Clearinghouses and the Swaps Market: A Decade On
Summary and Keywords
In the wake of the 2008 financial collapse, clearinghouses have emerged as critical players in the implementation of the post-crisis regulatory reform agenda. Recognizing serious shortcomings in the design of the over-the-counter derivatives market for swaps, regulators are now relying on clearinghouses to cure these deficiencies by taking on a central role in mitigating the risks of these instruments. Rather than leave trading firms to manage the risks of transacting in swaps privately, as was largely the case prior to 2008, post-crisis regulation requires that clearinghouses assume responsibility for ensuring that trades are properly settled, reported to authorities, and supported by strong cushions of protective collateral. With clearinghouses effectively guaranteeing that the terms of a trade will be honored—even if one of the trading parties cannot perform—the market can operate with reduced levels of counterparty risk, opacity, and the threat of systemic collapse brought on by recklessness and over-complexity.
But despite their obvious benefit for regulators, clearinghouses also pose risks of their own. First, given their deepening significance for market stability, ensuring that clearinghouses themselves operate safely represents a matter of the highest policy priority. Yet overseeing clearinghouses is far from easy and understanding what works best to undergird their safe operation can be a contentious and uncertain matter. U.S. and EU authorities, for example, have diverged in important ways on what rules should apply to the workings of international clearinghouses. Secondly, clearinghouse oversight is critical because these institutions now warehouse enormous levels of counterparty risk. By promising counterparties across the market that their trades will settle as agreed, even if one or the other firm goes bust, clearinghouses assume almost inconceivably large and complicated risks within their institutions. For swaps in particular—whose obligations can last for months, or even years—the scale of these risks can be far more extensive than that entailed in a one-off sale or a stock or bond. In this way, commentators note that by becoming the go-to bulwark against risk-taking and its spread in the financial system, clearinghouses have themselves become the too-big-to-fail institution par excellence.
Clearinghouses and the Crisis: Introduction
Following the 2008 Financial Crisis, regulators rapidly converged on key principles to guide the reform and restructuring of the over-the-counter (OTC) market for derivatives.1 A catalyst for the Global Financial Crisis, credit default swaps (CDS) had flourished in size and complexity within a light-touch regulatory environment in the years prior to the events of 2008.2 Having permitted the OTC swaps market to develop largely within a system of private self-regulation by the major banks and investment banks that constituted its dominant players, the 2008-crisis led regulators toward urgent and thoroughgoing top-down reform.3
The core tenets guiding reform reflected the perceived deficiencies of the pre-2008 OTC swaps market: (i) that single players could assume far too much risk placing themselves and the financial system in peril; (ii) that regulators did not possess sufficient information about the risks of derivatives trading; and (iii) that market players suffered from a lack of clarity and consistency about how they could and should manage their risk.4 To cure these deficits, regulators looked to exchanges and clearinghouses to implement a thoroughgoing solution. Following the crisis, reform mandated that swaps be standardized and simplified, to the extent possible. Transactions would be reported systemically and in-depth. Most importantly, rather than leave risk to be handled privately between individual financial firms, swaps would be required to trade on exchange-like venues and to be cleared and settled by clearinghouses.5
Clearinghouses have historically been an essential fixture of securities markets (Pirrong, 2009). Their major purpose lies in reducing the “counterparty” risk that traders face when agreeing bargains with one another. Becoming a central contract party to transactions, clearinghouses effectively guarantee that traders will see their deal conclude and settle.6 Clearinghouses act as a pillar to support the flow of trading by reducing the idiosyncratic risks that traders face. The Chicago Mercantile Exchange (CME), a major provider of trading and clearing services for derivatives, intermediates around 3 billion contracts annually, worth around $1 quadrillion dollars, and subject to central clearing.7 With clearinghouses familiar and deeply established in securities markets, it is unsurprising that regulators have turned to rely on their expertise to anchor post-Crisis reform. With clearinghouses standing between swaps counterparties, and assuming counterparty risk, the market should now rest on surer foundations. Swaps exchanges and clearinghouses can ensure that trading parties take appropriate measures to manage the risks they take on as well as oversee trade reporting and record-keeping.8
This article briefly explains the rationales underpinning the overhaul of the swaps market and its shift from over-the-counter private self-regulation by the industry’s top financial firms towards greater standardization and institutionalized risk management by clearinghouses. It then surveys the challenges of implementing this regulatory design. In particular, it highlights a new challenge facing regulators as clearinghouses grow bigger and more significant in managing ever-more complex risks in financial markets. In outlining the risks posed by clearinghouses, this article relies on arguments set out in my past articles on this topic as well as reviewing scholarly research (Yadav, 2013, 2014; Yadav & Turing, 2016). The analysis in this article summarizes the risks of: (i) clearinghouses growing far too-big-to-fail; (ii) a problematic governance structure that can incentivize risk-taking; and (iii) the intrinsic difficulty facing regulators in overseeing swaps clearinghouses.
