the tenuous case for derivataves clearinghouses

7/31/2019 The Tenuous Case for Derivataves Clearinghouses

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GEORGETOWN LAWFaculty Publications

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

The Tenuous Case for Derivatives

Clearinghouses

101 Georgetown Law Journal (forthcoming 2013)

Adam J. LevitinProfessor of Law

Georgetown University Law [email protected]

This paper can be downloaded without charge from:SSRN:http://ssrn.com/abstract=2119249

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2012, Adam J. Levitin

THE TENUOUS CASE FORDERIVATIVES CLEARINGHOUSES

ADAM J.LEVITIN

ABSTRACT

Mandatory use of swaps clearinghouses represent the major

regulatory response to the systemic risk from credit derivatives.

Scholars are divided on the merits of clearinghouses; some scholars see

them as reducing systemic risk, others contend they increase it.

The case for swaps clearinghouses comes down to two related

propositions: (1) that clearinghouses are better able to manage risk

than dealer banks in the over-the-counter derivatives market, and (2)that clearinghouses are better able to absorb risk than dealer banks.

Both propositions are heavily dependent on the details of clearinghouse

design, the structure of the clearinghouse market, and the manner of

clearinghouse regulation.

In theory, however, a well-designed clearinghouse boasts one

major advantage over dealer-banks: capital. Clearinghouses can have

deep capital structures, including callable capital from their members.

Clearinghouses thus diffuse losses out across their membership, thereby

avoiding catastrophic losses to any single institution. If designed

properly, a clearinghouse should be much more resilient to losses than

an individual dealer bank. Clearinghouse owners, however, are likely to

pursue lower capitalization, leaving it up to regulators to ensure

sufficient capitalization.

Clearinghouses concentrate risk and also potentially encourage

greater risk taking via underpricing and reduced capital to gain market

share and increase returns on equity. Therefore, if poorly regulated,

they can present a dangerous increase in systemic risk relative to dealer

banks. Thus, the case for clearinghouses remains tenuous and ultimately

dependent upon the still-to-be-determined particulars of their regulation.

INTRODUCTION ...................................................................................................... 2I. OTC VS.CENTRAL CLEARING ........................................................................... 5II. CLEARINGHOUSE AS RISKMANAGER............................................................... 9

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

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


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derivatives clearing organizations), rather than being cleared bilaterallyby dealer banks in the over-the-counter (OTC) market.

5

While the clearinghouse requirement was the centerpiece ofderivatives market reform under the Dodd-Frank Wall Street Reform and

Consumer Protection Act, it has been heavily criticized. Critics have

argued that clearinghouses present concentrated nodes of systemic risk,which is worrisome because they are unlikely to manage risk well and

may themselves fail;6

that they are likely to underprice risk, therebycreating a moral hazard that will encourage more unwarranted risk-taking; 7 that they may result in markets that favor too-big-to-fail

financial institutions;8

and that to the extent clearinghouses are

successful, they merely effectuate a risk transfer from creditors inside the

clearinghouse to creditors outside the clearinghouse. 9 Evenclearinghouse proponents freely admit that they are an imperfectsolution.

10As Professor Hal Scott has rightly observed, Clearinghouses

can reduce but not eliminate systemic risk.11

So what, then, are we to make of clearinghouses? At core, the

case for clearinghouses comes down to two related propositions:

(1) Clearinghouses are better able to manage risk than dealerbanks, and;

5 Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203, 124 Stat.1376, 1675-76, 1762-63, July 21, 2010, 723, 763, codified respectively at7 U.S.C. 2(h) and 15U.S.C. 78c-3. The SEC and CFTC are empowered to exempt certain types of swaps from the

clearing requirement. Id. Derivative market participants are also subject to capital and marginrequirements. Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203, 124Stat. 1376, 1703-12, 1784-96, July 21, 2010, 731, 764, codified respectively at7 U.S.C. 6s and

15 U.S.C. 78o-8(e). In addition, to bank capital requirements as part of Basel III require additionalcapital to be held against derivative positions, but the details of this remain to be determined.

6See, e.g., Mark J. Roe, Post-Crisis Clearinghouse Over-Confidence, working paper,

April 30, 2012 (on file with author); Yesha Yadav, The Problematic Case of Clearinghouses inComplex Markets, 101 GEO. L.J. __ (2012); Jeremy C. Kress, Credit Default Swaps,Clearinghouses, and Systemic Risk: Why Centralized Clearing Parties Must Have Access to Central

Bank Liquidity , 48 Harv. J. on Legis. 49, 72-73 (2011); Craig Pirrong, The Clearinghouse Cure,REGULATION 44 (Winter 2008-2009); Kirsi Ripatti, Central counterparty clearing: constructing a

framework for evaluation of risks and benefits, Bank of Finland Discussion Paper 30/2004 at 21-24

(2004).7 Pirrong,supra note 6.8 Michael Greenberger, Diversifying Clearinghouse Ownership in Order to Safeguard

Free and Open Access to the Derivatives Clearing Market, 17 FORDHAM J.CORP.&FIN.L. (2012);Rena S. Miller, Conflicts of Interest in Derivatives Clearing, Cong. Research Serv. Mar. 22, 2011.

9 Roe,supra note 6; Pirrong,supra note 6.10See, e.g., Scott,supra note 3 at 688; Kent Cherny & Ben R. Craig,Reforming the Over-

the-Counter Derivatives Market: Whats to be Gained? Cleveland Fed. Reserve Bank, EconomicCommentary, 2010.

