Destructive Collectivism: Dodd-Frank Coordination and Clearinghouses

Yuliya Guseva is Associate Professor of Law at Rutgers Law School. This post is based on her recent article, published in the Cardozo Law Review.

Research on financial regulation consistently focuses on several critical paradigms, including, inter alia, the calls for better economic justification of regulations and the role of the Financial Stability Oversight Council (FSOC). Prominent commentators, including Robert Bartlett, John Coates, Jeffrey Gordon, Robert Jackson, Eric Posner, Cass Sunstein, and others, have dissected the pros and cons, as well as the feasibility, of economic and cost-benefit analysis in financial regulation. One of the recent articles in this debate, by Prof. Revesz, proposes expanding the FSOC’s role in the economic analysis of individual regulations or, in the alternative, adding an additional layer of administrative review to be provided by the Office of Information and Regulatory Affairs. The underlying presumption is that the independent regulators, such as the Securities and Exchange Commission (SEC), often do not have the required expertise to run proper economic analysis. The FSOC, by contrast, is an entity focused on the gestalt of the financial landscape and systemic risk identification. In this task, it is aided by the well-respected Office of Financial Research.

By the same token, the lack of FSOC-centered coordination is often viewed as a downside of the U.S. regulatory system. For instance, GAO has been for years championing the idea of coordination and lamenting the lack of regulatory collaboration that “can also be challenging at times, as almost all of [the FSOC members] represent independent agencies that retained existing authorities.” According to its 2016 and 2017 reports, there is room for more collaboration. A related underlying presumption must be that regulators, such as the SEC, do not have the capacity and sufficient incentives to proceed in the right direction. In a similar vein, Schwarcz and Zaring suggest in their recent article that the FSOC performs a valuable task of holding not only individual systemically risky firms, but also individual regulators to account, which they describe as “regulation by threat.”

An alternative approach to achieving efficiencies in financial regulation is suggested in one of my articles on clearinghouses (Yuliya Guseva, Destructive Collectivism: Dodd-Frank Coordination and Clearinghouses, 37 Cardozo Law Review 1693 (2016)). The Article demonstrates that the dominant regulatory strategy in securities clearing was premised on a cooperative market-regulator arrangement which allowed for continuously efficient rulemaking and information exchange between the regulated institutions and the SEC, i.e., an independent expert regulator.

The Article identifies the key trends characterizing clearing agency regulation between 1975 and 2010. All pre-Dodd-Frank reforms followed a pattern. In contrast to today’s reforms, the SEC de facto expedited the processes that the market itself had already demanded of the securities clearing industry. The regulations tracked earlier industry experiments, converted prior private practices into generalized standards, and generally followed the impetus supplied by the market. The Article shows that the history of the securities clearing industry is full of market-regulator cooperation where the regulator memorialized best practices through regulations. The question whether the SEC had the best team of economists was less relevant. Regulatory efficiency was promoted because the Commission could, in part, rely on the inputs provided by the industry.

The SEC’s statutory mandate in clearing was broad. The Ninth Circuit Court of Appeals observed, for example, that Congress “did not impose any specific standards of efficiency and instead relied on the Commission to regulate clearing agencies.” (Whistler Investments, Inc. v. Depository Trust and Clearing Corp., 539 F.3d 1159, 1167 (9th Cir. 2008)). Despite the broad mandate, the SEC developed somewhat low-key “standards to be used by the Division of Market Regulation.” (Exchange Act Release No. 16900, 45 Fed. Reg. 41920 (June 23, 1980)). The Standards survived until the post–Dodd-Frank overhaul. The same restraint was evident in enforcement strategies. There were only two major actions against clearinghouses. In both cases, the violators were peripheral clearing institutions, both of which promptly exited the industry. By contrast, the major clearinghouses ensured their safety and efficiency through a unique corporate governance structure and direct participation of the clearing members. The approach optimized risks and incentives, monitoring objectives, and self-regulatory mechanisms. Finally, the very industry organization, similar to a contestable monopoly, helped to keep major securities clearinghouses in check.

My review of all cases against clearing agencies registered with the SEC between 1975 and August 2014 suggests that courts were supportive of this arrangement. So long as a clearinghouse stayed within the preapproved boundaries of SRO and SEC programs and rules, and exercised its discretion in good faith, courts seemed reluctant to interfere with the established market-regulator arrangements. Instead, they relied on the implied integrity of the clearing rules and the SEC rule approval processes.