Why Clearinghouses Matter
The Problem of Counterparty Risk
Clearinghouses are a bedrock supporting the function of securities markets. Put simply, they are designed to solve the problem of “counterparty” risk.9 The seeming prosaicness of this explanation hides the complexity and cost that this problem creates for market design. Counterparty risk represents a source of major concern for traders. When firms come together to buy and sell securities, one side expects delivery of a specific order of securities, and the other expects to receive payment for conveying these assets. In turn, each side might rely on this bargain succeeding for various reasons: the seller needs the money to make its own asset purchase; the buyer might need these securities as a key component of its investment portfolio.
Each side, however, faces the risk that its counterpart may not perform as planned, undermining the bargain and creating uncertainty about how fully any side should be able to rely on transactions to be fulfilled in securities markets. For example, after agreeing with the buyer to sell a Company’s shares, the seller could find a more lucrative deal for these shares elsewhere. Or, the buyer may find that she does not have enough money to pay for the Company’s shares, perhaps because she is in financial distress and lacking cash. In other words, even after parties agree to trade, transactions may fail for any number of reasons. The costs to the market of pervasive “counterparty risk” are high. In such a world, traders may hesitate before entering the market. Some may never do so. Others who do may not wish to enter into further bargains because they do not know whether the first one will actually conclude and settle (Edwards, 1984; Yadav, 2013, Part II).
Counterparty risk in the context of swap trades can be especially pernicious. Unlike a trade in shares or bonds—where counterparty risk attaches to a single transaction—swaps usually reflect a longer-term commitment to “swap” cash flows.10 In a typical interest rate swap, for example, Bank A might commit to swap cash flows from a fixed rate loan with Bank B that holds a floating rate loan.
Such a swap can last for months, even years. Every quarter, Bank A and Bank B swap the difference between the floating rate and fixed rate cash flows from their respective loans for a pre-agreed period of time. The parties here may have agreed to the swap for any number of reasons. A bank may wish to cushion its risk. Bank A holding a fixed rate loan may have to pay out on a floating rate obligation and would benefit from regular, floating rate cash flows to cover this exposure. Bank B, by contrast, may be speculating that the fixed rate cash flows are likely to be larger than what it will have to pay out to Bank A. In other words, Bank B believes that it will emerge a winner from the bargain. Each side depends on the other to perform in order for its private risk and investment preferences to be honored.
It is easy to see why counterparty risk is particularly live in the case of swaps contracts. Over a long period of time, parties may renege on the deal or go bankrupt. Changing market conditions (e.g., interest rate announcements) can set the stage for an exit by whichever party stands to lose. Such high degrees of counterparty risk can result in a market that is characterized by a pervasive uncertainty regarding the quality of the bargains it concludes. It may thus only be open to those that are willing to take on this risk and powerful enough to be capable of ensuring that others abide by the bargain. In this way, it may end up only populated by those with repeat dealings with one another and likely to face retaliation and reputational shaming from a close group of peers if they consistently break their promises.11
How Clearinghouses Mitigate Counterparty Risk
Clearinghouses have developed as a market mechanism designed to reduce counterparty risk. As Craig Pirrong describes, their origins are largely private in nature, with the market’s most dominant players coming together to share their risk and reduce the transaction costs involved in settling trades (Pirrong, 2008, 2009). While clearinghouses have certainly evolved over time in their design and governance, their core function remains largely the same.
In short, clearinghouses reduce the counterparty risk of trading by becoming the contract party to every trade: the buyer to every seller, and the seller to every buyer. The legal mechanism enabling this transformation is novation, or the creation of a brand new contract between the clearinghouse and each trader, in place of the original contract that traders had with one another.12 This means that the clearing process results in the creation of two contracts where once there had been one. By becoming the central contract party (CCP) to every trader, the clearinghouse offers a stronger guarantee that a trade settles (meaning that the seller receives payment and the buyer receives securities) even if one or other trader reneges on the contract or goes bankrupt (Singh & Turing, 2018, pp. 5–7). Rather than relying on other traders to meet their end of the bargain, market participants can depend on the clearinghouse. In so doing, idiosyncratic counterparty risk is effectively replaced by traders assuming risk on the creditworthiness of the clearinghouse.13
In general, clearinghouses offer a far more robust counterparty for market participants than single traders. To do this, they rely on a number of mechanisms that bolster the institutional capacity of the clearinghouse to perform on its contracts in case a trader is unable to do so.