11 Scott,supra note 3 at 688.


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(2) Clearinghouses are better able to absorb losses than dealerbanks.

An assessment of clearinghouses should then come down to whether theyare more likely to incur losses than dealer banks in the current OTC

market, and, if they do, whether they are they more likely to fail because

of those losses.

Professor Yesha Yadavs article, The Problematic Case of

Clearinghouses in Complex Markets, focuses on the risk management

proposition. In particular, Professor Yadav is concerned thatclearinghouses lack the legal rights necessary to properly manage risk.To remedy this situation, she proposes that clearinghouses be given

greater information about the risks they assume, tools to disciplinemembers risk-taking, and debt governance rights to shield them from

empty creditor problems.12

Whether clearinghouses are superior risk managers to dealerbanks is an open question, as neither has an obvious advantage in riskmanagement, and both are subject to dangerous competitive pressures to

underprice risk. Nonetheless, I am more sanguine than Professor Yadav

about clearinghouses risk management capability. As it stands, theyhave considerable information about risks and substantial ability to

discipline members risk-taking, including the ability to forceinformation about risk-taking. Debt governance rights defeat the wholepurpose of using a derivative contract, which is to decouple credit risk

from the debtor-creditor relationship. In any case, debt governancerights are unlikely to be worth the costs involved in engaging in a wholly

distinct line of business as an asset manager.

More importantly, as long as a clearinghouse is well-capitalizedmeaning it can absorb losses without failing to meet its

obligationsits lack of debt governance rights will not be material to itssystemic risk profile. Thus, I believe that the risk management

proposition is less important than the loss absorption proposition, which

Professor Yadav treats as tangential. Even if clearinghouses are morelikely to incur losses than dealer banks, what matters is their resilience tothe losses.

Ultimately, it is capital, not information or legal rights, that willdetermine the success of clearinghouses. Well-capitalizedclearinghouses can absorb and diffuse losses, serving as systemic

lightning rods. But without sufficient capital (protected by regulation),

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


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Working through the dealer bank helps end-users limit searchcosts for finding swap counterparties, and also means that the end-usersassume the default risk of the dealer banka regulated, major financialinstitution with a strong reputationrather than each other. By

intermediating between the end-users, neither of which knows the

identity of the other or the terms of its swap with the dealer bank, thedealer bank can make a spread on the matched transactions.

14The dealer

bank, however, has assumed the credit risk of both end-users, and, to the

extent it does not match the swaps perfectly, it also assumes the risk onthe swap itself.

Because the dealer bank has assumed the credit risk of its

counterparties (end-users or other dealer banks) it will take precautions:

it will price for risk; it may require its counterparty to post margin(collateral) upfront or to be adjusted throughout the duration of the swap;it may limit its total exposures to any single swap counterparty. The

dealer will also have setoff and netting rights under the standardagreement governing most OTC swaps.

15Moreover, if a dealer bank

finds risk rising too fast during the contract, it may attempt to limit itsrisk through a novation. A novation is the assignment of a position toanother party in exchange for entering a matched swap with the assignee.

Typically the novation would be to another dealer bank thereby

substituting the counterparty risk of the assignee dealer bank for that ofthe original counterparty.

16

All in all, the OTC dealer market represents a risk-sharingarrangement in which dealer banks assume significant credit risk on bothend-users and one another, as well as potential exposure on thederivatives themselves if they do not hedge the exposure through

matched swaps. This raises the concern that dealer banks may not

manage these risks well, and may fail as a result.

The failure of a dealer bank presents a serious risk to the entire

financial system because dealer banks are central nodes in the system,highly interconnected with each other and many other financial

institutions in a multitude of ways.17

The interconnectedness of dealer

14 The private dealer benefits from opacity in the OTC market may answer ProfessorCraig Pirrongs question of why centralized clearing did not emerge on its own for credit

derivatives; dealers did not want to give up the spread. See Pirrong, supra note 6, at 44 (If thebenefits of centralized clearing are so great, why havent CDS market participants embraced theconcept before now, and then only under regulatory pressure?).

15 International Swaps and Derivatives Association Master Agreement.16 Darrell Duffie, TheFailure Mechanics of Dealer Banks, 24 J.ECON.PERSPECTIVES 51,

__ (2010).17Id.


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banks means that the failure of one could easily cascade into the failureof others and thus transmit distress throughout the financial system.Indeed, in 2008, the dealer bank system showed itself to be exceedinglyvulnerable, as shown from the most acute phase of the crisis following

the failure of Lehman Brothers.

Centralized clearing through a clearinghouse presents analternative risk sharing arrangement. There are numerous possible ways

to design a clearinghouses risk-sharing structure. The details of thedesign in terms of capital structure and risk management techniques arewhat will determine clearinghouses success in mitigating systemic risk,

not whether clearinghouses are given expanded risk management tools,

as Professor Yadav urges.

While the precise ownership of clearinghouses varies, they

typically have features of mutual insurance via a common guaranty fund

to which all members contribute pro rata, and sometimes also the abilityto levy assessments (essentially callable capital) on their members. Thus,clearinghouse members have liability for each other, even if the

clearinghouse itself is not a mutual company.18

Clearinghouses use their

mutual insurance features to diffuse losses out across their membershipon a pro rata basis, thereby avoiding catastrophic losses to any singleinstitution and preventing cascades of failure.19 The loss spreading

enabled by clearinghouses is perhaps their single most important featurein terms of reducing systemic risk.

