As is well known, a key feature of the Dodd-Frank Act is the effort to treat swaps more like commodities. In particular, large categories of swaps are to be centrally cleared, replacing the pre-Lehman OTC model with a commodities model that has worked reasonably well for decades.
But the result is to massively increase the importance of the clearinghouses in the global financial system. Clearinghouses are regulated, but given the vital place of clearinghouses in Dodd-Frank, it is surprising that Dodd-Frank makes no clear provision for the failure of a clearinghouse.
Given the key role that clearinghouses will play in a post-Dodd-Frank world, my paper, forthcoming in the Virginia Law & Business Review, begins the hard discussion of what should happen if the worst should happen.
The most obvious tool for addressing a distressed clearinghouse is the new orderly liquidation authority under the Dodd-Frank Act. Indeed, many have assumed that OLA applies to clearinghouses. But a close reading of Dodd-Frank indicates otherwise.
Moreover, putting a clearinghouse into OLA would place the FDIC in charge of the clearinghouse, despite the FDIC’s complete lack of involvement in the regulation of clearinghouses under Dodd-Frank. And the CFTC is given no role in triggering an OLA proceeding – indeed, it goes unmentioned in OLA entirely – despite its central role in regulating clearinghouses, and in regulating the OTC market more generally. Both indicate that Congress never intended OLA to apply to clearinghouses regulated under Dodd-Frank.
That leaves the generally applicable provisions of the Bankruptcy Code. There is no legal reason to bar a clearinghouse from bankruptcy court. But the so-called safe harbors provide a practical impediment to the use of the Code.
These provisions exempt derivatives and securities trades, and their associated margin, from three key provisions of the Code – the automatic say, the assumption and rejection power, and the various avoidance powers. And without securities and derivatives contracts in place, there will be little left to reorganize at a clearinghouse – assuming “reorganize” is the right term for a proceeding that could only happen under chapter 7 of the Code. Under the terms of section 109(d) of the Code, the clearinghouse would not be allowed into chapter 11.
Instead of a formal insolvency proceeding, most clearinghouse rules state that upon exhaustion of their default fund and any assessment rights they have against members, all contracts will be closed and member positions netted. Given the concentration of certain trades in one or two clearinghouses, the sudden termination of more than half of the index CDS trades, to take one example, could not help but have systemic effects.
In Europe, clearinghouses often also provide for reduction of variation margin payments when the default fund has been fully tapped. For example, LCH.Clearnet Ltd, a key clearinghouse for interest rate swaps, provides for variation margin payments to be cut by the higher of £100 million or the amount of the member’s default fund contribution.
In essence, the haircutting of margin is simply a capital contribution that eliminates the counterparty, nonpayment risk to the clearinghouse. This seems like an attempt to save the clearinghouse at the expense of its members and their customers.
In situations where this power would be invoked, the effect of these additional losses on members, and likely their customers, would make a bad situation worse.
The lack of insolvency mechanisms for clearinghouses is particularly concerning given the unique way in which clearinghouses are apt to fail. Unlike most businesses, clearinghouses will never find themselves suffering from ever increasing degrees of financial distress. Instead, they will most likely fail as the result of one of their member’s failure, or as a result of a massive operational problem. In short, they will “jump to default,” just like a credit default swap.
As Congress recognized in Dodd-Frank, all of this places special stress on the need for risk management at the clearinghouses. But what if a clearinghouse nonetheless fails?
Industry participants acknowledge that this eventuality, although arguably unlikely, could happen. What happens next is unknown.
In the paper, I propose that the government should nationalize the clearinghouses upon failure, and that the intention to do so should be made clear ex ante. That is, the government should expressly state clearinghouses that ultimately fail will be nationalized, with specific consequences to investors, and an expectation of member participation in the recapitalization of the clearinghouse, once that becomes systemically viable. This should provide stakeholders in the clearinghouses with strong incentives to oversee the clearinghouse’s management, and avoid such a fate.
In essence, what I propose is a system of precommitment or “structured bailouts.” Bailouts of clearinghouses seem inevitable. We must specify what would happen today, both to discourage an avoidable situation, and to facilitate an organized response in the event of an essential bailout.
In a world of limited liability, this may not be enough to get the incentives “just right.” But it is better than the status quo.
The paper makes three basic claims. First, bailouts of clearinghouses are now foreseeable, because the important, central place of clearinghouses after Dodd-Frank makes their failure too disruptive to be politically tolerated. Second, the United States needs to enact a clear, ex ante procedure to deal with the failure of a clearinghouse and address the consequences of a bailout. Third, those consequences must include clearly delineated outcomes for the stakeholders best situated to avoid problems at the clearinghouse.
In short, both shareholders and members must incur real costs if a clearinghouse fails. Hence, upon failure, clearinghouses must be nationalized and memberships cancelled.
The preceding post comes to us from Stephen J. Lubben, Harvey Washington Wiley Chair in Corporate Governance & Business Ethics, Seton Hall University School of Law. The post is based on his article, which is entitled “Failure of the Clearinghouse: Dodd-Frank’s Fatal Flaw?” and available here.