First, clearinghouses seek to mutualize the risks of trading. This technique relies on the clearinghouse sharing the risks of losses between its members (Yadav, 2013, pp. 416–420). If a clearinghouse member fails, causing the clearinghouse to face pay-outs on the member’s obligations, the clearinghouse can take funds from remaining viable members to make good on outstanding claims.14 Through the clearinghouse, top industry players insure one another in case one of their own does not have the funds to fulfill the terms of its obligations. Mutualizing risks provides safety to the marketplace by ensuring that single instances of firm failure do not result in a widespread, system-wide cascade of broken contracts and missed payments within the financial system.15
Secondly, for mutualization to be effective, the clearinghouse needs to be able to access the resources necessary to cover the obligations of a failing member. To do this, it implements mechanisms designed to ensure that members provide the clearinghouse with access to cash and other assets and that these resources can be accessed by the clearinghouse in an orderly way.
To start with, clearinghouses require that their members post cash and other high-quality assets as security to reflect the degree of riskiness they create for the clearinghouse. Clearinghouse members provide a basic reserve of assets as security (“initial margin”) that must always be maintained to a pre-agreed level specified by the clearinghouse. In addition, members also provide fluctuating top-up collateral to reflect the changing degrees of risk they create by their activity (“variation margin”). The more day-to-day risk a member creates, the more variation margin a clearinghouse can demand (BIS, 2012). Finally, in addition to pools of initial and variation margin, clearinghouses usually also maintain a general “default fund,” a final back-stop of cash and assets designed to buffer the institution in a worst-case scenario where members’ margin has been depleted.16 Because these pools of available assets should be high quality—meaning, they should retain their value, be easy to trade and sell for cash—the clearinghouse can offer comfort that it continuously monitors and provisions for the risks that members create.
In addition to keeping its members’ high-quality collateral, clearinghouses also implement a clear order of priority by which these resources will be accessed during a crisis. This “default waterfall” prescribes the exact protocol that a clearinghouse will follow in finding the resources to pay off counterparties or procure the securities that have been promised by failed clearinghouse member. For example, when a member fails, a default waterfall might first access the initial and variation margin of the failing member. Once this is used up, it can move to tap into security provided by its members (perhaps taking an equal amount from each one) before finally moving to access its default fund in case there is still a shortfall (Singh & Turing, 2018, pp. 5–7). This hierarchy informs members of the processes by which losses will be allocated between members and the clearinghouse in case of crisis. It also bolsters the marketplace that can look to a deep reserve of assets and a clear distribution process to support the function of the clearinghouse.
It is worth mentioning that clearinghouses also deploy mechanisms that reduce a member’s overall net exposure. When a member fails, clearinghouses can set-off and net out a member’s exposure to its various counterparties. To take a simplified illustration, if Bank A owes $100 to Bank B on a contract; and Bank B owes Bank A $75 on another separate contract, the clearinghouse can net out these obligations such that the overall exposure that Bank A has to Bank B is $25. Rather than transact in sums that are calculated on a gross basis, necessitating a far higher outlay in terms of the cash and assets needed to meet payout obligations, setting-off and netting obligations across all of its members can help a clearinghouse reduce its exposure.
These risk management practices have helped clearinghouses become an essential pillar of securities markets. Instances of clearinghouse failure, while notable, are still few in number. When markets collapsed on Black Monday in October 1987, the Chicago Mercantile Exchange and the Options Clearing Corporation came perilously close to failure, requiring the Federal Reserve to offer an emergency liquidity life-line in order to tide them through the event.17 These isolated examples of clearinghouse collapse, however, are noteworthy precisely because they are rare. Even during the extreme distresses of 2008, clearinghouses came through relatively unscathed. LCH.Clearnet, a major international derivatives clearinghouse, successfully handled around $9 trillion notional value of interest rate swaps when Lehman Brothers collapsed and did so without having to access the default fund.18
The Turn to Clearinghouses in the Swaps Market
With this position within financial markets, it is clear why regulators have turned to clearinghouses following the crisis. Rather than leaving swaps to be structured and traded privately between top Wall Street firms, and for their risk to be managed by these players, regulation requires the intercession of exchanges and clearinghouses in this market.
Prior to 2008, regulators widely assumed that the risks of trading swaps could be handled by the sophistication and deep pockets of the major Wall Street outfits that functioned as the major hubs of the OTC derivatives market. Within a close-knit community of repeat players, parties could be expected to respect bargains and ensure that contract terms were fulfilled even if the market turned sour. Their expertise and experience could offer an exactly calibrated assessment of risk and what collateral ought to be maintained between counterparties. Finally, they possessed deep pockets from which pay-outs could be handled in the event of losses.
