandra G. Balmer - Regulating Financial Derivatives - Clearing and Central Counterparties (2018)

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© Alexandra G.

All rights reserved. No part of this publication may be reproduced, stored in a

Edward Elgar Publishing, Inc.

A catalogue record for this book

Library of Congress Control Number: 2018931662

This book is available electronically in the

ISBN 978 1 78811 191 1 (cased)

Typeset by Columns Design XML Ltd, Reading

an important area of the regulatory reform debate and is well-researched

Professor Kern Alexander

AAA best credit rating by Standard & Poor’s

Dodd-Frank Dodd-Frank Wall Street Reform and Consumer Protection

G-SIFI global systemically important financial institution

USD United States Dollar

The current regulatory direction, which is prevalent in every aspect of

process, which is why new regulation is only recently being phased in

1.1 FINANCIAL STABILITY

includes elements taken from finance and economics where it is neces-

1.2 SYSTEMIC RISK AND MACRO-PRUDENTIAL

equity to attain profits. This is referred to as leveraging. In good times,

To counterbalance and pre-empt the negative externalities of systemic

micro-prudential and macro-prudential rules can be found in the new

The OTC derivatives market was implicated as a major source of

from the regulators merits an in-depth analysis of both the purpose of a

of OTC derivatives certainly played a role in increasing risk stemming

experience in assessing exposure to their counterparties. This is particu-

to any situation, they are exceedingly difficult to define. Nevertheless,

A derivative is a risk transfer agreement, the value of which is derived from

This definition incorporates all structures necessary for a derivatives

2.2 DERIVATIVE FUNCTIONS

2.2.1 Purpose of Derivatives

Because derivatives allow for risk to be shifted between counterparties,

usage to protect against price shifts.16 A speculator takes a position in the

Hedging not only is employed by institutional investors and other large

2.2.1.1.1 Market risk To protect against future shifts in market move-

2.2.1.1.2 Credit risk Credit risk addresses a second, separate risk

Therefore, derivatives addressing said risk allow the transferal of credit

2.2.1.1.3 Risks from hedging Despite hedging having positive aspects

provide opportunities to both short- and long-term hedgers.36 Optimally,

2.2.2 Trading Derivatives

In the analysis of the purpose of derivatives in the financial market, it

purchase a derivatives contract traded there or bilaterally seek a counter-

2.2.2.1 Exchange-traded derivatives

trading and to gain access to their (electronic) trading platforms.50 While

2.2.2.2 Over-the-counter derivatives

2.2.3 Types of Derivatives

2.2.3.1 Financial derivatives

2.2.3.1.1 Forwards/futures Forward contracts remove uncertainties

2.2.3.1.2 Options Options are traded both OTC and on exchanges.71

2.2.3.1.3 Swaps The swap contract is an agreement between parties to

2.2.3.2 Credit derivatives

risk from his books, at a relatively small price in comparison to the

2.2.3.3 Comparative summary

against corporate or mortgage-bond default. Simplifying a CDS trans-

2.3 DERIVATIVES AND THE FINANCIAL CRISIS OF

diminished as the ratio of debt liabilities to household income rose.112

2.3.2 The Case of AIG

To demonstrate counterparty credit risk, the case of AIG is illuminating.

2.3.3 Lessons from the Crisis

volatility. Metallgesellschaft overtly exposed itself to the financial risk of

to the counterparties. The opacity of the OTC market increases the

may underestimate the riskiness emanating from the underlying, the

Clearing has many different meanings in financial markets.4 This