The Dodd-Frank Act’s Maginot Line: Clearinghouse Construction

This post summarizes “The Dodd-Frank Act’s Maginot Line:  Clearinghouse Construction,” which will appear in the California Law Review later this year.

Regulatory reaction to the 2008–2009 financial crisis, following the failures of AIG, Bear Stearns, Lehman Brothers, and the Reserve Primary Fund, focused on complex financial instruments that deepened the crisis. A consensus emerged that these risky financial instruments should move through safe, strong clearinghouses, which would be bulwarks against systemic risk.

The consensus turned into law, via the Dodd-Frank Wall Street Reform Act, in which Congress instructed regulators to construct clearinghouses through which these risky financial instruments would trade and settle. Clearinghouses could repel financial risk, reduce contagion, and halt a local financial problem before it became an economy-wide crisis.

But clearinghouses are weaker bulwarks against financial contagion, financial panic, and systemic risk than is commonly thought. They may well be unable to defend the economy against financial stress such as that of the 2008–2009 crisis. Although they can be efficient financial platforms in ordinary times, they do little to reduce systemic risk in crisis times.

The problem for evaluating clearinghouses’ capacity to reduce systemic risk, as opposed to their being efficient trading platforms, is that they generally do not reduce the core risk targeted — that the failure of a financial firm will cause other firms to fail — but rather transfer that risk and loss to others in the financial system. Sometimes that risk is mutualized among the clearinghouse members, sometimes it is transferred elsewhere (and, if the recipient is aware of the risk transfer, the transfer will be priced). Some of these limits have been raised before, some not.  Many of the limits to clearinghouses can be conceptualized as applications of basic finance theory on risk transfer, namely, that transferring a risk does not in and of itself eliminate that risk.

The systemic difficulty in being confident that clearinghouses are reducing systemic risk is that a major part of the reduction in risk among the clearinghouse insiders is largely achieved by pushing that risk elsewhere. But with a little further analysis, we can see that the spot to which it can readily be pushed is often going to be a systemically dangerous spot as well. Financial contagion can thus side-step the clearinghouse fortress and bring down other core financial institutions.

Worse, clearinghouses cannot readily handle the major stresses that afflicted the economy in 2008–2009, could well have transmit and magnify them, and can only weakly act on the type of financial stress that Congress targeted with Dodd-Frank. For example, clearinghouses are expected to more efficiently collect collateral than bilateral, over-the-counter traders. In normal times, this is a benefit to the economy and the trading market emanating from clearinghouses. But in a financial crisis, the ability to collect collateral can just as readily be detrimental as beneficial, as it could force weaker clearinghouse members to sell assets (so they can post good collateral), potentially exacerbating the kind of downward asset pricing spiral we experienced in the recent financial crisis. Moreover, we can see that the interconnections induced by the clearinghouse can create transparency when the economy is good, but can spread financial opacity in a crisis. When we add in the other weaknesses of the new clearinghouses — as too-big-to-fail institutions, as institutions whose members’ interests in containing clearinghouse riskiness are not as strong as the public’s, and as institutions that will not be easy to regulate well — even the direction of clearinghouses’ impact on systemic risk is uncertain.

The stakes are high in correctly assessing the value of clearinghouses in containing systemic risk, because the reigning over-confidence in clearinghouses lulls regulators to be satisfied that they have done much to arrest problems of contagion and systemic risk, when they have not.

The full paper is available for download here.