These assumptions were proved badly wrong—at enormous cost to the financial system. The events of 2008 are now well known. With extensive latitude accorded to the industry in the years prior to 2008, the OTC swaps market had grown enormously in size as well as the intricacy of financial engineering applied to deals. Following the failure of Lehman Brothers and the American International Group (AIG), regulators identified key deficiencies in the pre-2008 system of private self-regulation within the OTC derivatives market: (i) a high degree of opacity in swaps contracts owing to a lack of mandatory, standardized reporting mechanisms; (ii) insufficient collateral and risk-management; and (iii) complexity in contract design.19
As Dan Awrey observes, the move to mandatory reporting and central clearing post-crisis marks a significant step in shifting the structure and dynamics of the OTC derivatives market.20 Under the Dodd–Frank Wall Street Reform and Consumer Protection Act 2010, swaps that are capable of being standardized and have been accepted as eligible by a clearinghouse, must be centrally cleared. Those that are too complex to be subject to mandatory clearing and thus remain OTC are subject to higher capital charges to reflect the added risk.21 In addition to mandatory clearing, swaps must also be reported to special swaps data repositories that provide an information reserve and dissemination mechanism for swaps data—facilitating a more systematic understanding of risk for regulators as well as for the market.22
This means that clearinghouses are now required to serve as central counterparties for a variety of interest rate, currency and credit-related swaps, with a potential notional value in the hundreds of trillions of dollars. In this role, they must become the central counterparty to each side of the swaps trade, promising to meet the repeating transfers of cash flows and risk between parties over a period of time. To manage their risk, clearinghouses can deploy their expertise in calibrating collateral to match the on-going risk of the contract, rely on a default fund to support losses, a default waterfall as well as set-off and netting to help reduce their overall exposure. Not only does the move to clearinghouses seek to reduce the riskiness of transacting in swaps by diminishing counterparty risk, but it can also aid in simplifying the complexity of the market. In penalizing (through higher capital charges) swaps that are too complex to cleared, parties have an incentive to design their deals in a manner whose structure and risks are less likely to endanger the marketplace (Rosenberg & Massari, 2013).
While the post-crisis OTC derivatives market has declined in size, it is gradually rebounding. By the end of June 2017, the size of the OTC market was valued at around $542 trillion dollars on a notional basis, having reached around $596 trillion in 2007.23 While measuring the size of the market by reference to notional amounts can be problematic, it can convey, albeit imperfectly, the size and significance of this market from the systemic standpoint.24
Progress in relation to central clearing has been gradual and steady. The proportion of outstanding CDS that are subject to central clearing increased from 44% at end-December 2016 to 51% at end-June 2017. Around 70% of interest-rate swaps are moving to central clearing (Baker, 2016). Overall, according to the Bank of International Settlements, the number of bilateral contracts between swaps dealers declined in number, suggesting that more contracts were being novated to the clearinghouse owing to increasing compliance with the clearing mandate.25
Some Reflections on the Benefits and Risks of Clearinghouses
Clearinghouses offer a number of positives for anchoring the swaps market and ensuring that its operation rests on a more robust footing. With clearinghouses acting as a central counterparty (CCP) to a growing swath of swaps contracts, counterparty risk in the market should diminish. By constantly monitoring risk, provisioning for it and only taking on contracts with an acceptable level of complexity, the clearinghouse should avoid the kinds of mistakes that led to the collapse of AIG. In overseeing its members’ ongoing swaps exposures, it can work to curb the activities of those that seek to take on unsafe levels of risk (e.g., like those that sell extensive credit protection on risky debt).
Moreover, clearinghouses can provide a private oversight mechanism of the swaps market to help regulators maintain adequate and careful supervision of its risks (Yadav, 2013, 2014). In its capacity as CCP, the clearinghouse occupies prime position to observe how smoothly the market is functioning, what kinds of underlying borrowers or securities are attracting interest in credit protection for example, and the prices at which deals are being done. This wide view of the swaps market brings a superior and more systematic oversight mechanism to bear on an industry that has historically lacked transparency and a centralized repository of intelligence. In addition to just monitoring the flow of trades and crafting a picture of its activities, the terms on which the clearinghouse offers its services can structurally impact how the market functions (Yadav, 2013, 2014). That is to say, firms have an incentive to design their contracts in a manner that renders them eligible for central clearing and most likely to reduce the margin (collateral) they have to allocate to the clearinghouse. Indeed, as Gabriel Rosenberg and Jai Massari write, the stipulations of Dodd–Frank and the move to central clearing for swaps has resulted in a trend towards the “futurization” of swaps contracts, whereby parties seek to design deals in a manner that re-casts swaps into exchange-traded and centrally cleared futures contracts that may be more likely to incur a lower regulatory charge (Rosenberg & Massari, 2013). Stated simply, the introduction of the clearinghouse—and the conditions it demands of those that use it—can exert a broader impact on market structure and the behavior of private parties, reflecting their efforts to re-configure deal terms to make them suitable for what the clearinghouse considers acceptable. To the extent that clearinghouses do, in fact, design terms reduce risk-taking and foster adequate provisioning for the risks that are taken, its larger institutional impact on traders’ conduct confers an enormous gain for the market and for regulators charged with ensuring its safety. Unsurprisingly, given these benefits, Steven Schwarcz suggests pushing the policy further towards central clearing by bringing a host of non-derivative, financial contracts (e.g., loans) into the jurisdictional purview of clearinghouses.26
But this mandatory transition to central clearing comes with risks of its own. Charged with risk management and monitoring for the all-important, complex and high-value swaps market, the financial system has come to place even greater reliance on the effective functioning of the clearinghouse. This means that not only is the clearinghouse growing in prominence on account of this regulatory mandate, but it is also expanding in size (Singh & Turing, 2018, 16–17). By introducing a new and popular category of instrument into centrally clearing—the OTC swap—the clearinghouse becomes responsible for back-stopping the fulfillment of a growing swath of financial obligations.
