The new clearing requirements were one of the more widely applauded features of the 2010 Dodd-Frank Act. With good reason. Prior to the Great Recession, most derivatives transactions were unregulated and undisclosed. Under the Dodd-Frank Act, clearinghouses now guaranty many swaps by serving as a buyer to every seller and a seller to every buyer. If one of these buyers or sellers fails, the clearinghouse can step into the gap, thus limiting the risk that the failure will interfere with the financial markets.
But what if the clearinghouse itself topples? The Dodd-Frank Act authorizes regulators to designate a clearinghouse as systemically important, and provides a source of emergency funding.1 But the law doesn’t say what happens if the clearinghouse fails.
This may be the single greatest weakness of the new financial architecture. Several of the clearinghouses themselves are now systemically important.2 They need a blueprint for failure, just as systemically important banks do. In contrast to Europe, where clearinghouse resolution has received considerable attention,3 the regulatory gap is not addressed in the Choice Act or in alternative calls for reform in the United States.
S. Samuel Arsht Professor Corporate Law - University of Pennsylvania Law School
The good news is that several small legal changes could solve the most urgent problem—the uncertainty as to whether the Dodd-Frank Act’s resolution rules apply to clearinghouses. After describing the limitations of current law and of the contractual strategies the clearinghouses are developing to fill the gap, I explain the potential Dodd-Frank Act reforms, as well as several adjustments to bankruptcy law.
The New Clearinghouse Landscape
Prior to Dodd-Frank, the vast majority of derivatives were traded over-the-counter, and were subject to very little regulation. Dodd-Frank authorized the principal regulators—the Commodity Futures Trading Commission (CFTC) for most swaps, and the Securities and Exchange Commission (SEC) for securities-based swaps—to require any given type of derivatives be presented to a clearinghouse for clearing. If a swap is cleared, the clearinghouse interposes itself between the two parties. The clearinghouse requires each partyto post collateral (known as “initial margin”) and to augment that collateral if prices move against them (the “variation margin”) during the life of the contract.
In the seven years since Dodd-Frank was enacted, the clearing requirements have had their biggest effect with interest rate swaps and credit default swaps. Roughly 80 percent of new interest rate swaps are now cleared, as are 70 percent of credit default swaps. There also has been a trend toward concentration in the clearing markets; there now are a small number for any given type of swap. LCH.Clearnet dominates over-the-counter interest rate derivatives, handling 95% (nearly $33 trillion in notional amount) of the derivatives that are cleared, while Intercontinental Exchange (ICE) controls more than 98% ($88.7 trillion notional) of the credit default swap clearing market.4
Overall, the shift to clearinghouses appears to have been quite successful. Although the applause is not universal,5 central clearing is widely viewed as an important regulatory improvement. So long as the clearinghouses are financially stable, they can significantly reduce the risk to one party to a derivative that its counterparty may fail.
But what if the clearinghouse itself fails? Failure of a major clearinghouse could paralyze large swaths of the financial markets.
To be sure, the Dodd-Frank Act does not ignore the risk of a major clearinghouse failure altogether. The law authorizes regulators to designate a clearinghouse as systemically important, as the Financial Stability Oversight Council has done with CME, ICE Clear Credit and The Options Clearing Corporation. Regulators can subject the designated clearinghouses to more stringent oversight and the Fed is authorized to provide access to emergency funding from the Fed’s discount window. These provisions—which the Choice Act proposes to repeal—are designed to prevent a clearinghouse failure.
This, unfortunately, is the point at which the drafters of the Dodd-Frank Act stopped They did not consider what should happen if the bulwark collapses, and a clearinghouse does in fact fail.
One might assume, as some commentators have, that regulators would simply apply the resolution rules that the Dodd-Frank Act provides for other systemically important financial institutions.6 Under Title II of Dodd-Frank, the Orderly Liquidation Authority, regulators can take over a troubled financial institution whose default could have systemic consequences for the financial system. Perhaps regulators could use these provisions to resolve the failure of a troubled clearinghouse.
At first glance, Title II seems capacious enough to encompass a clearinghouse, although it clearly wasn’t designed with clearinghouses in mind. Any “financial company,” which is defined to include companies that are “predominantly engaged in activities that are financial in nature,” and whose failure could cause systemic harm, is eligible for Title II.7 Since everything clearinghouses do is financial, they might seem to easily meet the financial transactions requirement. But the regulation promulgated by the Federal Deposit Insurance Corporation (FDIC) to define “activities that are financial in nature” does not explicitly include clearing activities. Because several of the activities that are included are similar to clearing, it is possible that a clearinghouse could be shoehorned into Title II.8 But this is far from certain.
