Derivatives clearinghouses and systemic risk: a bankruptcy and Dodd-Frank analysis.

• Author: Allen, Julia Lees

INTRODUCTION I. DERIVATIVES CLEARINGHOUSES' ROLE IN REDUCING AND MANAGING SYSTEMIC RISK A. Derivatives and Clearinghouse Basics 1. What is a derivative? 2. Counterparty credit risk and systemic risk 3. What is a derivatives clearinghouse? B. A Derivatives Clearinghouse's Successful Management of Systemic Risk in 2008 1. LCH. Clearnet's default management process 2. LCH. Clearnet's effective management of Lehman Brothers Special Financing Inc. 's 2008 default C. Potential weaknesses in derivatives clearinghouse management of systemic risk: how a clearinghouse could fail to manage a member default II. DERIVATIVES CLEARINGHOUSES' POTENTIAL TO INCREASE SYSTEMIC RISK: FAILURE OF EXISTING RESOLUTION SYSTEMS A. Bankruptcy Analysis 1. Safe harbor provisions 2. Inevitable run on the derivatives clearinghouse B. Dodd-Frank Orderly Liquidation Authority Analysis 1. Why a clearinghouse would likely be subject to the Orderly Liquidation Authority 2. Basic elements of the Orderly Liquidation Authority and special provisions for qualified financial contracts 3. Logistical impossibility of resolving a derivatives clearinghouse III. REGULATORY SOLUTIONS TO ENSURE EFFECTIVE MANAGEMENT OF SYSTEMIC RISK CONCLUSION An Act

To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes. (1)

INTRODUCTION

A derivative is a contract between two or more parties whose value is determined based on the fluctuations in the value of the underlying asset. The primary benefit of derivatives is that they supplement the financial markets by improving the pricing of risk and facilitating market participants' risk management. (2) As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in July 2010, derivatives clearinghouses will play a central role in enhancing transparency and regulation of the over-the-counter (OTC) derivatives industry. A clearinghouse, or central counterparty (CCP), is an entity that stands between the two original counterparties of a derivatives trade and assumes the rights and obligations of both parties. Dodd-Frank mandates that certain derivatives products designated by the Commodities Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) must be cleared through regulated clearinghouses; for these products, the clearinghouses will serve as a backstop in case one party defaults, reflecting an effort to reduce the risk of contagion among financial firms and markets. As a result, a large portion of the over-the-counter derivatives market will require clearing by a regulated clearinghouse. (3)

Because the clearinghouses assume and guarantee the risks of the cleared trades' counterparties, clearinghouses will play a central role in managing systemic risk in the financial markets. Systemic risk is "the risk of a significant reduction in the effectiveness of the financial system, caused for example by a chain reaction of failures of major financial institutions." (4) The issue then becomes how well these clearinghouses will be able to manage the significant risk concentrated in the institutions.

The experience of LCH.Clearnet, Ltd. (LCH) during the Lehman Brothers bankruptcy proceedings provides a recent example of how a clearinghouse can successfully manage a member default and decrease systemic risk. LCH is a clearinghouse specializing in interest rate swaps that has been clearing trades for over twenty years. In 2008, LCH successfully managed the $9 trillion default of Lehman Brothers Special Financing, Inc. The clearinghouse also protected all other market participants from counterparty and systemic risk following the unprecedented default. Moreover, LCH forced the defaulter, rather than the survivors, to pay for the default. Accordingly, the clearinghouse's actions in 2008 create a foundation for understanding the complexities of the default management process necessary for a derivatives clearinghouse to effectively manage risk.

Despite LCH's success in decreasing systemic risk during the recent financial crisis, the new clearing provisions create uncertainty as to whether clearinghouses will be as effective in the future. As the volume of trades requiring clearing increases, more risk will be concentrated in the clearinghouses. Consequently, either existing clearinghouses will have to increase in capacity or new clearinghouses will form to support the increased number of trades requiring clearing. What if other clearinghouses do not maintain default management procedures that are tested as rigorously or effectively as LCH's procedures?