Accordingly, in addition to contracts that they have long cleared—such as equities or exchange-trade derivatives like futures and options—clearinghouses are now opening their doors to clearing swaps contracts. Of course, not all clearinghouses have to do so. Some may choose to avoid or withdraw from this market. However, with the promise of profit through the added business of clearing swaps as well as the prestige coming from taking on a share of this market, top clearinghouses also have powerful inducement to bring swaps within their umbrella of cleared products. In the U.S. for example, the Intercontinental Exchange (ICE) operates a network of clearinghouses globally that clear and settle a variety of common securities as well as well as swap products (e.g., credit derivatives and currency swaps).27 LCH.Clearnet, a U.K.-based clearinghouse, clears multiple types of swaps.28 As Singh and Turing note, the number of clearing members of LCH’s Swap Clear facility grew four-fold in the five years leading into the implementation of the mandate (Singh & Turing, 2018). By contrast and perhaps showcasing the challenge and cost of migrating to central clearing for certain kinds of swaps, the Chicago Mercantile Exchange (CME), a leading U.S. based derivatives exchange and clearing services provider, announced that it would withdraw from clearing CDS and focus instead of interest rate and currency swaps.29 Broadly, however, with the expansion of swaps trading and clearing, major clearinghouses now occupy a place of growing economic significance and importance to financial regulatory policy.
The reliance that markets place on clearinghouses—alongside the increasing risks that they assume as CCPs for the swaps market—raise two key questions: (i) are the risks created by swaps potentially opening CCPs up to complex dangers that increase the costs and challenges of risk management?; and (ii) do these difficulties, alongside the size and role of clearinghouses mean that CCPs constitute an institution of such systemic size and consequence that they have become the quintessential too-big-to-fail financial firm?
A full analysis of these questions is outside of the scope of this article. However, some brief observations illustrate the depth of the challenge faced by regulators. First, as amply evidenced by the size and attractiveness of the swaps market prior to the crisis, these instruments constitute a source both of utility as well as riskiness for those that use and trade them. Users rely on swaps to hedge their risk. They also harness them to express a position on future fluctuations in the value of interest rates, currency values as well as credit risk. Of these, credit risk—traded through CDS—proved to be especially vulnerable to risk-taking in the years leading up to the crisis. Credit protection buyers—paying to be safeguarded against the default of corporate borrowers or securities—placed confidence in the effectiveness of this instrument to be protected and to engage in further lending. Credit protection sellers on the other hand—those being paid regular sums to deliver protection on an underlying credit’s default—could profit during the term of the contract if no default materialized. When default did eventually materialize, as housing prices crashed, mortgage-backed securities stopped paying and Lehman Brothers fell, protection sellers like AIG found themselves suddenly facing the prospect of high pay-outs as well as margin calls in the interim to reflect the rapid escalation of this risk (Acharya & Bisin, 2014).
These dynamics reveal difficulties for clearinghouses in taking on the risks of CDS as CCPs. As noted earlier, swap contracts are longer in duration than a sale or purchase of a share. While clearinghouses are used to dealing in securities whose risks can endure for a period of time, such as a futures contract or an option, swaps (especially CDS) can entail clearinghouses to monitor recurring payment streams for months, even years. And credit risks can be especially difficult to provide for within this timeframe even if clearinghouses are well used to dealing with longer-duration risks. As vividly exemplified by the crisis, CDS suffer from the risk that an underlying reference borrower or security “jumps-to-default.” In this scenario, a borrower moves rapidly from a state of seeming solvency to one where its ability to repay its debts is called into question (D’Errico et al., 2016). AIG and Lehman Brothers, for example, both enjoyed healthy A-Grade credit ratings from all three major credit rating agencies right up until their collapse in mid-September 2008 (e.g., Nasripour, 2009).
The difficulty in predicting default, and its potentially rapid onset, means that protection-sellers can face demands for margin that they may struggle to fulfill. In turn, these margin calls may result in further intensifying a struggling firm’s collapse if it has to sell assets at fire-sale prices in order to generate the cash it needs to make-good on margin obligations to a CCP.30 These dynamics make it hard for CCPs to easily model and provision for the credit risk that they face when clearing a CDS, particularly given the length of time a swap might remain on a CCP’s books (Yadav, 2013, pp. 402–405, 432–434). Determining how much margin a CCP member should keep presents a difficult question. If default might materialize quickly, then it makes sense for a CCP to demand a high level of top-quality collateral (cash, U.S. Treasuries) even when dealing with a well-rated underlying credit. This strategy provides cushion for the clearinghouse that might then see a reduced need to make sudden, emergency margin calls of a member.