Although Title II may not apply to clearinghouses, the ordinary bankruptcy laws clearly do. Bankruptcy would therefore be the likely venue for a clearinghouse resolution. But here too there are potential problems. The logical strategy would be for the clearinghouse to file for Chapter 11, bankruptcy’s reorganization provisions. But a clearinghouse would probably be defined as a “commodities broker” for bankruptcy purposes.9 For reasons that were sensible in the 1970s but are much less so today, stock and commodities brokers are excluded from Chapter 11. They are only permitted to file for Chapter 7, the liquidation provisions.10 Chapter 7 has a special framework for liquidating stock and commodities brokers, but these provisions were not designed with clearinghouses in mind. More importantly, neither Chapter 7 nor Chapter 11 provides a stay on derivatives—a standstill that would prevent counterparties from immediately terminating their derivatives contract—which would seriously complicate the effort to resolve the financial distress and to preserve the smooth functioning of the relevant derivatives market.
Clearinghouses fall through the cracks of the current bankruptcy and resolution rules. If a substantial clearinghouse threatened to default, regulators’ only options would be to bail out the clearinghouse, or to risk a messy and potentially disastrous bankruptcy. This is precisely the scenario the Dodd-Frank Act was intended to remedy.
Contractual Approaches to Clearinghouse Resolution
The major players are aware of the lacuna in regulation. They have been working to put contractual resolution rules in place the clearinghouses.11
The approaches that have emerged thus far provide for a “waterfall” of responses to the prospect of financial distress.12 Under one strategy, if the crisis is triggered by the failure of one or more members of the clearinghouse, the first response is to use the member’s contribution to the clearinghouse’s guaranty fund and its initial margin payments. If this is not sufficient to staunch the losses, the second response is to use part of the clearinghouse’s operator capital. Third comes the guaranty fund contributions of the other members of the clearinghouses, and fourth is the remainder of the clearinghouse’s operator capital. If this sequence of responses is not sufficient to stabilize the clearinghouse, the clearinghouse can take the more dramatic steps of taxing the variation margin gains of clearinghouse members whose contracts are in the money, and finally, “tearing up” or partially “tearing up” some or all of the contracts—that is, unilaterally restructuring or cancelling them.
But what if the clearinghouse itself fails? Failure of a major clearinghouse could paralyze large swaths of the financial markets.
The contractual strategies are elegant but precarious and incomplete. The first problem is the uncertainty created for the nondefaulting members of a clearinghouse.13 Even if a member has managed its risks prudently, it faces the prospect of variation margin gain cuts or contract tearups if another member defaults. The uncertainty as to the magnitude of the cuts, and whether the clearinghouse will in fact resort to these drastic measures, is costly to the nondefaulting members. To avoid this uncertainty, a nondefaulting member that it not dependent on the clearinghouse’s services may seek to exit the clearinghouse if it anticipates problems, which could exacerbate the clearinghouse’s instability. If the nondefaulting member has major exposure to the clearinghouse and does not exit, by contract, the cuts could undermine the member’s own stability.
Second, it is difficult to know for sure whether the “waterfall” will in fact work; even if only one member defaults, or at most two,14 the adjustments may not be sufficient, or they may not be implemented quickly enough to stabilize the troubled clearinghouse. The risks that the procedure will not be adequately are especially high if the distress is more widespread.
Given these uncertainties, regulators can hardly be expected to trust the contractual resolution process.
Filling the Most Urgent Regulatory Gaps
The simplest solution to the current impasse would be to make Title II clearly applicable to the failure of a systemically important clearinghouse. Because a clearinghouse that is not systemically important might be resolved in bankruptcy, I also will note several reforms that would make bankruptcy better suited for clearinghouse resolution.
The first step would be to make clear that Title II is indeed available. The FDIC could remove the uncertainty by simply adding clearinghouse activities to the definition of “activities that are financial in nature” for the purposes of Title II.
The other major problem with current Title II is its choice of regulator. The primary regulators for clearinghouses are the CFTC and the SEC, and the Fed is a potential source of discount window financing, yet Title II assumes that the FDIC will be the receiver in a Title II case. The FDIC does not have experience regulating clearinghouses or the derivatives markets.15 In theory, the single point of entry strategy the FDIC has developed for resolving systemically important banks in Title II could be adapted for clearinghouses. But this strategy is a poor fit for clearinghouses, which do not have the significant bond debt that is central to single point of entry resolution.
Either the Federal Reserve, as the lender of last resort for systemically important clearinghouses, or the CFTC or SEC, as the primary regulator, would be in a better position than the FDIC to effectively oversee the resolution process. Since Title II is designed for institutions whose failure could cause systemic harm, the Fed, perhaps in coordination with the CFTC or SEC, seems the most logical receiver for a clearinghouse in Title II.
For a clearinghouse that is not systemically important, bankruptcy is likely to be the resolution venue. Current bankruptcy law falls short of providing an adequate resolution mechanism in two key respects. First, regulators have little role. Perhaps most importantly, current law does not authorize regulators to initiate the bankruptcy case. Given the importance of having stability and continuity in the derivatives markets, this is a crucial disability. The principal regulators—the CFTC or the SEC— and the Fed should each be authorized to file a bankruptcy petition.