What if a clearinghouse were to face multiple clearing member defaults simultaneously? Determining the effectiveness of Dodd-Frank in decreasing systemic risk and addressing the "too big to fail" phenomenon requires understanding the potential strengths and weaknesses of derivatives clearinghouses in managing systemic risk as well as the implications of a clearinghouse's insolvency.

This Note analyzes the effectiveness of derivatives clearinghouses in containing the impact of counterparty default and reducing systemic risk. A derivatives clearinghouse can successfully decrease systemic risk, as seen in LCH's successful management of the Lehman default in 2008. However, if a clearinghouse were unable to manage a member default and became insolvent, systemic risk would greatly increase. Both existing resolution regimes, the Bankruptcy Code and the Dodd-Frank Orderly Liquidation Authority, would be unable to successfully unwind the institution. An insolvent derivatives clearinghouse in effect creates an unsolvable problem with respect to resolution: untangling the derivatives trades would inevitably take more than one day, but if sorting out the portfolios took even a few days, clearing members would start a run on the clearinghouse. The resulting increased systemic risk would necessitate government intervention. A major derivatives clearinghouse would be too big to fail. (5)

This Note sets forth two recommendations to ensure that derivatives clearinghouses successfully reduce systemic risk upon a counterparty default: regulators should (1) minimize the risk of clearinghouse insolvency through strict collateral, capital, and default management requirements, and (2) create an ex ante guarantee fund to serve as a government backstop and to provide liquidity to an insolvent derivatives clearinghouse, thereby avoiding enhanced systemic risk.

Part I introduces background information about the fundamentals of derivatives and derivatives clearinghouses. Part I also presents the case of LCH to demonstrate how a derivatives clearinghouse can effectively reduce systemic risk as well as how a clearinghouse could become insolvent by failing to manage a member default. Part II discusses the scenario in which a clearinghouse fails, analyzing treatment under the Bankruptcy Code and under Dodd-Frank's Orderly Liquidation Authority. Part III then provides regulatory solutions to ensure that derivatives clearinghouses effectively reduce systemic risk.

1. DERIVATIVES CLEARINGHOUSES' ROLE IN REDUCING AND MANAGING SYSTEMIC RISK

   1. Derivatives and Clearinghouse Basics

      1. What is a derivative?

         A derivative is a contract between two or more parties whose value is determined based on the fluctuations in the value of the underlying asset (the "underlier"). A multitude of derivative types exist. The most common types are forwards, futures, swaps, and options. Each type of derivative includes an underlier, which could be anything for any type of agreement. Common examples of derivatives underliers include interest rates, currencies, stocks, or commodities; however, the underlier could also be as specific as the weather in Houston, Texas.

         The payoff for a derivative contract is contingent on the realization of some future event at some future date. For example, a forward is an agreement to buy something (the underlier) at a specific price on a specific future date. In a plain forward contract, such as on oil, the buyer and the seller agree to a price that the buyer will pay the seller on the contract's expiration date. If the price of oil at the expiration date is higher than the forward price, the buyer profits and the seller loses. By contrast, if the price of oil at the expiration date is lower than the forward price, the buyer loses and the seller profits.

         The primary benefit of derivatives is that they "serve to complete financial markets by improving the pricing of risk and helping market participants manage the risks they face.'' (6) For example, a credit default swap permits companies to hedge the risk of credit default and the uncertainty related to that risk. In a credit default swap, the underlier of the financial product is the credit risk of a particular company or sovereign entity (the "reference entity"). The buyer pays a premium to the seller each quarter based on the creditworthiness of the reference entity. In exchange for this payment, the seller must pay the buyer if the reference entity defaults: the credit default swap ensures that the buyer will be protected.

         The important role that derivatives play in completing the financial markets can be seen in the size of the over-the-counter derivatives market. As of December 31, 2010, the notional amount outstanding in the over-the-counter derivatives market reached $601 trillion. (7) Moreover, the interest rate derivatives market accounts for the vast majority of the over-the-counter market--$465 trillion at the end of 2010. (8)

      2. Counterparty credit risk and systemic risk

         Even when a derivative performs as intended, an over-the-counter derivatives contract exposes its holders Ccounterparties") to the risk of loss in two ways: through the performance of the...