Governing Financial Markets: Regulating Conflicts
Johnson, Kristin N., Washington Law Review
Abstract: Payment, clearing, and settlement systems constitute a central component in the infrastructure of financial markets. These businesses provide channels for executing the largest and smallest commercial transactions in local, national, and international financial markets. Notwithstanding this significant role, there is a dearth of legal scholarship exploring central clearing counterparties (CCPs) and their contributions to the regulation of financial markets. To address this gap in the literature, this Article sketches the contours of the theory that frames regulation within financial institutions and across financial markets, examines the merits of implementing CCPs, and explores the role of CCPs as primary regulators within financial markets. Applying these theoretical constructs to a practical issue, this Article analyzes Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the statute's introduction of mandatory clearing requirements in the over-the-counter (OTC) derivatives market.
This Article advances several arguments that explore the merits of Title VII's clearing mandate. First, this Article posits that introducing clearing requirements and authorizing only a handful of CCPs to execute clearing obligations concentrates systemic risk concerns. Title VII's clearing mandate endows CCPs with the authority to serve as gatekeepers. As a result, these institutions become critical, first-line-of-defense regulators, managing risk within the OTC derivatives markets. Second, weak internal governance policies at CCPs raise noteworthy systemic risk concerns. CCP boards of directors face persistent and pernicious conflicts of interest that impede objective risk oversight, and thus may fail to adopt effective risk management oversight policies. Well-tailored corporate governance reforms are necessary to address these conflicts and to prevent CCP owners' self-interested commercial incentives or other institutional constraints from triggering systemic risk concerns.
Finally, this Article deconstructs the theory of self-regulation that characterizes financial markets regulation. After reviewing the benefits and weaknesses of the self-regulatory approach, this Article explores the emerging New Governance paradigm. Drawing from the New Governance literature and internal corporate governance reforms employed by venture capital and private equity firms, regulators, and federal prosecutors, this Article proposes that regulators appoint an independent, third party board observer or monitor to CCPs' board of directors. The appointed board observer or monitor will endeavor to ensure the safety and soundness of CCPs' risk-management decisions and that their risk-taking decisions are consistent with the public's interest in mitigating systemic risk concerns.
I. ECONOMIC ORGANIZATION THEORY PROMOTES THE DEVELOPMENT OF SPECIALIZED FIRMS 193
A. The Theory of the Firm Reveals the Contours of Allocational Efficiency 194
B. Production Decisions Require Firms to Evaluate Transaction Costs and Agency Costs 196
C. Industries Endow Specialized Firms with Property Rights.. 198
D. Self-Regulating Organizations Illustrate the Development of Specialized Firms in Financial Markets 199
1. Financial Markets Employ a Self-Regulatory Framework 201
2. The Dynamic of Clearinghouse and Exchange Ownership Evolves from Cooperative to Corporate 204
II. MITIGATING SYSTEMIC RISKS REQUIRES REGULATING OTC DERIVATIVES MARKETS 207
A. The Complexity of Financial Innovation and the Severity of the Crisis 208
B. Dodd-Frank Introduces Mandatory Clearing 215
1. Anti-Competitive Incentives Will Limit Access to Clearinghouse Membership 222
2. Anti-Competitive Incentives Will Limit Clearing Eligibility 224
3. Weak Clearinghouse Governance Creates Moral Hazard, Risk Management, and Systemic Risk Concerns 225
C. The Dodd Frank Act Imposes Federal Corporate Governance Reforms 229