Clearinghouse members are usually large financial institutionsmore or less the existing dealer banks. Other parties access the

clearinghouse through customer accounts with the clearinghousemembers, with the clearinghouse serving as a central counterparty to all

swaps. Technically this happens through a novation, which replaces the

swap with two separate swaps, each with the clearinghouse.20

Thus, in aclearinghouse, the end-user directs its agent, the clearinghouse member,

to enter into a swap with another end-user, which also has a

18See Yadav,supra note 6, at ___. [Discussion of clearinghouse ownership.]19 EUR. CENT. BANK: EUROSYSTEM, CREDIT DEFAULT SWAPS AND COUNTERPARTY

RISK 53 (Aug. 2009) available athttp://www.ecb.int/pub/pdf/other/creditdefaultswapsandcounterpartyrisk2009en.pdf (noting that aclearinghouse default fund effectively mutualises the residual loss from a members default, sharing

it out across clearing members, rather than having losses concentrated in one non-defaultingmember).

20See, e.g., LCH.Clearnet Ltd. Rulebook, June 20, 2012, Rule 3(a) (Upon registration of

an original contract by the Clearing House, such contract shall be replaced by novation by twoopen contracts, one between the seller and the Clearing House as buyer, as principals to suchcontract, and one between the buyer and the Clearing House as seller, as principals to such

contract.).


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clearinghouse member as its agent. The two clearinghouse memberstake their swap to the clearinghouse, which through novation places itselfin the middle of the swap. The result is that the clearinghouse membersboth swap with the clearinghouse, rather than with each other directly.

(See Figure 3.)

Figure 3. Clearinghouse as Central Counterparty21

Unlike dealer banks, clearinghouses make only perfectly

matched swaps between their members.

22

If a clearinghouse memberdefaults, the clearinghouse will make good the payment on the matched

swap to the other member. Thus, all counterparty risk falls on the

clearinghouse. The clearinghouse, however, does not assume the risk onthe swap itself other than through counterparty risk.

Because clearinghouses do only matched swaps, they typically

charge a flat, per transaction fee or a transaction size-based fee.

Clearinghouses adjust for risk based on collateral requirements ratherthan fees. This means that it is impossible for dealers to make an

invisible spread on cleared transactions. Instead, they have to price theirexecution of the transaction upfront to their end-user clients.Clearinghouses make dealer spreads transparent, and this price

transparency should result in a more efficiently priced swaps market.

21See EUR.CENT.BANK,supra note 19, at 52.22 The swaps are only necessarily matched for the clearinghouse, not for its members, as a

clearinghouse member can also be the end-user, holding some or all of the non-counterparty risk on

the swap.

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A. Balance Sheet Risk vs. Position RiskDealers and clearinghouses both assume credit risk in their

intermediation, but this risk comes from two distinct sources. First, thereis a risk that their counterparties will default on their swap obligations

based on losses on the swaps. As long as the counterparties havesufficient capital to make good these losses, there is no problem, but if

the losses are large enough, the counterparty could be rendered insolvent.

This type of risk is what Professor Craig Pirrong has termed positionrisk.25 Second, there is the risk that counterparties will default on their

swap obligations because they are rendered insolvent from losses from

other transactions. This is what Professor Pirrong has termed balance

sheet risk.26

B. Risk Management Tools

Clearinghouses and dealers have the same basic toolkit forresponding to risk. First, both clearinghouses and dealers can decidewhether they want to deal with a counterparty at all. Clearinghouses has

membership requirements that including minimum capital standards.27

Counterparty screening provides an important risk management tool.Dealers can simply refuse to deal.

Second, both clearinghouses and dealers can price risk. Pricing

can come in a number of forms. For clearinghouses, there are clearingfees, while for dealer banks, pricing is in the form of the spread required

on the swap. For both clearinghouses and dealers, pricing can also comein the form of collateral (also known as margin or performancebonds). Clearinghouses and dealers can require upfront collateral

postings (initial collateral) and also subsequent adjustments to it(maintenance collateral).28 Both clearinghouses and dealers can specify

what types of collateral are acceptable.29

Clearinghouse margin requirements work differently than the

typical OTC arrangement. The typical OTC CDS is governed by the

International Swaps and Derivatives Association (ISDA) Master

25 Pirrong,supra note 6, at 46.26Id.27 See, e.g., LCH.Clearnet, Ltd., Clearing House: General Regulations, Reg. 1.2

(membership), 1.8-1.9 (capital requirements); CME Group, CME Rulebook Rule 8H04 (capital

requirements for CDS clearing members).28See, e.g., LCH.Clearnet, Ltd., Clearing House Procedures, 2.C.8 (initial margin),

2.C.9 (intraday margin); CME Group, CME Clearing Financial Safeguards 7-8, athttp://www.cmegroup.com/clearing/files/financialsafeguards.pdf. See also CME Group, CMERulebook, Rules 8H824 (additional performance bond requirements).

29 See, e.g., CME Group, Acceptable Performance Bond Collateral for CDS, at

http://www.cmegroup.com/clearing/files/acceptable-collateral-cds.pdf.


