An article in the August 8, 2014 Harvard Law School Forum on Corporate Governance and Financial Regulation entitled “Nationalize the Clearinghouses!” brought up some interesting issues. We take a look.
The post was by by Stephen Lubben, chair in corporate governance and business ethics at Seton Hall University School of Law, who cited his recent paper of the same name. (A link to the paper is here.)
Lubben noted that CCPs are not subject to OLA. Bankruptcy could indeed be very complicated. From the article:
“…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…”
and
“…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…”
The idea that a CCP going bust would create all sorts of problems is hardly new. In October, 2011 we wrote a post “Bank of England’s Tucker: “There is a big gap in the regimes for CCPs – what happens if they go bust? I can tell you the simple answer: mayhem.” Has a lot has changed since then?
So is the answer to recognize that CCPs really are market utilities and should be treated as such? Should regulators set out a clear path toward nationalization in the case of massive stress? Well, back in 2012 the FSOC designated eight Financial Market Utilities (FMUs) as systemically important. These include the Chicago Mercantile Exchange (CME), the Fixed Income Clearing Corp. (FICC), and ICE Clear Credit.
What does FMU status mean? Beyond the regulatory burden, it can mean access to the Fed’s safety net. From a Harvard Business Law article “The Federal Reserve’s Supporting Role Behind Dodd-Frank’s Clearinghouse Reforms” by Colleen Baker, Associate Professor at the University of Notre Dame Law School:
“…For the first time, systemically significant clearinghouses can be permitted access to Federal Reserve bank accounts and services. Such services include FedWire, a settlement service and also a component of the federal safety net. The Federal Reserve can also pay interest on clearinghouse account balances...”
If you believe the argument that CCPs are already covered by the Fed in the event of a failure, then Lubben might be going too far when he says:
“…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…”
There is little question that a CCP failure would be a catastrophic systemic event. Some suggest that concentrating exposure in CCPs — a central point of failure in engineering parlance — is an invitation for disaster. Having lots of CCPs might lessen the concentration risk, but eliminate many of the efficiencies they were designed to create. CCPs can build up enough capital, margin, and guarantee funds to make them bankruptcy-remote, but there is always that extreme tail risk. While the political optics of nationalization or bail out still are awful, the reality is there needs to be a LOLR that comes in to save the day, in the process wiping out the clearing members capital & guarantee funds as well as margin. It looks like that is going to be the Fed.