If a Clearinghouse Collapses, Then What?
The financial crisis of 2007-09 undoubtedly had many causes. Afterward, regulators were tasked with identifying the financial instruments and the players that were most responsible for the buildup of excessive risk. Over-the-counter (OTC) derivatives—which played a principal role in the collapse of insurance giant AIG—were quickly identified as one such instrument.[i] At the center of the new OTC derivative reforms are clearinghouses, which reduce counterparty risk by acting as the middleman, or central counterparty, of the derivative contract. Today, around 75 percent of swaps are cleared through clearinghouses, up from 15 percent pre-crisis.
Instead of the classic bilateral OTC derivative contract between “end user” and “trade counterparty,” the clearinghouse acts as counterparty to each. It takes the opposite side of every derivative trade cleared through it.
However, central clearing does not magically dissolve risk, but only transforms it. Under the reforms, the market for standardized OTC derivatives has consolidated into large institutions that are easier to monitor and generally mitigate counterparty risk. At the same time, they fragment the market because clearinghouses tend to specialize in specific contract types, for instance, credit default swaps. Therefore, the failure of any of these parties would have to be considered systemic.[ii] In fact, it could be argued that the Dodd-Frank Act has removed concern about a single default rippling through the market by creating central hubs that are, in the familiar phrase, too big to fail.
The Dodd-Frank Act’s primary intention is to not only make the financial system more resilient but ensure that companies can fail without requiring public bailouts. If the recovery and resolution of a failed clearinghouse were not flawless, we’d face serious implications for systemic risk.[iii] However, the process of winding down a tottering clearinghouse, as currently conceived, is itself flawed. Its internal default management process may be intact or even robust, but still inadequate to resolve its instability. Yet there is no regulatory blueprint to address a clearinghouse default. In most cases it would trigger the closing and netting out of all contracts, which, given the concentration of clearinghouses in specific derivatives, will unquestionably have systemic effects. Therefore, we can’t rely on internal default management alone.
As an alternative, regulators could wind down the clearinghouse in an orderly manner through the Bankruptcy Code or Dodd-Frank’s Orderly Liquidation provision. This approach, however, would be hindered by the safe harbor provision of derivatives. Under those provisions, derivatives are exempt from bankruptcy law, allowing parties to settle and liquidate their contracts regardless of a debtor’s bankruptcy. Given that the sole purpose of a clearinghouse is to clear derivatives, all counterparties that are “in the money”[iv] will act on doubts about financial soundness by terminating their derivative contracts, thereby putting the clearinghouse at the center of a classic bank run with nothing but a bailout to stop it.
With the Dodd-Frank mandate that standardized OTC derivatives must be cleared at clearinghouses, these institutions have been put at the center of the financial system. To ignore the possibility, however small, that a clearinghouse might fail should not be an option. Regulators need to specify what will happen in the wake of a clearinghouse failure if they want to maintain them as private institutions.
The options, however, are plenty, from expanding the number of clearinghouses or its members to nationalizing a central clearinghouse or clearly defining the structure of a bailout, should one be necessary. This doesn’t mean that these strategies come with no caveats—think of the effect of deposit insurance on the banking sector’s risk-management practices. But to hold fast to the status quo and hope that a clearinghouse bailout will never happen is rejecting history.
[i] For a more in-depth overview of derivatives, see the Milken Institute’s “Deriving the Economic Impact of Derivatives.”
[ii] See Lin and Surti, “Capital Requirements for Over-the-Counter Derivatives Central Counterparties,” IMF.
[iii] Although considered unlikely, the default management of a clearinghouse can fail, e.g. ISDA, “Principles on CCP Recovery.”
[iv] There are even incentives for counterparties that are “out of the money” to close out their positions (see J. Lees Allen, “Derivatives Clearinghouses and Systemic Risk”).