June, 2016

Derivatives Clearinghouses: Clearing the Way to Failure

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The remaking of the United States derivatives markets is among the most celebrated pieces of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”). The Dodd-Frank reform, however, has unnecessarily destabilized the financial markets through mandatory reliance on central counterparties (“CCPs”), which are financial institutions that collect derivatives transactions from many market participants and manage the associated risks. A better approach would be to abandon the central clearing mandate and the associated trading mandate and allow the derivatives markets to develop through market—not regulatory—mechanisms. Combined with principles-based regulation for CCPs and robust regulatory reporting, an organically developed market structure would enable the derivatives markets to mitigate risk—including through the voluntary use of CCPs—without undermining financial stability.

Derivatives are financial contracts that derive their value from the price of something else, such as a commodity, stock, bond, index, or currency. These contracts—which include futures, forwards, swaps, and options—enable companies and individuals to shift risks to parties willing to bear that risk. Financial and nonfinancial companies use derivatives to manage a wide array of risks, including foreign exchange risk, interest rate risk, and counterparty risk.

Many derivatives trade on exchanges and are cleared through CCPs, which are often affiliated with the exchange. These derivatives adhere to a standard set of terms governing each aspect of the contract. Derivatives also can be executed offexchange in a bilateral transaction between a dealer (usually a large bank) and another dealer or customer. These bilateral transactions afford substantial flexibility in contract terms to accommodate the unique needs of the customer. Accordingly, risks that are particular to the specific transactions or to a specific company are typically managed through bilateral transactions and are not cleared through CCPs.

Reform advocates often cite uncleared, over-the-counter (“OTC”) derivatives (also referred to as “swaps” in this article) as a core cause of the crisis and posit mandatory central clearing as a key solution. Their theory is that large banks and other large financial firms were dangerously bound together through a nontransparent web of derivatives exposures. Dodd-Frank proffered mandatory central clearing, which substitutes a central clearinghouse for the bilateral relationship between the parties to an OTC transaction, as the best way to bring order to the chaos of the large OTC derivative markets. To complement central clearing, DoddFrank imposes trading and reporting mandates with the goal of making the OTC markets more transparent and competitive.

This Article argues that the combination of clearing mandates, government prescriptions regarding clearinghouse design, and government support for CCPs threatens financial stability. As Professor Craig Pirrong warned, “a wholesale reengineering of the structure of derivatives markets via legislative fiat is fraught with danger.” A preferable approach would eliminate government backstops and leavedecisions about which products should be centrally cleared and how CCPs should operate to private decision-makers. The current regulatory framework would be replaced by a principles-based regulatory approach and mandatory reporting of swaps transactions.

The Article proceeds as follows. Part I briefly describes OTC derivatives and clearinghouses and how they are regulated under Dodd-Frank. Part II describes why this framework is problematic. Part III posits an alternate framework. 

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