A Reassessment of the Clearing Mandate

Ilya Beylin is a Postdoctoral Research Scholar at Columbia Law School and the Editor-at-Large of the CLS Blue Sky Blog. This post is based on an article authored by Mr. Beylin.

Following the financial crisis, the G-20 nations committed to a raft of reforms for swap markets. These reforms are intended to mitigate systemic risk, and with it, the damage that failing financial institutions inflict on the financial sector and the broader economy. A core component of the reforms is the introduction of the “clearing mandate” for standardized swaps.

Clearing refers to the interposition of a clearinghouse, or central counterparty, between the two parties to a financial transaction. When a swap is cleared, the initial swap is extinguished and two new swaps are created in its place. The first is an identical swap between the first counterparty and the clearinghouse, and the second is another identical swap between the clearinghouse and the second counterparty. In this manner, absent default, parties make payments as they would if they had transacted bilaterally and the clearinghouse simply passes the payments between counterparties. However, when one of the counterparties to a transaction defaults, the presence of the clearinghouse as an intermediate counterparty shields the non-defaulting party from losses; that is because although the defaulting party may not pay the clearinghouse, the clearinghouse is still liable for, and makes, the payment to the remaining counterparty.

The clearing mandate has been implemented in the U.S. with respect to interest rate and index credit default swaps. On a global basis, these swaps represent upwards of $14 trillion in cash flows. The rerouting of these payment obligations through government regulated clearinghouses represents a massive intervention into financial markets. Following the introduction of the clearing mandate, the great majority of scholarship has rebuked the intervention for exacerbating rather than mitigating systemic risk. Prior criticisms have generally proceeded by comparing how a set of swaps would perform in a non-cleared context with how it would perform if cleared. My recent paper, A Reassessment of the Clearing Mandate: How the Clearing Mandate Affects Swap Trading Behavior and the Consequences for Systemic Risk, reviews and synthesizes prior scholarship assessing the clearing mandate. The paper then takes a step beyond and identifies how swap trading will change in response to the clearing mandate (in economics terms, my paper applies a “dynamic” as opposed to “static” analysis of the intervention).

Clearinghouses are a fundamental tool for controlling credit quality in financial markets, as exchanges are fundamental tools for managing liquidity and price transparency. Like any significant intervention into complex markets, mandatory clearing has costs as well as benefits from the perspective of systemic risk. A few of these, including those proposed in my paper, are reviewed here:

Benefits Costs
Clearinghouses can stop domino effects from emerging between swap market participants as they prevent the failure of one swap party and associated defaults on its swaps from causing losses to its counterparties. Clearinghouses concentrate risk. In the event that a clearinghouse has insufficient funds to pay a party to a swap, it will call on funds from all of its members potentially weakening them and instigating a wave of failures.
Clearing may or may not more efficiently apply the loss mitigation technologies of netting, setoff and margin. Whether clearing increases efficiencies depends on whether (a) the effect of some transactions between two counterparties being split off into one or more clearinghouses predominates over (b) transactions between different counterparties being united in the same clearinghouse.
Clearing is a form of insurance for swaps. Mandatory clearing prevents adverse selection into insurance by parties with transactions that impose more risk than their clearing costs cover. Market participants may seek to free ride on each others’ monitoring of the clearinghouse, with none of them actually monitoring clearinghouse solvency. This problem is not unique to the clearing context however, as diversification may serve as a substitute for monitoring in bilateral markets.
During a financial crisis, clearing prevents herding behavior among market participants from emerging. In the last financial crisis, bilateral counterparties of distressed swap participants sought to novate obligations to new counterparties. In doing so, they contacted prospective counterparties that in some cases themselves had exposure to the distressed entity. These prospective counterparties would then contact further third parties seeking to transfer their trades with the distressed entity. These dynamics could cascade into runs on the distressed counterparty manifested in commercial paper, overnight repo and other markets. Cleared transactions do not pose concerns of cascades because once a transaction is cleared, there is no longer the incentive to seek to transfer the obligation if the counterparty becomes distressed. Clearing can safeguard swap markets, e.g., through ensuring there is adequate collateral to make payments as they come due. However, in protecting swap markets, clearing may reduce the protection available to other financial markets. In the words of Mark Roe, clearing can create a Maginot Line that channels systemic risk to new markets rather than bottling it up.
Clearing allows continued management of a swap position even where the counterparty is unavailable or unwilling to terminate or reduce that position. If a transaction is cleared, it can be downsized or terminated through entering into the inverse transaction with any market participant and then having that inverse transaction cleared.
In combination with swap trading platforms created under the Dodd-Frank Act, clearing allows the disintermediation of swap markets. Without clearing and platform execution, swap dealers are indispensable market intermediaries offering dependable liquidity and credit quality. Clearing allows any market participant—not just large established banks—to serve as dependable counterparties from a credit perspective; and platform execution allows demand for swaps to be aggregated from both sides of the market and thus also serve as supply.
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