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Agreement. Almost all CDS are collateralized.30

Collateralized swapsusing ISDA documentation use the Credit Support Annex (CSA) to theISDA Master Agreement to specify collateral terms.

31The specific terms

for the collateral are customized by the swap counterparties. Collateral

can is marked-to-market on whatever frequency the parties agree,32

but

often CDS provide for margin calls only upon the ratings downgrade of acounterparty or a significant increase in the credit exposure of the in-the-money party.33 The result is that margin calls are infrequent, but when

they occur, they are often large, a phenomenon similar to the jump-to-default problem in CDS.

34Moreover, because these margin calls are

linked to a counterpartys credit rating, they are likely to occur

simultaneously for numerous swaps.35

The result can be an acute

liquidity crisis for the party faced with the margin call.

36

In contrast, clearinghouses typically evaluate margin twice

daily.37

This means that clearinghouse margin calls are more

incremental, giving the party facing the margin calls more time to find asolution to its financial travails.

While collateral postings are usually set based on the size of

positions, clearinghouses and dealers can also require generalcollateral. For clearinghouses, this can be in the form of a lien on theclearinghouse membership or account itself,38 or a required contribution

30 ISDA, Market Review of OTC Derivative Bilateral Collateralization Practices, Release2.0, Mar. 1, 2010, athttp://www.isda.org/c_and_a/pdf/Collateral-Market-Review.pdf at 6.

31 There are distinct New York and London versions of the CSA. The most importantdistinction is that the New York CSA permits rehypothecation of the collateral, whereas the LondonCSA does not. Id. at 16, 18.

32Id. at 11.33 Risk Management Consulting Services, Inc., Review of CME Groups Credit Default

Swap Margin Model and Financial Safeguards for CDS Clearing 4 athttp://www.cmegroup.com/trading/cds/files/cds-review.pdf.

34 Jump-to-default is the phenomenon in which protection sellers CDS payout liabilityoccurs suddenly through triggers such as payment defaults or bankruptcy filings, rather than

incrementally. The effect is to make the liquidity demands on CDS protection sellers more volatile.35 Risk Management Consulting Services, Inc.,supra note 33.36Id.37Id.38See, e.g., CME Group, CME Rulebook, Rule 8H08 (Each CDS Clearing Member

hereby grants to the Clearing House a first priority and unencumbered lien to secure all obligations

of such CDS Clearing Member to the Clearing House against any property and collateral depositedwith the Clearing House by the CDS Clearing Member.); CME Group, CME Rulebook, Rule 133,athttp://www.cmegroup.com/rulebook/CME/I/1/33.html (CME clearing membership is sold upon a

default, with recourse if the sale is insufficient to cover the debt); Federal Reserve Banks, OperatingCircular 1 Account Relationships, Effective Sept. 1, 2011, 5.3, athttp://www.frbservices.org/files/regulations/pdf/operating_circular_1_090111.pdf (providing

Federal Reserve with security interest in clearinghouse account); Federal Reserve Banks, OperatingCircular 10 Lending, Effective Oct. 15, 2006, 12 athttp://www.frbservices.org/files/regulations/pdf/operating_circular_10.pdf, (providing Federal

Reserve with security interest in clearinghouse account).


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to a guaranty fund,39

or liability for assessments.40

This type ofcollateral is can be used not only to offset losses on a membersdefault, like deal-specific collateral, but also to offset losses from othermembers defaults if necessary. This collateral is essentially a form of

capital for the clearinghouse. For dealers, more general collateral may

come in the form of required maintenance of a brokerage or depositaccount or other assets with the dealer that can then be used to offsetswap losses. Similarly, both clearinghouses and dealers can obtain

guarantees from third-parties.41

These types of general collateral are closely related to a third

risk management tool, setoff. Setoff (combined with the netting of

multiple transactions) permits the clearinghouse or dealer to offset

obligations it owes the defaulted counterparty against the debt owed bythe counterparty.

42Thus, if the defaulted counterparty owes the

clearinghouse or dealer $100 million, and the clearinghouse or dealer

owes the defaulted counterparty $120 million on other transactions, theclearinghouse or dealer need only pay the defaulted counterparty $20

million. Transaction-specific collateral, more general forms of collateral,and setoff all function like deductibles, which help reduce moral hazardin swap clearing by forcing a defaulting party to internalize its losses.

A fourth tool for risk management is position limits. Both

clearinghouses and dealer can limit the size of their counterpartiespositions.

43Clearinghouses are likely to have formal exposure limits,

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

required).40 See, e.g., CME Group, CME Rulebook, Rule 8H07 (liability for guaranty fund

assessment).41See, e.g., CME Group, CME Rulebook Rule 901 (requiring guarantee from control

parties of CME Clearing Members).42See, e.g., CME Group, CME Rulebook Rule 8H802.B.3 (netting and setoff); Federal

Reserve Banks, Operating Circular 1 Account Relationships, Effective Sept. 1, 2011, 5.3, athttp://www.frbservices.org/files/regulations/pdf/operating_circular_1_090111.pdf (providingFederal Reserve with right of setoff); Federal Reserve Banks, Operating Circular 10 Lending,

Effective Oct. 15, 2006, 12 athttp://www.frbservices.org/files/regulations/pdf/operating_circular_10.pdf, (providing FederalReserve with right of setoff). Most OTC CDS use the International Swaps and Derivatives

Association (ISDA) Master Agreement, which provides for bilateral netting between counterpartiesvarious transactions, and setoff in the event of default.

