CHARTING A COURSE IN CLEARING
by Colleen Baker, Associate Professor of Law at the University of Notre Dame.
Memorable tales of financial collapse, such as that of Lehman Brothers (Lehman), Bear Stearns, and American Financial Group (AIG), frequently drive narratives of financial market crises and future preventative regulatory solutions. Much U.S. financial regulation, such as the monumental and historic Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), can be understood from this perspective.
Aspects of such responses, however, are sometimes puzzling. An example is the reforms surrounding certain financial market utilities in Dodd-Frank’s Title VIII, “Payment, Clearing, and Settlement Supervision Act of 2010” (Title VIII). Financial market utilities often play a vital role in a process known as “payment, clearing and settlement,” which occurs after a trade is made. Title VIII authorizes the Federal Reserve (Fed), in consultation with the Treasury Department, to extend discount and borrowing privileges in emergency circumstances to financial market utilities designated1 by Dodd-Frank’s new Financial Stability Oversight Council as “systemically important” or of “systemic importance;” i.e., to provide an emergency credit and liquidity backstop. The Fed’s new emergency authority is separate from its “13(3)” emergency powers.2
What little attention so far has focused on Title VIII analyzes the Fed’s new authority in relation to OTC derivatives, especially CDS. The actual scope of financial contracts for which this new authority is relevant, however, is quite vast: It applies to any financial transactions using designated financial utilities. Title VIII’s financial utility reforms are applicable not only to OTC derivatives, but also potentially to repurchase agreements (repos),3 and any other “financial transactions” that use designated financial utilities now or in the future. On the one hand, these reforms purport to be a critical component in solving the AIG problem, but this conclusion is uncertain. On the other hand, these reforms lay the groundwork for alleviating the problem of Lehman and Bear Stearns, but fall short of this goal. Consequently, I suggest4 that Title VIII’s financial utility reforms both go too far in theory in addressing the “AIG problem,” but not far enough in practice in addressing the “Bear Stearns and Lehman problem.”
Payment, clearing, and settlement systems and the financial market utilities involved, such as central counterparty clearinghouses (CCPs) provide the “plumbing” of financial markets. They represent an important source of potential systemic risk. A CCP “steps” into the middle of a trade, becoming the buyer to the seller and the seller to the buyer. While its market risk should be flat, it is concern about counterparty credit risk that largely motivates CCP use. CCPs are concentrated centers of credit risk. They minimize counterparty credit risk for market participants, but in moments of extreme economic distress, CCPs have both teetered upon and experienced collapse.5
In September 2008, AIG faced imminent financial collapse as its CDS counterparties demanded collateral payments that it could not meet. Prior to the onset of the financial crisis, these counterparties had rested secure in the guarantee provided by the AIG parent. Without emergency financial assistance from the U.S. government, AIG would have collapsed. To prevent future “AIGs,” reforms in Dodd-Frank mandate that all standardized derivatives, including CDS, use a CCP. But not only is it unclear that AIG’s CDS were “clearing eligible,”6 but it seems likely that its lax risk management practices also stemmed from the presence of a deep-pocketed parent guarantor. The reason Title VIII’s financial utility reforms go too far in theory is because they risk replicating this “guarantor dynamic” by potentially creating an important moral hazard that risks replacing one deep-pocketed guarantor – the AIG parent – with another – the U.S. government.
In September 2008, without a U.S. government rescue, Lehman collapsed. The proximate cause of both Lehman and Bear Stearns’ breakdowns has been termed a “run-on repo.”7 Heavy reliance upon repo financing by borrowers such as Lehman or Bear Stearns can result in a serious funding shortage in a brief time. Lehman reportedly used approximately $200 billion in overnight repos.8 Curiously, neither financial regulatory reform discussions nor Dodd-Frank focused on repos. Title VIII’s reforms provide the emergency authority to backstop a financial utility for repos. Congress should address repo market reform. Reforming the repo markets could take various approaches,9 but should provide additional regulatory transparency, strengthened risk management and collateral practices, and improved market structure.10
In sum, although in theory, the Fed’s new emergency authority created in Title VIII to backstop systemically important financial utilities should be removed because it introduces an important moral hazard, in practice, this authority is likely necessary because financial regulators are unlikely to allow a systemically significant financial utility, such as a CCP, to fail. Assuming this is the case, the potential government backstop or “liquidity option” available to designated financial utilities in emergency situations should be explicitly recognized and “purchased” by market participants. Ultimately, Title VIII’s financial utility reforms highlight the need for additional discussion about the provision of such public “options” or “backstops” because the vast majority of all trading activity depends upon financial utilities such as CCPs.
1. These designations will be made by Dodd-Frank’s newly created Financial Stability Oversight Council. Such designations should be made later this year. See Silla Brush, Gensler Wants Decision Mid-Year on Derivatives Clearinghouses, Bloomberg, Nov. 23, 2010.
2. Dodd-Frank amends the Fed’s 13(3) emergency powers in Title 11, Federal Reserve System Provisions.
3. In a May 2010 white paper, the Federal Reserve Bank of New York solicited comments upon the use of a central counterparty clearinghouse in the repo markets. See Tri-Party Repo Infrastructure Reform, available at http://www.newyorkfed.org/banking/nyfrb_triparty_whitepaper.pdf.
4. In a working paper, I expand upon the ideas in this piece, including an analysis of the expansive scope of the financial utility reforms in Title VIII, the Fed’s new emergency authority contained therein, potential implications of these reforms in the OTC derivative and repo markets, and several suggestions for “reforming the reforms.”
5. See Jeremy C. Kress, Credit Default Swaps, Clearinghouses, and Systemic Risk: Why Centralized Counterparties Must Have Access to Central Bank Liquidity, 48 Harv. J. on Legis. 49 (Winter 2011).
6. Professor Darrell Duffie notes that AIG’s problematic CDS were not “standardized,” so a CCP “solution” would have been inapplicable. See Darrell Duffie, How Should We Regulate Derivatives Markets? (PEW Fin. Reform Project, Briefing Paper No. 5, 2009), available at http://www.pewfr.org/project_reports_detail?id=0017. Note that what percentage of the OTC derivative markets will ultimately be sufficiently standardized and, therefore, “clearing eligible” remains uncertain.
7. See Gary B. Gorton & Andrew Metrick, Securitized Banking and the Run on Repo (Yale ICF Working Paper No. 09-14, Nov. 9, 2010), available at SSRN: http://ssrn.com/abstract=1440752.
8. As the name implies, “overnight” repos require lenders to daily reenter the transaction or “rollover” the debt. See Linda Sandler, Lehman Had $200 Billion Overnight Repos Pre-Failure, Bloomberg, Jan. 28, 2011.
9. Various approaches to repo market reform have been suggested, some include the use of financial utility-like entities. For example, see the “repo banks” proposed by Gary B. Gorton and Andrew Metrick in Regulating the Shadow Banking System (Oct. 18, 2010), available at SSRN: http://ssrn.com/abstract=1676947, see also the “repo resolution fund” proposed by Viral V. Acharya & T. Sabri Öncü, The Repurchase Agreement (Repo) Market, in Regulating Wall Street (2010).
10. J.P. Morgan Chase and Bank of New York Mellon, the two clearing banks in the tri-party repo markets, essentially act as default CCPs.