But this approach comes with challenges of its own. Most notably, members (and clients of members) will hesitate before entering into CDS and subjecting them to central clearing if it becomes too expensive. Firms may consider strategies that seek to keep their swaps outside of clearing or to seek out ways to reduce the margin they need to provide (Rosenberg & Massari, 2013). Paying extra for non-cleared swaps may be worth the trade-off if the risk results in a lucrative pay-out. Firms may also seek to structure their swaps in a way that over-engineers or obfuscates the true risk of the transaction, placing a cost on clearinghouse to thoroughly investigate the quality of the underlying risk. In the case of CDS, for example, understanding the fuller credit risk of an underlying asset is tricky. To do so effectively requires that clearinghouses get a complete picture of the loan a creditor makes to an underlying company, this debtor’s business, its assets, the source of its future cash flows, the quality of its management and so on. To understand and price the risk of mortgage-backed securities, a clearinghouse would need to garner insights into the asset-quality of the mortgages, their geographic location, the creditworthiness of the borrower and their repayment history etc. Acquiring such granular information on the credit quality of underlying reference borrowers or securities is not easily feasible, nor necessarily reliable if members (and clients) fail to properly furnish fulsome data.
As I have written elsewhere, clearinghouses can also face a risk from their own members that may look for ways to take privately, profitable risks at the expense of the clearinghouse.31 Because the clearinghouse functions as a CCP vis-à-vis counterparties, promising to meet their obligations if they fail, it cannot afford to take risks with just any counterparty. As such, its members usually comprise some of the most trusted firms in the financial system and are selected from the ranks of Wall Street’s major banks and investment banks. This provides clearinghouses with comfort that their transaction partner constitutes a well-regulated and deep-pocketed entity that is unlikely to fail.32
However, notwithstanding the high stature of its members, clearinghouses can still face costs arising from their capacity to mutualize member losses. As described earlier, clearinghouses promise to pay-out or cover a member’s obligations in the event that it fails. To do so, the clearinghouse first uses the member’s resources and then reaches for those of other members in order to make-good on the losses. This model, while reducing counterparty risk, can also raise the risk that members utilize the clearinghouse in order to seek out private profit, while shifting the costs to the clearinghouse.
Put simply, the clearinghouse structure may motivate members to clear risky contracts knowing that the fuller cost of this risk-taking is underwritten by the mutualization function of the clearinghouse. Because clearinghouse members are protecting each other through the clearinghouse, it follows that they may seek out ways to optimize the protection this offers to lower the cost of their private risk-taking. By taking advantage of the clearinghouse to clear risky securities for private gain, members can off-set some of the costs they face as members of a clearinghouse (e.g., to provide margin, contributions to the default fund, membership dues). Further, because risk is shifted to the clearinghouse, swaps counterparties can also lower their own information and due-diligence costs. As these costs can be long-term in nature for a swap contract, shifting their burden to the clearinghouse can offer gains for members.
A fuller discussion of such institutional risk is outside the scope of this article. In short, the risks of swaps (notably, CDS) as well as the potential for members to harbor distorted incentives in utilizing the clearinghouse, create dangers for regulators and the financial system. As I and other scholars have written, the realization of these risks—through multiple member failure and insufficient resources to continue operations—presents a catastrophic scenario for financial markets (e.g., Roe, 2013; Chang, 2014). Supporting the operation of multiple markets—equities, exchange-traded derivatives as well as swaps—the possibility of clearinghouse failure can threaten the very viability of financial markets to maintain their capacity to effectively allocate capital.
Lingering Questions for Regulation
The essential place of clearinghouses in financial markets—and the deeply systemic consequences of their failure—raises the stakes for regulators looking to oversee them. This challenge is especially difficult in light of the international nature of the derivatives market, where counterparties to a swap are very often located in different jurisdictions. According to the Bank of International Settlement’s 2013 study, of all the CDS concluded, 19% involved swaps counterparties that were located in the same home country.33 The CME, ICE, and LCH.Clearnet themselves constitute international providers of trading and clearing services, straddling multiple markets in an effort to cater to the cross-border nature of financial markets. This creates a need for regulators to coordinate in calibrating common standards for the supervision of clearinghouses and also to develop processes and procedures capable of handling the possible failure of a large-scale, international clearinghouse (Yadav & Turing, 2016).
Neither of these conditions is satisfactorily fulfilled in the implementation of the post-crisis regulatory consensus. It is well established that regulators from across the major markets have come together to develop common standards and guiding principles regarding the regulation of derivatives markets and clearinghouses. International standard-setting bodies like the Bank of International Settlements Committee on Payment and Market Infrastructures have provided a focus of effort to institutionalize co-ordination on rule-making and oversight.34 However, jurisdictions have varied, sometimes sharply, in the detailed implementation of these shared aspirations into their domestic legal systems.