43See, e.g., CME Group, CME Rulebook, Rule 5559 (position limits). The Federal

Reserve operates an automated clearing house (ACH) and a wire transfer service (FedWire). TheFederal Reserve has position limits in the form of daylight overdraft limits, restricting how much a

party can owe the Federal Reserve at any point. See Federal Reserve Policy on Payment System

Risk, Mar. 24, 2011, at http://www.federalreserve.gov/paymentsystems/files/psr_policy.pdf. TheFederal Reserve both caps the overdraft amount, id. at 22-27, and charges a 50 basis point fee foruncollateralized daylight overdrafts. Id. at 21. CHIPS, a private wire transfer clearinghouse operated

by The Clearing House, does not permit any daylight overdrafts,


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while dealer banks are more likely to impose ad hoc limits, but the tool isthe same.

Clearinghouses and dealers operate with the same basic set ofrisk management tools. While they may have different pricing or margin

requirements or position limits, they tools are functionally the same. The

question, then, is how they will be deployed, which depends on theidentification and evaluation of risk.

C. Information Fragmentation and Limitations

The ability of dealers and clearinghouses to manage position and

balance sheet risk is heavily dependent upon the information theypossess. In the presence of complete and accurate information and good

modeling of risks, both dealers and clearinghouses should be able to takesufficient precautions to limit risk. Whether they will be so incentivized

is a separate topic, discussed below.

Dealers and clearinghouses have access to different types ofinformation. Dealers and clearinghouses both have good basicinformation about position risk. They know the extent of their

counterparties maximum exposure with them, and can compare thepotential and likely losses on those positions with the counterparties

overall financial wherewithal.

How dealers and clearinghouses calculate the likely value at risk

is a matter of modeling. It is not clear that dealer banks risk modeling

will necessarily be superior to clearinghouses. Dealer banks may havean informational advantage regarding modeling of position risk. To the

extent that dealer banks are also active the market underlying the swap,dealer banks will have a modeling advantage, but that is no guarantee of

their modeling success. For example, a dealer bank that arranges

mortgage securitizations should have a better understanding than aclearinghouse of the risks involved in a credit default swap on mortgage-

backed securities (MBS), but this assumes that the securitization desk at

the dealer is in close communication with the swaps desk. The

experience of the dealer banks incurring large losses on MBS in 2008suggests that this may not always be the case. Moreover, dealer banks,as active proprietary trading participants in the market, can also affect

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


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risk, particularly if they stake out large positions, like the infamousLondon Whale of JPMorgan Chase.

44

Dealers and clearinghouses have largely similar informationregarding balance sheet risk. Most of the information a dealer bank will

have is the same is available to a clearinghouse: quarterly public

information about its counterparties, credit ratings, secondary market andcredit derivative pricing on their counterparties, and anecdote.

45

Dealer banks will have a slight informational edge if they can

supplement this information with whatever they glean from their ownnon-swap dealings with their counterparties (such as loans or brokerageservices). Dealers have necessarily incomplete information, however, as

a dealer bank can never know how much of a counterpartys business itis seeing. Indeed, dealer banks cannot know the extent of a

counterpartys total position, either in swaps or in general because of the

fragmented nature of the dealer market. Goldman Sachs might know thatAIG has $10 billion in long positions on CDS with it, but Goldmandoesnt know if AIG has hedged this with another dealer or if AIG has

long positions with other dealers. The same holds true for AIGs non-

swap exposures. Goldman cannot know the full extent of AIGsliabilities, much less the details of their structuring, such as the existenceof affiliate guarantees, etc. Dealer banks lack real-time, birds eye views

of their counterparties balance sheets.

In contrast, depending on the number of clearinghouses and

whether they share information, clearinghouses may be able to see theirmembers total swap exposure. If there is only a single clearinghouse,

then it will know the full extent of all of its members swap exposures. Ifthere are multiple clearinghouses, this information advantage is lost;

information will be fragmented as it is for dealer banks, unless

clearinghouses share information.

Clearinghouses might be more willing to share data than dealer

banks, as they typically make money on per transaction fees, rather than

on spreads between matched transactions. This means clearinghousesare less likely to view exposure data as proprietary in the same way adealer would view bids and asks. The clearinghouses profits do not

depend on informational opacity, but transparency.

44 Daniel Schfer & Ajay Makan, JPMorgans whale causes a splash, FIN.TIMES, May11, 2012.

45 CME Group, Financial Safeguards, supra note 28, at 12 (financial surveillance).Mandatory clearing gives clearinghouses a great deal of leverage to force information fromcounterparties. This may help clearinghouses address balance sheet risk, although, competition

among clearinghouses may erode this leverage, however, as discussed below.


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Mandatory clearing gives clearinghouses a great deal of leverageto force information from counterparties. This may help clearinghousesaddress balance sheet risk, although, competition among clearinghousesmay erode this leverage, however, as discussed below.

Professor Pirrong has observed that futures clearinghouses only

attempt to price position risk, not balance sheet risk.46

To the extent thisholds true for swaps clearinghouses, they are unlikely to manage risk

better than dealer banks. But there is no reason that this must be the casefor derivatives clearinghouses, especially those that clear creditderivatives. Indeed, the Dodd-Frank Act places systemically important

financial market utilities (SIFMUs), including swaps clearinghouses

under federal regulatory authority.47

Federal regulators (SEC for

securities-based swaps, like CDS on MBS or corporate bonds; CFTC foreverything else, like CDS on loans) are required to promulgate riskmanagement standards for SIFMUs.

