Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis

Article excerpt

INTRODUCTION

  I. DERIVATIVES CLEARINGHOUSES' ROLE IN REDUCING AND MANAGING
     SYSTEMIC RISK
     A. Derivatives and Clearinghouse Basics
        1. What is a derivative?
        2. Counterparty credit risk and systemic risk
        3. What is a derivatives clearinghouse?
     B. A Derivatives Clearinghouse's Successful Management of Systemic
        Risk in 2008
        1. LCH. Clearnet's default management process
        2. LCH. Clearnet's effective management of Lehman Brothers
           Special Financing Inc. 's 2008 default
     C. Potential weaknesses in derivatives clearinghouse management of
        systemic risk: how a clearinghouse could fail to manage a
        member default

 II. DERIVATIVES CLEARINGHOUSES' POTENTIAL TO INCREASE SYSTEMIC
     RISK: FAILURE OF EXISTING RESOLUTION SYSTEMS
     A. Bankruptcy Analysis
        1. Safe harbor provisions
        2. Inevitable run on the derivatives clearinghouse
     B. Dodd-Frank Orderly Liquidation Authority Analysis
        1. Why a clearinghouse would likely be subject to the Orderly
           Liquidation Authority
        2. Basic elements of the Orderly Liquidation Authority and
           special provisions for qualified financial contracts
        3. Logistical impossibility of resolving a derivatives
           clearinghouse

III. REGULATORY SOLUTIONS TO ENSURE EFFECTIVE MANAGEMENT OF
     SYSTEMIC RISK

CONCLUSION

An Act

To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes. (1)

INTRODUCTION

A derivative is a contract between two or more parties whose value is determined based on the fluctuations in the value of the underlying asset. The primary benefit of derivatives is that they supplement the financial markets by improving the pricing of risk and facilitating market participants' risk management. (2) As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in July 2010, derivatives clearinghouses will play a central role in enhancing transparency and regulation of the over-the-counter (OTC) derivatives industry. A clearinghouse, or central counterparty (CCP), is an entity that stands between the two original counterparties of a derivatives trade and assumes the rights and obligations of both parties. Dodd-Frank mandates that certain derivatives products designated by the Commodities Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) must be cleared through regulated clearinghouses; for these products, the clearinghouses will serve as a backstop in case one party defaults, reflecting an effort to reduce the risk of contagion among financial firms and markets. As a result, a large portion of the over-the-counter derivatives market will require clearing by a regulated clearinghouse. (3)

Because the clearinghouses assume and guarantee the risks of the cleared trades' counterparties, clearinghouses will play a central role in managing systemic risk in the financial markets. Systemic risk is "the risk of a significant reduction in the effectiveness of the financial system, caused for example by a chain reaction of failures of major financial institutions." (4) The issue then becomes how well these clearinghouses will be able to manage the significant risk concentrated in the institutions.

The experience of LCH.Clearnet, Ltd. (LCH) during the Lehman Brothers bankruptcy proceedings provides a recent example of how a clearinghouse can successfully manage a member default and decrease systemic risk. LCH is a clearinghouse specializing in interest rate swaps that has been clearing trades for over twenty years. In 2008, LCH successfully managed the $9 trillion default of Lehman Brothers Special Financing, Inc. …