Indeed, recent years have witnessed considerable tension emerge between the U.S. and the EU regarding mutual recognition of their respective regimes for regulating clearinghouses. To some extent, this hesitation to fully and enthusiastically embrace the other’s framework is unsurprising. These jurisdictions are home to the world’s most sophisticated derivatives markets and clearinghouses. They also differ in important ways on the regulatory environment under which swaps clearinghouses are expected to operate. A full discussion is outside of the scope of this article, though I (alongside Dermot Turing) have written in greater detail on this issue elsewhere (Yadav & Turing, 2016). But certain aspects of these divergences stand out. For example, the EU pointed to the U.S. regulatory regime for clearinghouses as lacking in essential ways, such as in relation to rules governing provisioning for margin, the default fund, liquidity management and the composition of a clearinghouse’s governance arrangements on risk management and business continuity.35 In turn, however, the U.S. could point to certain fronts on which the EU’s regime appeared much less, rather than more stringent, in the standards it applied to clearinghouses. Most notably, U.S. regulation requires margin to be provided on a gross basis by members, rather than on a net-basis. This provision can increase the amount of margin that a clearinghouse’s members must provide.36 In other cases, the comparison is less straight-forward and points to a more nuanced contrast. Non-systemic clearinghouses in the U.S. must keep sufficient resources to be able to survive the failure of its largest member (the cover-one requirement) in comparison to the EU’s stricter requirement that clearinghouses must survive the default of two significant members (“cover two”). However, for U.S. clearinghouses that are international and systemically important, the cover-one requirement is increased to mandate that it be capable of surviving the failure of two of its clearing members that pose the greatest risk. On this metric, the “cover two” requirement is broadly similar to that imposed by the EU. This patchy picture, however, of diverging rules, with varying levels of strictness and possible enforcement intensity, point to uncertainties about what measures can most optimally control the risks of clearinghouses in swaps markets. More worryingly, they raise the risk that swaps traders might seek out ways to forum shop when looking to clear their contracts to choose a lighter compliance regime and one where their transaction costs seem cheaper.
These divergences spell trouble in the event of a clearinghouse failure. While regulators have rules and standards in place to deal with the regulation of clearinghouses, little detail exists to guide authorities in cases where a clearinghouse fails at home and internationally. As Manmohan Singh and Dermot Turing note, measures to deal with clearinghouse resolution and recovery are sorely lacking (Singh and Turing, 2018). Regulators have failed to substantively develop reliable and workable processes to deal with a clearinghouse collapse in their own borders. As shown in the U.S., considerable skepticism exists regarding the viability of the post-crisis regulatory regime designed to deal with the insolvency of a large and important bank to also be able to manage the collapse of a clearinghouse. With domestic processes unclear, there can be little hope of clarity for an international framework to govern the distress and failure of a major clearinghouse (e.g., Skeel, 2017). As already discussed, major groups such as ICE, CME, and LCH.Clearnet operate a dispersed network of multi-jurisdictional exchanges and clearinghouses. Within this context, a failure to arrive at a formulation for dealing with the failure of an international clearinghouse is clearly problematic: Which jurisdiction’s regulator constitutes a clearinghouse’s home supervisor? Where does a clearinghouse conduct the majority of its business? Which regulator should offer access to emergency liquidity?37 How should a default waterfall operate where creditors are located in different jurisdictions—in other words, should domestic creditors have priority or be capable of requesting a ring-fencing of assets to protect their exposures?
These questions remain, for all practical purposes, unresolved—and perhaps for good reason. Clearinghouse failure constitutes a rare and systemic event that may be as hard to envision as it is to model. Such a calamity is likely to follow from the failure of multiple members. Whether those remaining will have sufficient resources to safeguard the clearinghouse is impossible to determine ex ante. Balancing these crisis-driven resource needs against the importance of creating incentives to bring firms to the clearinghouse represents a policy challenge that may ultimately be insurmountable. At their core, they underline the place of clearinghouses as institutions as both necessary to markets as well as those that are far too significant to fail.
The swaps market is undergoing transformational structural changes as it migrates from an OTC model to one where its contracts are standardized and subject to central clearing. In the decade since the crisis, jurisdictions have implemented a detailed framework of rules to guide this migration ever more fully in an effort to avoid a repetition of the calamity witnessed in 2008. To that end, clearinghouses have developed processes to enable the clearing of complex swaps, becoming CCPs to each end of the bargain. While this process brings enormous benefits in risk management and a reduction of counterparty risk, it also raises serious red flags for financial market stability. The danger that clearinghouses are more important and systemic than ever before is hard to deny. They face the challenge of fully understanding and provisioning for the risks that underlie the swaps contracts whose risks they backstop. Further, they may be vulnerable to risk-taking by members that opportunistically shift the risk of complex contracts to the clearinghouse. These dynamics leave a number of open questions for regulators to answer. Is the clearing mandate post-crisis meeting expectations, or is it creating new risks that require attention? Do regulators have a workable plan to resolve a clearinghouse failure, and if not, why? The size and significance of the clearinghouse necessitates urgent attention to these inquiries. The risk of clearinghouse failure is one that regulators can ill-afford to ignore.