48These standards may include

collateral and margin requirements and capital requirements among otherthings.

49SIFMUs are also subject to annual examination by their

regulators,50

and gain access to Federal Reserve liquidity facilities.51

SIFMU regulations have not yet been promulgated as of thewriting of this article (and indeed, the SIFMU designation process is on-going), but one hopes that swap clearinghouses will have to consider

their members overall balance sheets and require members to providethem with sufficient real-time information in order to evaluate balance

sheet risk.D. Empty Creditor Problems?

Professor Yadav argues that clearinghouses ability to manage

risk is compromised by derivatives separation of legal rights from

46 Pirrong,supra note 6, at 47.47 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the Dodd-

Frank Wall Street Reform & Consumer Protection Act of 2010), P.L. 111-203, 124 Stat. 1376, 1802-

1822, July 21, 2012, 801-814, codified at12 U.S.C. 5461-72.48 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the Dodd-


11, July 21, 2012, 805(a), codified at12 U.S.C. 5464(a).49 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the Dodd-


11, July 21, 2012, 805(c), codified at12 U.S.C. 5464(c).50 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the Dodd-

Frank Wall Street Reform & Consumer Protection Act of 2010), P.L. 111-203, 124 Stat. 1376, 1814,

July 21, 2012, 807, codified at12 U.S.C. 5466.51 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the Dodd-


14, July 21, 2012, 806, codified at12 U.S.C. 5465.


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economic risk poses serious risk to clearinghouses. She worries thatclearinghouses will find themselves dealing with empty creditorsnominal creditors with no economic interest in a loan.

52The implication

of Professor Yadavs argument is that risk management is the key to

clearinghouse success.

I disagree. While an empty creditor problem can exist, I believeit is a red herring in the debate over clearinghouses, and that they key is

capital, not risk management. While risk management helps protectcapital, clearinghouses relative advantage over OTC clearing is capital,not risk management. To be sure, risk management is intimately related

to capital; without good risk management, capital is quickly squandered.

Nonetheless, I believe that clearinghouse design needs to start with

capital standards, not risk management techniques.

Professor Yadav sketches out a scenario in which A has bought

credit default swap protection from B on C, to whom A has made aloan.

53The CDS makes A indifferent to Cs default and to the losses

incurred in the default. Therefore A will not take steps to mitigate the

losses on the loan to C, which could in turn increase the amount that B

has to pay out on CDS contract with A. Moreover, A might even act toproduce a credit event forC, such as a bankruptcy filing that triggersthe CDS payout in order to ensure its own losses from Care covered by

the CDS insurance.

Professor Yadav worries that without the ability to protect itself

against the empty creditor problem, clearinghouses will assume risksthey cannot manage properly, which is particularly concerning given the

concentration of risk in clearinghouses due to their role as nodes offinancial interconnectivity. The scenario Professor Yadav presents is

standard empty creditor theory applied to clearinghouses, but it is not

in any way specific to clearinghouses.54

It applies equally to OTCderivatives. Given that the empty creditor problem is not unique to

clearinghouses, it is hard to see why it is a particular concern in theclearinghouse context any more so than in the dealer bank context.

52 Yadav,supra note 6, at ___. [section III.A.2.]53Id. at ___.54 See Henry T.C. Hu & Bernard Black, Debt, Equity and Hybrid Decoupling:

Governance and Systemic Risk Implications, 14 EUR. FIN. MGMT. 663 (2008); Henry T.C. Hu &

Bernard Black, Equity and Debt Decoupling and Empty Voting II: Importance and Extensions, 156U. PA. L. REV. 625 (2008); Henry T.C. Hu & Bernard Black, Hedge Funds, Insiders, and the

Decoupling of Economic and Voting Ownership: Empty Voting and Hidden (Morphable) Ownership,

13 J.CORP.FIN. 343 (2007).


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In any case, it is not apparent why any of this particularlymatters for a clearinghouse that stands between A and B. As failure tomitigate its loss on the underlying asset will increase Bs obligation tothe clearinghouse, and thus the clearinghouses obligation to A. This

only affects the clearinghouse if B is insolvent. Otherwise, the

clearinghouse is just a pass-through entity. Even ifB is insolvent, theempty creditor problem still does affect systemic risk unless theclearinghouse also lacks sufficient capital to payA.

Put another way, the critical question is whether theclearinghouse is sufficiently capitalized, not whether it has debt

governance rights or any other risk management tool. If the

clearinghouse is sufficiently capitalized, then the empty creditor problem

is not material from a systemic risk standpoint.55

Even if the empty creditor problem did pose a major threat to

clearinghouses, Professor Yadavs solutions seem impractical. ProfessorYadav would attempt to mitigate the empty creditor problem byproviding clearinghouses with more information about market

conditions, greater tools to discipline their members, and perhaps most

importantly, debt governance rights.56

I have no objection to ensuring that clearinghouses have more

information or disciplinary tools. It is not apparent, however, that theyare lacking for information or disciplinary tools. Clearinghouses are ableto demand information from their members

57and purchase data on the

open market from vendors, just like financial institutions and regulators.They also already engage in information sharing with regulators.

