Incomplete Clearinghouse Mandates

DOIhttp://doi.org/10.1111/ablj.12149
Published date01 September 2019
AuthorColleen M. Baker
Date01 September 2019
American Business Law Journal
Volume 56, Issue 3, 507–581, Fall 2019
Incomplete Clearinghouse Mandates
Colleen M. Baker*
In the 2007–08 financial crisis, over-the-counter (OTC) derivatives triggered the
collapse of colossal financial institutions. In response, global policy makers instituted
clearinghouse mandates. As a result, all standardized OTC derivatives must now
use clearinghouses, and global financial market stability now depends upon these
institutions. Yet certain underlying legal and regulatory structures threaten to under-
mine clearinghouse stability, particularly were a significant clearinghouse to become
distressed. This article argues that the clearinghouse mandates are incomplete in that
they fail to reform these problematic arrangements.
As with electric utilities, the lights at the financial market infrastructures known as
clearinghouses must always be on. Yet the legal frameworks for handling a distressed
clearinghouse, the problem of clearinghouse recovery, and resolution, remain uncertain.
This article advances debate on this issue. It argues that recovery, a private market res-
tructuring process, can be conceptualized as a bargaining game dependent upon time-
critical cooperation between a clearinghouse and members. This article uses transaction
cost economics to demonstrate, however, that certain underlying legal and regulatory
structures could work at cross-purposes to this necessary cooperation, and actually
increase its cost. Based upon this analysis, it proposes reforms designed to ensure that
parties’ incentives promote efficient recovery. In the absence of efficient recovery frame-
works, the path of a distressed, significant clearinghouse is likely to resemble that of the
government-backed mortgage lenders whose fate more than ten years after their entry
into conservatorship remains uncertain. This article aims to help avoid a repeat of this
history.
*
Assistant Professor of Legal Studies, University of Oklahoma; PhD The Wharton School;
J.D./MBA University of Virginia. I wish to thank many helpful participants for comments
during presentations on various iterations of this research at the National Business Law
Scholars Conference, the Wharton Conference on Financial Regulation, George Mason
Law School, and the Huber Hurst Seminar at the University of Florida Warrington College
of Business. An appendix provides abbreviations used throughout the article.
©2019 The Author
American Business Law Journal ©2019 Academy of Legal Studies in Business
507
I’ll tell you what happens when a CCP [clearinghouse] goes bust. There is
mayhem–possibly greater mayhem than if the biggest dealers and banks in the world
go bust.
1
INTRODUCTION
On September 11, 2018, an individual Norwegian power trader, Einar
Aas, defaulted on his obligations to NASDAQ Clearing AB, a systemically
important clearinghouse, according to the Financial Stability Board
(FSB).
2
The losses that followed exhausted two-thirds of the clearing-
house’s default fund. This was a big deal. It sent shockwaves through the
financial industry and the global financial policy-maker community.
Clearinghouses,
3
via postfinancial crisis clearing mandates
4
in the over-
the-counter (OTC) derivative markets, were supposed to be a solution,
not the next big problem. The timing of Aas’s default was ironic. It hap-
pened during the week marking the ten-year anniversaries of the invest-
ment bank Lehman Brothers’s bankruptcy, the largest in U.S. history,
and the U.S. government’s $180 billion rescue of American International
Group (AIG).
5
Both events became among the most symbolic of the dir-
est financial crisis since the Great Depression of the 1930s.
1
JON GREGORY,CENTRAL COUNTERPARTIES 181 (2014) (quoting Sir Paul Tucker, former deputy
governor of the Bank of England).
2
See Wenqian Huang, Central Counterparty Capitalization and Misaligned Incentives 1 (BIS
Working Papers No. 767, 2019), https: //www.bis.org/publ/work767.htm (examining capital
incentives of investor-owned clearinghouses with limited liability).
3
Technically, several types of clearinghouses exist and there are important differences. This
article uses the generic term “clearinghouse” to refer to a central counterparty
clearinghouse.
4
Global policy makers framework of reforms for the OTC derivative markets are delineated
in the G20 Leaders’ Statement, The Pittsburgh Summit (Sept. 24–25, 2009), https://www.
treasury.gov/resource-center/interna tional/g7-g20/Documents /pittsburgh_summit_leaders_
statement_250909.pdf. In the United States, these reforms are implemented in Title VII
of the Dodd-Frank Wall Street Reform and Consumer Protec tion Act. Dodd-Frank Wall
Street Reform and Consumer Protecti on Act, Pub. L. No. 111-203, 124 Stat. 1376, 21 13
(2010) [hereinafter Dodd-Frank].
5
See generally William K. Sjostrom, The AIG Bailout,66WASH.&LEE L. REV. 943 (2009) (pro-
viding an overview of the AIG bailout).
508 Vol. 56 / American Business Law Journal
With an estimated size of $595 trillion,
6
the OTC derivative markets
are the largest global financial markets. AIG had sold nearly half-a-
trillion dollars in credit protection via credit default swaps (CDS), a type
of OTC derivative. It did not use a clearinghouse to manage credit risks
associated with these trades. Its CDS played a significant role in its near
collapse during the financial crisis of 2007–08.
7
In contrast, when
Lehman Brothers defaulted, the clearinghouse LCH.Clearnet deftly
managed nearly $10 trillion of its derivatives positions.
8
Hence, clearing-
houses were supposed to be the solution to the AIG problem learned
through the lessons of Lehman Brothers’s bankruptcy. As a result, these
institutions are now at the center of global financial market stability.
Now, the question is what happens if a clearinghouse becomes distressed
or collapses? This critical issue, known as clearinghouse recovery and resolu-
tion, is the focus of this article.
Long ago,
9
financial market participants developed market infrastruc-
tures known as clearinghouses.
10
These club-like institutions reduce
transaction costs associated with trading by facilitating the netting of pay-
ment obligations and the monitoring of trade counterparties. Most
important, however, clearinghouses manage counterparty credit risk by
mutualizing it among clearing members. But if the default of an individ-
ual trader such as Aas at a relatively smaller clearinghouse triggered such
losses, are these institutions really up to their new, breathtaking responsi-
bility for global financial market stability?
6
BANK FOR INTLSETTLEMENTS,STATISTICAL RELEASE: OTC DERIVATIVES STATISTICS AT END-JUNE
2018 (2018), https://www.bis.org/statistics/about_derivatives_stats.htm?m=6%7C32. This is a
notional amount or a reference amount used to calculate payments owed to derivative
counterparties.
7
For simplicity, this article uses the generic terms “the financial crisis,” “postcrisis,” and “cri-
sis” to refer to the financial crisis of 2007–08.
8
PETER NORMAN,THE RISK CONTROLLERS:CENTRAL COUNTERPARTY CLEARING IN GLOBALIZED
FINANCIAL MARKETS 26 (2011).
9
GREGORY,supra note 1, at 6 (noting that derivatives exchanges have used clearinghouses for
more than 100 years).
10
While several types of financial instruments use clearinghouses, this article is primarily
focused on derivatives and, specifically, over-the-counter derivatives, the instruments
targeted by the clearinghouse mandates.
2019 / Incomplete Clearinghouse Mandates 509

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