Nationalize the Clearinghouses!

The following post comes to us from Stephen J. Lubben, Harvey Washington Wiley Chair in Corporate Governance & Business Ethic at Seton Hall University School of Law.

A clearinghouse reduces counterparty risks by acting as the hub for trades amongst the largest financial institutions. For this reason, Dodd-Frank’s seventh title, the heart of the law’s regulation of OTC derivatives, requires that most derivatives trade through clearinghouses.

The concentration of trades into a very small number of clearinghouses or CCPs has obvious risks. To maintain the vitality of clearinghouses, Congress thus enacted the eighth title of Dodd-Frank, which allows for the regulation of key “financial system utilities.” In plain English, a financial system utility is either a payment system—like FedWire or CHIPS—or a clearinghouse.

But given the vital place of clearinghouses in Dodd-Frank, it is perhaps surprising that Dodd-Frank makes no provision for the failure of a clearinghouse. Indeed, it is arguable that the United States is not in compliance with its commitment to the G-20 on this point.

Clearinghouses are presently excluded from the new Orderly Liquidation Authority under title II. Title II and titles VII and VIII do not work well together in any event, and the notion that a derivatives clearinghouse might file a regular bankruptcy petition is farcical, given that Congress previously decided to exclude derivatives, and most securities trades, from the most important parts of the Bankruptcy Code. A clearinghouse might file, but there would be little point.

And because clearinghouses are oddly defined as “commodities brokers” under the Bankruptcy Code, they are only permitted to file a chapter 7 liquidation cases.

Then there is the unique way in which clearinghouses are apt to fail. Unlike most businesses, clearinghouses will never find themselves suffering from ever increasing degrees of financial distress. Instead, they will most likely fail as the result of one of their member’s failure, or as a result of a massive operational problem. In short, they will “jump to default,” just like a credit default swap.

As Congress recognized in title VIII, all of this places special stress on the need for risk management at the clearinghouses. But what if the clearinghouse nonetheless fails?

In my paper—Nationalize the Clearinghouses!, which I recently posted on the SSRN—I review the law of clearinghouses and clearinghouse failure, before making three basic claims in answering this question. First, bailouts of clearinghouses are inevitable, because the important, central place of clearinghouses after Dodd-Frank makes their failure too disruptive to be politically tolerated. Second, the United States needs to enact a clear, ex ante procedure to deal with the failure of a clearinghouse and address the consequences of a bailout. Third, those consequences must include clearly delineated outcomes for the stakeholders best situated to avoid problems at the clearinghouse. In short, both shareholders and members must incur real costs if a clearinghouse fails. Hence, upon failure clearinghouses must be nationalized and memberships cancelled.

In essence, both types of equity in the clearinghouse—memberships and formal equity—must be forfeited in exchange for the bailout.

The full paper is available for download here.

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