INTRODUCTION 1329 A. Terminology 1332 B. Historical Context 1333 I. EXAMINING THE SYSTEMIC 1336 RISKINESS OF FINANCIAL CONTRACTS A. Explaining Why Derivatives 1336 Contracts Are Systemically Risky B. Explaining Why Nonderivative Financial 1340 Contracts Could Be Systemically Risky II. CENTRAL CLEARING OF DERIVATIVES CONTRACTS 1343 III. CENTRAL CLEARING OF 1347 NONDERIVATIVE FINANCIAL CONTRACTS A. Estimating the Benefits of Centrally 1348 Clearing Nonderivative Financial Contracts B. Estimating the Costs of Centrally 1352 Clearing Nonderivative Financial Contracts 1. Transaction Costs 1352 2. Systemic Costs 1354 C. Balancing Benefits and Costs 1356 IV. ADAPTING AND ENHANCING CENTRAL 1357 COUNTERPARTY RISK PROTECTION A. Adapting Existing Protections 1357 B. Enhancing the Protections 1361 V. JURISPRUDENTIAL PERSPECTIVES 1362 A. Should Regulators Mandate How 1363 Financial Institutions Control Their Risk? B. Should Regulators Require 1365 Financial Institutions to Mutualize Risk? CONCLUSION 1367 APPENDIX 1: CENTRALLY CLEARING NONDERIVATIVE FINANCIAL CONTRACTS 1369 A. Central Clearing of 1369 Derivatives Contracts B. Central Clearing of Nonderivative 1369 Financial Contracts C. Central Clearing's Difference in Practice 1370 APPENDIX 2: STANDARDIZING 1372 NONDERIVATIVE FINANCIAL CONTRACTS INTRODUCTION
Since the global financial crisis of 2007-2009 (the "financial crisis"), an increasing number of countries, including the United States, have been requiring most derivatives contracts to be cleared (1) and settled (2) through central counterparties (CCPs). (3) CCPs are typically well-capitalized entities, (4) often associated with derivatives, commodities, or other securities exchanges. (5) The CCP legally substitutes its credit for that of the contracting parties, making the CCP the primary counterparty on both sides of the contract--for example, the buyer to every seller and the seller to every buyer. (6) The CCP thus ensures the performance of a financial contract even if a contracting party fails, (7) thereby reducing counterparty risk (8)--the risk that a contracting party's default will harm other parties to the contract. Regulators believe this reduction of counterparty risk will reduce "systemic" risk (9)--the risk that, in this context, a failure of one or more counterparties could lead to events that impair the financial systems ability to function as a network (10) and cause an economic collapse. (11)
This emerging regulatory norm raises the question on which this Article focuses: should regulators also require other types of financial contracts (hereinafter "nonderivative financial contracts") to be centrally cleared and settled, in order to reduce systemic risk? (12) This inquiry has real practical importance because the aggregate counterparty exposure (13) on nonderivative financial contracts--and thus the systemic risk that could be triggered by that exposure--greatly exceeds that on derivatives contracts. (14) Centrally clearing derivatives contracts through CCPs also has a "unique feature": the "mutualization of default losses." (15) Expanding central clearing to nonderivative financial contracts therefore raises fundamental issues about whether regulators should require financial institutions to mutualize losses in order to control systemic risk. (16)
To answer its question, this Article first shows that regulators require central clearing of derivatives contracts because they assume--driven in part by media pressure--that those contracts are inherently systemically risky. (17) This Article then explains why that assumption is misleading: the systemic riskiness of derivatives contracts comes not from their inherent nature but, rather, from their systemically important counterparties. (18) Finally, this Article uses that insight to theorize and argue as to when regulation should require central clearing for nonderivative financial contracts. (19)
This analysis builds on the following foundational terminology. Consistent with financial industry shorthand, references to "clearing" also include settlement, and references to "central clearing" mean the clearing (and thus settlement) of contracts through CCPs. Central clearing of a nonderivative financial contract therefore means using a CCP to transmit, reconcile, and confirm each transfer to be made under the contract, (20) and then to complete the transfer by paying funds or assigning securities as needed to satisfy counterparty obligations thereunder. (21) The term "counterparty" means, depending on the context, either the contracting parties themselves or a CCP acting as a central counterparty. Applying these terms, central clearing of a loan agreement--which exemplifies a straightforward nonderivative financial contract--means using a CCP (acting as a central counterparty) to monitor the amount and dates of payments to be made thereunder and to make each such payment, when due, to the (counterparty) lender on behalf of the (counterparty) borrower. (22)