This environment has been shattered by Dodd-Frank. The SEC’s jurisdiction now covers additional “supervisees,” including agencies providing derivatives clearing services. Derivatives clearinghouses are dually registered with the SEC and the Commodity Futures Trading Commission (CFTC). The corporate governance mechanisms of the newly added clearinghouses and of the securities clearinghouses are divaricate. The shareholders of the derivatives clearinghouses lack similar monitoring incentives, while other stakeholders do not have the same oversight authority as that enjoyed by the traditional securities clearinghouses’ stakeholders.

The regulatory expansion may force the SEC to regress to the regulatory mean. Namely, under Title VIII, clearing agencies that are systemically important financial market utilities (FMUs) are subject to enhanced supervision by not only the SEC, but also by other regulators, such as the Board of Governors of the Federal Reserve System, with whom the SEC must consult on certain aspects of rulemaking and examination. While the CFTC and the SEC logically cannot apply completely divergent requirements to FMUs, there is also the danger that an expert regulator, such as the SEC, may occasionally blunder and succumb to a “view [that] derives principally from the default management practices of derivatives [clearinghouses] . . . . [and] is in marked contrast to the U.S. cash markets” (Letter from Larry E. Thompson, Managing Dir. & Gen. Counsel, Depository Tr. & Clearing Corp., 8 (May 27, 2014)). Regulatory “averages” may create unnecessary challenges for clearing agencies.

The second problem is the reduced market input, the rigidity of the new regulations, and rules produced without previous industry experimentation. While the first 2012 clearing regulations paid homage to the SEC’s traditional principles-based approach, systemically important FMUs are increasingly faced with more rigid rules. In 2012, the SEC, for instance, still acknowledged that some risk management standards require business judgment due to ever-changing market conditions. The Commission admitted that in certain areas “a less prescriptive approach can help promote efficient practices and encourage regulated entities to consider how to manage their regulatory obligations and risk management practices in a way that complies with Commission rules while accounting for the particular characteristics of their business.” (Release No. 34-68080, 77 Fed. Reg. 66220, 66226 (Nov. 2, 2012)). Later, this philosophy suffered a setback as the Commission amended Rule 17Ad-22 and adopted Rule 17Ab2-2 (81 Fed. Reg. 70786-01 (Oct. 13, 2016)), which both mainly focus on FMUs designated as systemically important by the FSOC.

For instance, the SEC downplayed the value of discretion and placed greater emphasis on more specific provisions, including, inter alia, reporting, capital, auditing, stress testing, and statistical modeling. The SEC explained the shift toward more prescriptive regulations because the covered clearinghouses are systemically important and may transmit financial shocks, and that competition is limited and barriers to entry are high. However, they were so five, ten, and, to some extent, even thirty years ago. The aforesaid potential externalities and industry concentration did not suddenly materialize after the 2008 crisis and have been an innate feature of centralized securities clearing for decades.

The SEC also emphasized that the pressures to reduce costs and maximize profits or the moral hazard problem may temper the incentives for sound risk management. Since it appears that the major securities clearing agencies have been built on an inclusive, participatory corporate governance model and demonstrated uninterrupted performance for several decades, these general arguments need to be examined more carefully. In the same vein, even though the major securities and options clearinghouses performed well despite significant market volatility during the financial crisis, the Commission justified the new rules by referencing the financial crisis.

Finally, the SEC accepted as a given the putative “benefits that would accrue through maintaining consistency with regulations adopted by the Board and the CFTC.” (Release No. 34-71699, 79 Fed. Reg. 16865, 16935 (Mar 26, 2014)). Possibly, the SEC is generally acting under pressure from the fellow regulators, triggered by the post–Dodd-Frank designations of clearing agencies as systemically important FMUs. In taking into consideration the philosophies of other agencies, a smaller sector-specific regulator may become more conformist.

The new regulatory coordination may be detrimental when applied to historically successful systemically important FMUs such as clearing agencies. Encroaching on the previously successful cooperative framework may produce “average” regulations, limit the necessary information input from the industry, and result in information losses undermining well-informed agency rulemaking. In other words, the Dodd-Frank regulatory structure can propagate the risk of collectivism, i.e., a regulatory risk of a decision-making system where a more powerful agency or a group of agencies may impel a less influential regulator to unnecessarily modify its rules and regress to the “regulatory mean.” Collectivism may result in unnecessary regulations, which are not based on either the better expertise of individual regulators or the industry needs. To conclude, an important question in today’s rulemaking is whether and to what extent a regulator, such as the SEC, may be guided not only by cost-benefit studies conducted by government-employed economists or “average” suggestions of fellow regulators, which lack the same expertise, but also by market initiatives and best practices.

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