Governing Systemic Risk: Towards a Governance Structure for Derivatives Clearinghouses
Griffith, Sean J., Emory Law Journal
Derivatives transactions create systemic risk by threatening to spread the consequences of default throughout the financial system. Responding to the manifestations of systemic risk exhibited in the financial crisis, policy-makers have sought to solve the problem by requiring as many derivatives transactions as possible to be "cleared" (essentially guaranteed) by a clearinghouse. The clearinghouse will centralize and, through the creation of reserve accounts, seek to contain systemic risk by preventing the consequences of default from spreading. This centralization of risk makes the clearinghouse the new locus of systemic risk, and the question of systemic risk management thus becomes a question of clearinghouse governance. Unfortunately, each of the likely players in clearinghouse governance-dealers, customers, and investors-has significant incentive problems from the perspective of systemic risk management. I will argue that the policy-makers' responses to these problems-focusing on voting caps and director independence-are inadequate to address the problem of systemic risk inherent in derivatives transactions. I argue, instead, in favor of the adoption of a new board structure more reflective of the public-private role of clearinghouses and suggest that models for this new governance structure can be found outside of traditional U.S. corporate governance norms in the dual-board structure of continental Europe.
Derivatives are newly controversial, but they are not new. Derivatives transactions have been going on in the United States since at least 1848 and in Japan since at least 1730,1 and by some estimates, derivatives go back much further than that.2 Recently, however, derivatives have become a magnet for controversy, having been famously labeled "financial weapons of mass destruction" and implicated in the near destruction of the global financial system in 2008.3 As a result, they have become a target for regulatory reform.
Derivatives are all about risk. They are, at their core, nothing more than contracts by which parties agree to transfer the risk of an underlying asset or pool of assets.4 However, in providing a means for this transfer of risk, derivatives create a second risk-the risk of default on the contract.5 This second risk-counterparty credit risk-is inherent in derivatives transactions and is the basic way in which derivatives contribute to systemic risk.6
In targeting derivatives for regulatory reform, policy-makers have fastened upon the idea of centralizing counterparty credit risk in a single place-a clearinghouse-where it can be supervised and managed. A clearinghouse is a public-private solution to the problem of systemic risk. Funded with private capital to serve both commercial ends and the public purpose of containing systemic risk, clearinghouses provide a means for monitoring derivatives trades and, more importantly perhaps, for building reserves against default so that, if one party to a derivatives transaction defaults on its contractual obligation, the consequences of the default will be contained within the clearinghouse and not spread throughout the broader financial system.7 For this strategy of containment to work, however, much depends upon how the clearinghouse is governed. Specifically, much depends on how the clearinghouse models the risk of derivatives instruments, what the clearinghouse requires of its members in terms of credit quality and contributions to collateral and reserve funds, and what products the clearinghouse accepts for clearing.8 These are core issues of risk management, and they depend ultimately on clearinghouse governance.
Recognizing that clearinghouse governance is critically important for the management of systemic risk, policy-makers have sought to engineer governance structures for clearinghouses. Unfortunately, the policy-makers' proposals have generally failed to address the pervasive free-riding problem underlying clearinghouse governance. …