Evaluating Dodd-Frank and International Approaches to Clearinghouses, Central Banks, and Swap Lines

On June 26, in a House Committee on Financial Services hearing, “Examining How the Dodd-Frank Act Could Result in More Taxpayer-Funded Bailouts,” former FDIC Chair Shelia Bair testified to being “surprised at the lack of concern over the designation of “financial market utilities,” and particularly Section 806 which permits the Federal Reserve to provide safety net access to designated financial market utilities.”

Indeed, these reforms in Dodd-Frank’s Title VIII have received little attention.  Related provisions in Dodd-Frank’s Title XI mandating disclosure of the use of the Federal Reserve’s currency swap line authority with nongovernmental third parties have similarly been largely overlooked.  Nevertheless, as I’ve argued in recent companion articles (a short and a longer version), these highly significant reforms expand and fundamentally transform the Federal Reserve’s last resort lending role in global financial markets.

Post-financial crisis, clearinghouses have become the centerpiece of domestic (Dodd-Frank’s Title VII) and international (G20 initiatives) stability-oriented reforms to the $639 trillion over-the-counter (OTC) derivative markets.  Less in the spotlight, however, is the last-resort insurance (lending) role that central banks such as the Federal Reserve are now assuming to support these better-known clearinghouse reforms.

In July 2012, the Financial Stability Oversight Council designated eight financial market utilities – most of which are clearinghouses – as “systemically significant,” or in the market’s terms, “Too Big To Fail” (TBTF).  Clearinghouses, such as the designated ICE Clear Credit LLC which clears credit default swaps (CDS) – are one type of financial market utility.  Clearinghouses are core components of the background infrastructure systems – formerly termed payment, clearing, and settlement (PCS) systems – which complete the flows of money involved in financial trading.

Significant disruptions in PCS systems exacerbated the financial crisis of 2008.  They also motivated the reforms discussed in this post.  For example, during the financial crisis, international dollar settlement systems broke down.  Consequently, the Federal Reserve made emergency, stability-oriented dollar loans totaling over half-a-trillion via its currency swap lines to fourteen foreign central banks.  Recent international developments involving central banks, currency swap lines, and clearinghouses continue to expand central banks’ roles as last resort insurers in global financial markets.  They also attest to the importance of the related reforms in Dodd-Frank transforming the Federal Reserve’s last resort role.

On June 22, the Bank of England (BoE) announced a 3-year sterling/renminbi currency swap line agreement with the People’s Bank of China.  France reportedly plans to follow suit.  London Metal Exchange (LME) Clear – a London based clearinghouse – also recently announced plans for renminbi clearing.  LCH.Clearnet will soon begin to clear CDS in Paris for U.S. clients.  The BoE’s currency swap line is a government insurance mechanism.  It is designed to promote market stability.  It also aims to promote London as a hub for renminbi trading.  Importantly, however, no renminbi-related instability currently exists in London’s financial markets.  But this could change because of moral hazard related problems.  The BoE’s new stability-oriented, currency swap line insurance mechanism could actually introduce instability into financial markets and clearinghouse operations by inadvertently encouraging additional risk-taking by market participants.

Clearinghouses have many virtues.  Most importantly, they minimize counterparty credit risk – the most worrisome concern in OTC derivative markets – because they guarantee trade performance.  Through a novation process, the clearinghouse becomes the buyer to the seller and the seller to the buyer of the original trade.  The clearinghouse’s trade-related performance obligations are legally independent of the counterparties’ original obligations.  Clearinghouses are designed to be bastions of credit risk management.  Their renowned risk management practices aim to ensure they can perform their guarantee function if necessary.

Nevertheless, as Title VIII’s reforms implicitly highlight, clearinghouses can, and have, failed. Clearinghouses face many of the risks confronted by regulated banks.  Title VIII’s reforms enable designated clearinghouses to have a more “bank-like” status in the Federal Reserve System.  For the first time, designated clearinghouses can have access to Federal Reserve bank accounts and services such as FedWire – a settlement service forming part of the federal safety net – and also be paid interest on these account balances.  These changes are significant.  Previously such accounts and services have only been available to regulated depository institutions.

Title VIII’s most important reform is a new, highly expansive lending authority the Federal Reserve can use to combat disruptions in PCS systems in “unusual or exigent circumstances.”  The Federal Reserve’s lending authority – referred to as its “discount window” – can be thought of as existing on a spectrum between the access of regulated banking institutions on the one end and the Federal Reserve’s 13(3) emergency power on the other end.  Title VIII’s lending authority lies between these poles.  It is arguably much closer to – although not identical with – the access privileges of regulated banks to the discount window.

Yet despite Title VIII’s reforms which impart a more bank-like status to designated clearinghouses, it is unclear that such clearinghouses will be regulated sufficiently similar to regulated banks.  This is problematic.  The possibility of a central bank backstop creates significant moral hazard issues.  The moral hazard concern in the clearinghouse context is that a designated clearinghouse might relax its traditionally robust risk management practices to improve its competitive position and profits.  A race to the bottom in the risk management standards of clearinghouses could occur.  If a designated clearinghouse were to need central bank assistance, the public could end up absorbing the potential cost of this increased risk-taking as in the case of TBTF banks during the financial crisis.

In many ways, designated clearinghouses are the new “Too Big To Fail” banks.   The Federal Reserve recently increased capital requirements for banks.  Designated clearinghouses should perhaps be next in line.  Global banks – significant members of clearinghouses – have recently begun urging regulators to do just this.  Such warnings are similar to the International Swaps and Derivatives Association’s caution that “the contagion risk entailed by central clearing should not be understated, and the risk of multiple defaults across CCPs [clearinghouses] should not be underestimated.”[1]

The potential competitive motivations of these admonitions should not obscure the concerns they highlight.  For example, Dodd-Frank’s disclosure requirement for any Federal Reserve currency swap line lending to nongovernmental third parties – for example, overseas clearinghouses – support the worries behind such warnings.  It is foreseeable that a distressed overseas clearinghouse could need large amounts of emergency dollar liquidity for clearing and settlement purposes.  In fact, there is currently a “sustained collective push this year by clearing houses, central securities depositories [a type of financial market utility] and industry trade bodies to link borrowers and lenders of collateral, irrespective of where their underlying liquidity or collateral is held.”[2]

In sum, well-intentioned domestic and international reforms of OTC derivative markets and the complementary supporting expansions of central banks’ stability insurer role in financial markets could ultimately create an impossibly interconnected, concentrated, global web of clearinghouses, central banks, and swap lines resulting in a solution potentially worse than the original problem.

A short article discussing these issues is here and a longer article, The Federal Reserve As Last Resort, is here.

[1] ISDA, Risk Sensitive Capital Treatment For Clearing Member Exposure To Central Counterparty Default Funds (March 2013)

[2] Philip Stafford, Settlement houses in repo collateral deal, Fin. Times (July 15, 2013).

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