58As

for disciplinary tools, this is simply a matter of clearinghouse rules.Clearinghouses are free to give themselves whatever disciplinary tools

they choose.

If clearinghouse rules are too draconian, of course, it may behard to recruit members. Indeed, there is a very real possibility of

clearinghouse competition for membership and transaction volume based

on rules, including margin requirements and position limits and memberliability. If this sort of competition occurs, there will likely be adverseselection, as the riskiest swaps will go to the clearinghouse with the

55 Theoretically, the empty creditor problem could affect the sufficiency of capital at themargin. But a truly well-capitalized clearinghouse should not be vulnerable to failure based on anempty-credit problem.

56 Yadav,supra note 6, at ____. [PART IV].57 See, e.g., LCH.Clearnet, Ltd., Clearing House: General Regulations, Reg. 1.10

(reporting requirements).58See, e.g, CME Group, Financial Safeguards,supra note 28, at 12.


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III. CLEARINGHOUSE AS LOSS ABSORBER

The major potential advantage clearinghouses have over dealerbanks is in their ability to absorb risk, rather than manage it.Clearinghouses are essentially highly layered capital structures. While

the details of a clearinghouses capital structure are (but need not be) set

by private ordering, the structures of one the clearinghouses currentlyclearing corporate CDS, the Chicago Mercantile Exchanges CME

Clearing, is as follows.61

First, any losses from a default by a customer of a clearinghousemember are reduced by collateral, netting, and setoff against thecustomers account. 62 Second, if the members customer is unable to

make good its obligation via collateral and setoff, then the clearinghousemay engage in setoff and seize collateral from the clearinghouse

members proprietary account and its contribution to the clearinghouses

guaranty fund.63

Third, the clearinghouse itself will kick in some of itsown funds.

64Fourth, other clearinghouse members contributions to the

guaranty fund are applied against the default.65

And finally, if these

outer layers of defense are insufficient, the clearinghouse may make a

capital call (up to a limited amount) on its members.66

And, if the

61 LCH.Clearnet, Ltd., has a similar structure with losses allocated first to the defaultingcustomer, then to the member clearing that customer from its guaranty fund contribution and

proprietary accounts, then to the clearinghouse (capped at paltry 20 million), then outside

insurance, then to non-defaulting members guaranty fund contributions, and then the clearing houseitself again. LCH.Clearnet, Ltd., Default Fund Rules May 2012, 16.

62 CME Group, CME Rule 8H802A.d.2 (A CDS Loss arising in the defaulted CDS

Clearing Members proprietary account class shall be satisfied from the CDS Collateral. A CDSLoss arising in the defaulted CDS Clearing Members customer account class shall be satisfied byapplication of performance bond, excess performance bond and settlement variation gains

(collectively, the CDS Customer Collateral) held in the customer account class in which the CDSLoss is generated and by any excess CDS Collateral remaining after finalizing the CDS Loss of thedefaulted CDS Clearing Members proprietary account...).

63Id.64 CME Group, CME Rule 8H802B.1 (If the CDS Collateral, the CDS Customer

Collateral, and any excess assets from other product classes made available to cover CDS Losses, as

described in Rule 8H802.A, is insufficient to cover the CDS Loss produced by the default, theClearing House shall cover, or reduce the size of, such CDS Loss by applying the following funds tosuch losses in the order of priority as follows: First, the corporate contribution of CME for CDS

Products (the CME CDS Contribution), which shall be equal to the greater of (x) $50 million and(y) 5% of the CDS Guaranty Fund, up to a maximum of $100 million).

65 CME Group, CME Rule 8H802B.1 (Second, the CDS Guaranty Fund (excluding the

contribution of the defaulted CDS Clearing Member), which shall be applied pro rata to each non-defaulted CDS Clearing Members deposit to the CDS Guaranty Fund in accordance with Rule8H07).

66 CME Group, CME Rule 8H802B.1 (Third, CDS Assessments against all CDSClearing Members (excluding any previously defaulted CDS Clearing Members), which shall beassessed against each CDS Clearing Member pro rata in proportion to their required deposit to the

CDS Guaranty Fund). In theory, nothing prevents unlimited liability for clearinghouse members.


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clearinghouse is a SIFMU, it will be able to access emergency FederalReserve liquidity facilities.

67

This capital structure places losses first on the defaulted part(netting, setoff, collateral) and then disperses excess losses among the

clearinghouses members, thereby lessening the impact on any one of

them. The different layers of capital and sources of liquidity makeclearinghouses resilient to losses, and the diffusion of losses among

members makes no single members share of losses catastrophic. Thus,the feared domino chain of failures is broken.

This is not to say that a clearinghouse could not fail, eitherbecause of illiquidity or insolvency, and the details of the capital

structure clearly matter; it is certainly possible for a clearinghouse to beundercapitalized. In theory, though, the financial strength of a

clearinghouse could be the sum total of its members, making it stronger

than any single dealer bank.

Ultimately, ex post loss resilience, rather than ex ante riskmanagement, is more important from a systemic risk standpoint. If

clearinghouses can accomplish that, then they will serve as systemic risk

circuit breakers in the swaps space. Yet it is also quite possible thatclearinghouses will not be well-designed and will neither be resilient to

losses nor good risk managers. In particular, clearinghouse owners mayhave incentives adverse to good risk management and capitalization. Asthe next section discusses, clearinghouses could potentially increase

systemic risk.