The other impediment to resolution is the absence of a stay on termination of derivatives contracts. The ability of clearinghouse members to terminate their obligations under the clearinghouse agreement could make it impossible to assure the smooth, continued functioning of the derivatives market in which the clearinghouse operates.16
Addressing the other quirk of current bankruptcy law—that clearinghouses would need to file for Chapter 7 rather than Chapter 11—would be useful but seems less urgent than authorizing regulators to file the bankruptcy petition and providing a stay. In my view, this benefit is more limited with a clearinghouse than with other financial institutions, particularly given the existence of contractual resolution provisions. If contractual resolution does not prove sufficient, regulators should be the ones deciding whether to initiate formal resolution proceedings, and they are likely to liquidate the troubled clearinghouse.
I have focused throughout this Note on the most urgent shortcomings of the current framework—on triage, rather than complete surgery. A more thoroughgoing reform would need to address the particular kinds of provisions that might help to better adapt Title II (or bankruptcy) to the unique features of a clearinghouse. Darrell Duffie has suggested, for instance, that regulators should be given the authority to employ measures similar to those included in the current contractual resolution provisions, such as margin haircuts and the power to partially or completely tear up derivatives contracts.17
For now, however, the most important objective is to provide a plausible resolution framework for the clearinghouses that have assumed a central role in American finance since 2010. Absent reform, there is a serious risk that the instability of a major clearinghouse would cause systemic harm or necessitate a bailout. With a few simple adjustments to the existing regulatory framework, lawmakers could lay the foundation for a better alternative.
The author would like to thank Martin Baily, Darrell Duffie and David Wessel for comments, and Caitlin Miller for research.
The author did not receive financial support from any firm or person for this article or from any firm or person with a financial or political interest in this article. He is currently not an officer, director, or board member of any organization with an interest in this article.
- Most of the new regulations for clearinghouses are in Title VIII of the Dodd-Frank Act. Dodd-Frank Act section 804 authorizes the Financial Stability Oversight Council to designate a clearinghouse as systemically important, and section 806 provides access to the Federal Reserve’s discount window.
- Chicago Mercantile Exchange Clearing (which clears several types of derivatives), ICE Clear Credit (credit default swaps), and The Options Clearing Corporation (options) have each been designated as systemically important under Title VIII of the Dodd-Frank Act.
- For a recent discussion, see Boris Groendahl and John Glover, “EU Readies Plan for Clearing Crisis, the New Too-Big-to-Fail,” Bloomberg.com (Oct. 5, 2016).
- For an excellent overview, see Colleen M. Baker, “Clearinghouses for Over-the-Counter Derivatives,” working paper, The Volcker Alliance, 2016, p. 34.
- For criticism of clearinghouses, see Mark J. Roe, “Clearinghouse Overconfidence,” California Law Review 101 (2013): 1641; Yesha Yadav, “The Problematic Case for Clearinghouses in Complex Markets,” Georgetown Law Journal 101 (2013): 387; Hester Peirce, “Derivatives Clearinghouses: Clearing the Way to Failure,” Cleveland State Law Review 64 (2016): 589. For a defense, see Richard Squire, “Clearinghouses as Liquidity Partitioning,” Cornell Law Review 99 (2014): 857.
- See, for example, Julia Lees Allen, “Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis,” Stanford Law Review 64 (2012): 1079, 1100-1102.
- Dodd-Frank Act section 201(a)(8) defines a company that meets these requirements as a “covered financial company.”
- For a very good discussion of the uncertainty, see Robert Steigerwald and David DeCarlo, “Resolving Central Counterparties after Dodd-Frank: Are CCPs Eligible for ‘Orderly Liquidation,’” working paper, Federal Reserve Bank of Chicago, 2014.
- At least those regulated by the CFTC. The Bankruptcy Code defines “clearing organization” as a “derivatives clearing organization” registered under the Commodity Exchange Act in 11 U.S.C. section 761(2), and includes “clearing organization” in the definition of “commodity broker” in 11 U.S.C. section 101.
- 11 U.S.C. 109(d) prohibits commodity brokers from filing for Chapter 11. For detailed discussion, see Stephen J. Lubben, “Failure of a Clearinghouse: Dodd-Frank’s Fatal Flaw?,” Virginia Law & Business Review 10 (2015): 149.
- For discussion of the current strategies, see David Elliott, “Central Counterparty Loss-Allocation Rules,” Bank of England, Financial Stability Paper 20, April, 2013; Darrell Duffie, “Resolution of Failing Central Counterparties,” in Making Failure Feasible: How Bankruptcy Reform Can End ‘Too Big to Fail,’ ed. Kenneth E. Scott, Thomas H. Jackson & John B. Taylor, Stanford, CA, Hoover Institution Press, 2015), 87.
- The generic description in the text below comes from Duffie, pp. 90-96.
- See Duffie, p. 93.
- The contractual resolution rules are intended to handle the failures of up to two clearing members.
- Stephen Lubben has also made this point. Lubben, 151.
- For similar points about the need for a stay, see Duffie, p. 100-102, Lubben, p. 152.
- Duffie, p. 100.
David G. Victor speaks on Geoengineering at CERAWeek 2019 in Houston, Texas.