References to a "financial contract" mean any contract--exemplified above by a loan agreement--that governs a financial or financing transaction. (23) A derivatives contract is a specific type of financial contract: it is one that derives its value from the future performance of an underlying asset, index, or other reference entity. (24) In that sense, it is a "bet" on that future underlying performance. (25) For example, Party A may enter into a derivatives contract today to sell 1000 shares of XYZ stock, currently having a market value of $70 per share, to Party B a year from now, at that same price. If in a year the market value of XYZ stock has fallen to $50 per share, Party A would benefit. (26) But if that market value had instead risen to $80 per share, Party B would benefit. (27)
The move to require central clearing of derivatives contracts assumes that derivatives contracts are unusually systemically risky and, indeed, were a cause of the financial crisis. (28) The media portrayed American International Group (AIG)--which was potentially liable under multiple credit-default swaps (CDS), a type of derivatives contract, (29) to investors in mortgage-backed securities (MBS) (30)--as a "poster child" for that crisis. (31) The collapse of the MBS market threatened AIG's financial integrity as panicking investors commenced collection actions on their CDS contracts. (32) Observers believe that, absent its government bailout, AIG would have collapsed and caused massive systemic harm. (33) Although his statement is often taken out of context, Warren Buffet added fuel to the fire by famously referring to derivatives contracts as "financial weapons of mass destruction." (34)
In response, the Dodd-Frank Act--the Congressional legislation that seeks to redress the excesses that led to the financial crisis (35)--and followup regulation by the Securities and Exchange Commission (SEC) and CFTC require that many derivatives contracts be centrally cleared through CCPs. (36) In accord with recommendations of the Financial Stability Board, an organization established by the G20 nations to monitor and make recommendations about the global financial system, numerous jurisdictions outside the United States have similarly begun requiring central clearing of derivatives contracts. (37) If AIG's CDS contracts were centrally cleared, the argument goes, it would not have needed a government bailout. (38)
In the first instance, the answer to this Article's question--whether regulators should also require nonderivative financial contracts to be centrally cleared--turns on understanding why derivatives contracts are systemically risky. If derivatives contracts are inherently systemically riskier than nonderivative financial contracts, then centrally clearing nonderivative financial contracts might only marginally reduce systemic risk. If, however, derivatives contracts are systemically risky because of a trait they share with nonderivative financial contracts, then it could be valuable to extend central clearing to nonderivative financial contracts that share that trait.
This Article's analysis proceeds as follows. Part I examines the systemic riskiness of financial contracts. It finds that derivatives contracts are not inherently systemically risky; rather, their systemic riskiness derives from their systemically important counterparties. Observing that nonderivative financial contracts sometimes also have systemically important counterparties, Part I then builds on that shared trait to derive a theory to explain when regulation should require central clearing of nonderivative financial contracts. Part II develops the theory by testing it against current regulation requiring the central clearing of derivatives contracts. Part III examines the theory's regulatory and economic efficiency implications for determining whether to expand central clearing to nonderivative financial contracts. It also identifies and balances the benefits and costs of such a regulatory expansion. Part IV examines how to limit the costs of expansion, including by adapting the protections against CCP risk concentration that currently apply to central clearing of derivatives contracts. It also examines how to enhance those protections. Part V focuses in depth on two fundamental legal questions raised by central clearing: whether regulators should mandate how financial institutions control risk, and whether they should require financial institutions to mutualize risk. Appendix l to this Article illustrates how nonderivative financial contracts could be centrally cleared and compares that to the central clearing of derivatives contracts. Finally, Appendix 2 explains how to standardize nonderivative financial contracts, showing that such standardization would be quite feasible because, among other reasons, nonderivative financial contracts already are commonly documented on standardized forms.