IV. DO CLEARINGHOUSES CREATE SYSTEMIC RISK?

Clearinghouses might create systemic risk in three ways. First,they concentrate risk. Clearinghouses become centralized risk nodes

within the system. Accordingly, the failure of a clearinghouse wouldhave systemic consequences that would be far worse than a dealer banksfailure. Not only would CDS counterparties lose the insurance function

of the clearinghouse, but the market would also be in disarray if a

clearinghouse failed.

Concentration of risk on clearinghouses does have a benefititshould focus systemic risk regulation on clearinghouse regulation.

Systemic risk regulation may be easier when risk is not dispersed.Moreover, if a clearinghouse were to fail, it would be far easier to bailout

67 Payment, Clearing, and Settlement Supervision Act of 2010 (Title VIII of the Dodd-Frank Wall Street Reform & Consumer Protection Act of 2010), P.L. 111-203, 124 Stat. 1376, 1811-

14, July 21, 2012, 806, codified at12 U.S.C. 5465.


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than a dealer bank both in terms of bailout execution and as a politicalmatter. The direct rescue of a privately owned financial institution ispolitically much more different than bailing out a utility used by theentire market.

68

Second, clearinghouses may create systemic risk by underpricing

risk on CDS in order to gain market share. This underpricing could takethe form of lower margin requirements, lower capital and membership

requirements, or lower information production requirements.Clearinghouses are volume businesses, so expanding transaction volumeincreases revenue. If volume is increased without a concomitant increase

in equity, a clearinghouse has increased its leverage and hence its return

on equity. Market share is thus critical to clearinghouse profitability,

and, indeed, there may be network effects in the industry that make itespecially critical to establish market share. Thus, there will be a strongtemptation for clearinghouses to underprice risk without increasing their

capital in order to gain market share and thus increase returns onequity.

69

Underpricing for market share is analogous to an insurance rate

war. If this occurs the results are predictable: all the parties in the ratewar are left undercapitalized for the risks they have incurred. Indeed,underpricing risk is also likely to encourage more CDS transactions by

lowering transaction costs, further increasing the risk assumed by theundercapitalized clearinghouse. And there is likely to be adverse

selection, as the riskiest swaps are moved to the clearinghouses with thelaxest risk management (including lowest capital requirements in termsof margin and other collateral).

The standard insurance regulation responses to this problem are

rate-regulation or public provision of insurance. It seems unlikely,

however, that the SEC and CFTC would impose rate regulation onclearing utilities to limit risk-taking, and although the Federal Reserve

runs a payments clearinghouse, there seems to be little interest in apublic swaps clearinghouse.

All of this points to the market structure for clearinghouses beingcritical to their success. If there are too many clearinghouses, their

membership and their capital will be shallower; they will not be able to

disperse losses as effectively. There is also the potential for a destructive

68See Adam J. Levitin,In Defense of Bailouts, 99 GEO.L.J. 435 (2011).69 Underpricing is also a potential problem for dealer banks, but because they make

money on the opaque spread, rather than simply on volume, market share is less critical than for

clearinghouses.


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rate war. Yet competition may also encourage innovation and efficiencyin clearing. Thus we are faced with a tradeoff between innovation andefficiency and prevention of systemic risk. Given that clearinghousesraison dtre is systemic risk reduction, it would seem that innovation

and efficiency would be secondary concerns, but again it seems unlikely

that regulators would limit the number of clearinghouses or imposemandatory risk management requirements, rather than looser standardsupon them.

The third way clearinghouses may affect system risk is byshifting it outside the clearinghouse. Professor Mark Roe has argued that

clearinghouses reduce risk for cleared transactions at the expense of

creditors in transactions not handled by the clearinghouse.70

In particular,

clearinghouses are secured creditors, which transfers risk to membersunsecured creditors by limiting the assets available to them in the eventof a members bankruptcy. Clearinghouses use of setoff and netting also

functions similarly to secured credit, benefitting the clearinghouse at theexpense of other creditors of its members by giving the clearinghouse

priority in some of its members assets. (So too, one might add, doescallable clearinghouse capital.) Professor Roe observes that this transferof risk from inside to outside the clearinghouse could be systemically

damaging if the risk is transferred to systemically important parties.

The risk transfer effectuated by clearinghouses may well harmother systemically important parties. Yet the problem the Professor Roe

identifies is one of systemic risk transfer, not generation. Unless webelieve that parties outside the clearinghouses are more systemicallyimportant than those in the clearinghouses, it is hard to see this transferas deleterious. To the extent that systemic risk thrives on nodes of

financial interconnectivity, it is hard to think of institutions more

important than dealer banks.

Clearinghouses are merely a device to reduce the risk that stems

from a dealer bank failure. They are not general systemic risk panaceas.They do not even cover all of the risks from dealer banks, as Professor

Roe notes, given that dealer banks have other non-swap dealings witheach other outside of clearinghouses (and which may be made riskier by

clearinghouses).71

Instead, clearinghouses are one piece in a much larger systemicstability infrastructure of oversight, capital, and resolution mechanisms

that is being slowly assembled. This systemic stability infrastructure is

70 Roe,supra note 6.71Id. at __.


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the tenuous case for derivataves clearinghouses

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