Financial Regulation, Corporate Governance, and the Hidden Costs of Clearinghouses

Paolo Saguato is Assistant Professor of Law at George Mason University Antonin Scalia Law School. This post is based on his recent article, published in the Ohio State Law Journal.

Recent financial market events have splashed onto the front pages of newspapers the often-overlooked plumbing found in those markets: the clearinghouses that handle trillions of dollars’ worth of securities and derivatives trades. During the Robinhood and GameStop events, the National Securities Clearing Corporation, a securities clearinghouse, played a critical role when it required Robinhood to provide collateral to guaranty its open positions. And recently, FTX US Derivatives, a cryptocurrency exchange, brought further attention to the clearing business and the critical risk mitigation and containment function it provides to the financial system when it applied to the Commodity Futures Trading Commission to offer clearing services for non-intermediated margined crypto derivatives.

Given the magnitude of the trades crisscrossing clearinghouses every day, these vital market infrastructures warrant more scrutiny than they have received. My article calls for policymakers to focus on the existing governance and financial structure of clearinghouses and urges them to seriously address a critical open issue in their organization: the misaligned incentives across clearinghouses’ main stakeholders—particularly their shareholders and their members—and how that misalignment might affect clearinghouses’ risk profile and financial resilience.

Clearinghouses are, in fact, corporations with a unique financial structure. Clearing members are financial institutions that access clearing services. While such members are the ultimate risk bearers of the business, they lack any formal governance rights over the firm. Instead, clearinghouses are controlled by their shareholders, who are large publicly-listed for-profit financial infrastructure groups. These shareholders retain all governance rights, yet have extremely limited financial skin in the game.

Clearinghouses are systemic nodes and intermediaries: they stand between the parties of a trade, effectively acting as the buyer to every seller and as the seller to every buyer. Acting as central counterparties, clearinghouses centralize and bear certain risks of the processed transactions, the biggest one being counterparty risk. They manage and mitigate that risk, agreeing to eventually guarantee the obligations under the cleared contracts if one side defaults; and offering orderly default management in the form of internalization, but ultimately allocation and mutualization of residual losses among all clearing members. The Dodd-Frank Act embraced clearinghouses as risk managers, “shock absorbers,” and “stability buffers” for the over-the-counter derivatives markets, making them systemically important. Yet, these critical market infrastructures stand on fragile foundations. The economic and governance structure set in place by the existing regulatory regime and the private rules adopted by clearinghouses in their self-regulatory capacity have important and as-yet overlooked fragilities that are ripe for undermining clearinghouses’ mission as financial stability bastions.

While clearinghouses historically developed as private mutual enterprises owned by their members, they are now largely subsidiaries of public companies such as the Chicago Mercantile Exchange Group, the Intercontinental Exchange, and the London Stock Exchange Group. The existing ownership of clearinghouses, defined by a “member-shareholder divide,” reflects on their financial structure and governance, resulting in agency costs stemming from the “separation of risk and control.”

Clearinghouses operate in a framework of misaligned incentives. Clearing members are required to provide the clearinghouse with financial resources to mitigate the risks that they pose to the firm. These members pledge collateral—i.e. margin—as guaranty for their open positions; they contribute to a guaranty fund (a pre-funded pool of resources used to mutualize and internalize all non-collateralized losses caused by a fellow clearing member’s default); and finally, members are contractually bound to provide the clearinghouse with additional resources to cover any remaining losses—i.e. assessment power. In return for their financial commitment, however, clearing members receive no formal governance rights over the clearing business. Conversely, shareholders retain control and governance over the firm, yet have extremely limited financial exposure to a clearinghouse’s risks. The decoupling of final risk-bearing costs from control rights creates unique agency costs that threaten the firm’s systemic resilience and ultimately the stability of the financial system. Because a clearinghouse’s members—not its shareholders—bear the business’s ultimate risk, a clearinghouse is more inclined to act with moral hazard, taking risks to seek profits for shareholders who only have very limited skin in the game, and thus not truly liable for the costs associated with such risky behavior.

This dynamic is further exacerbated by the tension between the public policy role bestowed on clearinghouses as systemic risk buffers and the for-profit nature of the financial conglomerates to which they belong. Clearinghouses face an intrinsic tension: on one side they have been entrusted to act as risk managers and they nurture a risk management culture, but on the other side, being for profit corporations, they need to generate profits for their shareholders by taking on some forms of risks. In addition, while clearinghouses were embraced as countercyclical mechanisms to stabilize the markets, the operation of their loss-absorption and mutualization functions have procyclical features that put strong pressure on clearing members, while clearinghouses’ shareholders have little equity at stake.

The regulatory framework for clearinghouses is an unfinished business, the legislative byproduct of a post-financial crisis reform that did not fully internalize the uniqueness of the clearing business (or the peculiarity of clearinghouses’ financial structure and loss allocation mechanisms). Therefore, to turn these institutions into true financial bastions in the markets, more is needed to re-align the incentives of clearinghouses’ main stakeholders. Building on insights from corporate governance and finance literature, the article proposes reforms to address the unique agency costs that clearinghouses face, to enhance their governance and resilience, and to ensure they can succeed as private systemic stability infrastructures. Such reforms should include considering a multi-stakeholder board to enhance the participative governance of clearinghouses and support the legitimacy and accountability of their operations. Assigning formal governance rights to clearing members, particularly for risk management matters, would mitigate the agency costs of the member-shareholder divide and make members’ contributions to the loss mutualization mechanism less of a bitter pill to swallow. Additionally, clearinghouses’ financial structures should be further strengthened. Policymakers should reconsider the appropriate amount of skin in the game that clearinghouses (and indirectly their shareholders) have in their business. Furthermore, clearinghouses should be able to access a more diversified pool of financial resources for their recovery or resolution plans. Clearinghouses’ financial structures should be complemented with hybrid convertible financial instruments to more effectively allocate default and non-default losses, inject fresh loss-absorbing resources in times of distress and even (eventually) recapitalize the business—with the ultimate goal being to better align the economic incentives of clearinghouses’ stakeholders. Shareholders and members, respectively, should purchase contingent convertible debt instruments. When held by shareholders, these instruments would operate as supplemental skin in the game, and they would be triggered only after all resources in the guaranty fund are fully exhausted, yet before assessing members for additional contributions. When held by members, on the other hand, such instruments would operate as a recapitalization mechanism and convert into clearinghouse equity, thereby conducing a clearinghouse’s complete or partial remutualization. This approach to the recovery and resolution of troubled clearinghouses, which could even result in the remutualization of troubled clearinghouses, should be implemented to provide certainty in times of distress and ultimately realign the incentives of both members and shareholders.

Because of the central role clearinghouses have in the financial system, their governance and financial structure must be tuned perfectly, as the collapse of one would have cataclysmic consequences on markets.

The complete article is available for download here.

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One Comment

  1. Richard Berner
    Posted Monday, August 8, 2022 at 7:26 pm | Permalink

    Paolo, Agree completely. See my comment a year ago on the CFTC website