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(1.) G-20 Pittsburgh Summit (2009): “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.”
(2.) Commodities Exchange Act, 7 U.S.C § 2(g) (2006) (excluding swap transactions from regulation under the CEA); Commodities and Futures Modernization Act, Pub. L. No. 106–554, 114 Stat. 2763, 2763A-365 to -480 (2000). For a history of de-regulation in the derivatives markets and its implications, Karmel (2009); Lipton (2008); Barr (2012), analyzing the OTC derivatives market and highlighting the use of clearinghouses under the Dodd–Frank Act to mitigate that market’s risks. Noting that the contribution of derivatives to the Crisis may have been overstated, Stulz (2010).
(8.) Atlantic Council Divergence Report, 23–31.
(13.) Pirrong (2009); Duffie and Zhu (2011). See also Schwarcz (forthcoming), advocating for a wider spectrum of contracts to be cleared under the aegis of the clearinghouse owing to their risk management.
(16.) See for example, Section 5b(c)(2)(B)(ii)(I) of the Commodities Exchange Act, 7 U.S.C. 7a-1(c)(2)(B)(ii)(I); Derivatives Clearing Organizations and International Standards, 78 Fed. Reg. 72476 (Dec. 2, 2013) (on the “cover one” and “cover two” requirements for the resources necessary for clearinghouses to withstand losses).
(18.) Allen (2012); Press Release, LCH.Clearnet, $9 Trillion Lehman OTC Interest Rate Swap Default Successfully Resolved (October 8, 2008).
(19.) For discussion of the impact of the externalities generated by the OTC market through opacity and the direct and indirect connections between participants, Acharya & Bisin (2014); D’Errico et al. (2016).
(20.) Awrey (2016), 1165–1166. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111–203, § 723, 124 Stat. 1376, 1675 (2010) (codified at 7 U.S.C. § 2(h)(2)(D)) (“the Dodd-Frank Act”).
(21.) Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59898 (October 3, 2014); Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 Fed. Reg. 23732 (April 28, 2011); Margin and Capital Requirements for Covered Swap Entities, 76 Fed. Reg. 27564 (May 11, 2011); See also, Basel Committee on Banking Supervision and Board of the International Organization of Securities Commissions, Margin Requirements for Non-Centrally Cleared Derivatives (September 2013).
(22.) Dodd-Frank Act, § 729; see also Nazareth & Rosenberg (2013). As described here, the regulations for reporting are complicated in their implementation. However, what is clear is that swaps reporting is now subject to a thicket of reporting requirements designed to elicit a standardized set of data regarding swaps exposures from regulated market participants). See also, Awrey (2016), 1165–1166.
(23.) BIS, OTC Derivatives Market Activity in the Second Half of 2007 (May 2008).
(24.) BIS, Statistical Release: OTC Derivatives Activity at Year End June 2017 (November 2017). Remarks of Remarks of Chairman J. Christopher Giancarlo before Derivcon 2018, February 1 2018. The Commodities Futures Trading Commission (CFTC) is exploring so-called Entity-Netted Notionals (ENN) as a way of measuring market size, reflecting net positions for pairs of legal entities and across the marketplace.
(25.) BIS, Statistical Release: OTC Derivatives Activity at Year End June 2017 (November 2017).
(26.) Schwarcz (forthcoming). See also Squire (2014), noting the capacity of the clearinghouse to engage in “liquidity partitioning” on a member’s bankruptcy, whereby the capacity of the clearinghouse to keep high-quality and short-term assets out of bankruptcy and to speed up payouts to creditors.
(29.) Reuters, CME Group to Exit OTC Credit Default Swap Clearing Business, September 14, 2017. (2018).
(31.) Yadav, supra note .
(32.) BIS, Committee on Payment and Settlement Systems: Recommendations for Central Counterparties, 14–16 (2004).
(33.) BIS, Statistical Release: OTC Derivatives Statistics at end-June 2013 (November 2013), 10–11.
(35.) European Securities and Markets Authority, Technical advice on third country regulatory equivalence under EMIR—US, ESMA.2013/1157 (September 1, 2013) (analysing issues of equivalence between the U.S. and the E.U. in relation to the regulation of OTC derivatives and clearinghouses).
(36.) See e.g., CFTC Rule 39.13(g)(8)(i); CFTC Rule 39.13(g)(8).