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The Federal Reserve’s Supporting Role Behind Dodd-Frank’s Clearinghouse Reforms

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Colleen Baker*

I. Introduction

Trade—whether domestic or international and whether of goods, services, or financial assets—relies upon the exchange of money. The integrity of these “money flows” is critical to the smooth conduct of international exchange.[1] Background infrastructures formally termed “payment, clearing, and settlement systems” (PCS systems) enable these money flows and are often referred to as the “plumbing” of financial markets. PCS systems begin their work after a financial trade is made. They confirm the details of the trade, exchange and settle any interim payments (money flows) owed between counterparties during the trade contract’s term, and complete its final settlement.[2] The robustness of this infrastructure is of great importance in financial markets.[3] PCS systems generally function quietly, seamlessly, and in the background. However, breakdowns do occur and disruptions to PCS systems risk catastrophe in financial markets and in the broader economy. Although largely overlooked, failures in PCS systems both domestically and internationally exacerbated the financial crisis of 2008.[4] The Federal Reserve’s critical and significant role in responding to some of these disruptions has similarly been largely overlooked.[5]

This Article analyzes the Federal Reserve’s expanded role in PCS systems, particularly in connection with certain clearinghouses that have been designated by the newly created Financial Stability Oversight Council[6] as “systemically significant.” A central counterparty clearinghouse (clearinghouse) is a core infrastructure utility in PCS systems.[7] The Federal Reserve’s expanded role is a little understood, but critical supporting component of domestic and international regulatory reforms to the $639 trillion over-the-counter (OTC) derivative markets.[8] These reforms mandate the increased use of clearinghouses in OTC derivative markets. Due to critical reforms in Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act),[9] the Federal Reserve is now positioned to ensure the stability of designated clearinghouses. Importantly, systemically significant clearinghouses are the quintessential “too big to fail” financial institutions.[10]

II. Clearinghouses: The Centerpiece of Regulatory Reforms to OTC Derivative Markets

On September 16, 2008, the Federal Reserve loaned billions of dollars to AIG, one of the world’s largest insurance companies.[11] AIG could not make interim collateral payments it owed as the protection seller to guarantee its performance on about $446 billion of bilaterally settled OTC credit default swaps (CDSs).[12] Without the central bank’s assistance, AIG would have collapsed.[13] Many of AIG’s OTC derivative counterparties might have also collapsed, causing reverberations throughout the world economy. The Federal Reserve rescued AIG to prevent financial catastrophe by ensuring that the money flows expected by AIG’s OTC derivative counterparties continued. Bilateral clearing and settlement of AIG’s CDSs had obscured significant buildups of counterparty credit risk. Combined with counterparties’ reliance on the performance guarantee of the AIG parent, bilateral clearing and settlement also facilitated lax risk management practices by AIG’s CDS counterparties.

Immediately prior to AIG’s distress, Lehman Brothers, an investment bank, collapsed.[14] Yet the clearinghouse, LCH.Clearnet, ensured that the money flows related to Lehman Brothers’ more than $10 trillion of open trading positions continued uninterrupted.[15] The virtues of clearinghouses—long-standing, but sleepy background financial market infrastructure utilities—suddenly burst into the international spotlight. Policymakers saw clearinghouses as a major solution to problems in OTC derivative markets; they offered a way to prevent future AIG-like situations.[16] Consequently, the Dodd-Frank Act’s regulatory reforms to OTC derivative markets in Title VII—and similar reform initiatives by the G-20[17]—mandate that standardized OTC derivatives be traded on electronic exchanges and use clearinghouses for clearing and settlement.

The virtues of clearinghouses are many, including enforcing contractual performance,[18]facilitating multilateral netting and setoff of trades, promoting market liquidity, and enabling trade anonymity. Above all, clearinghouses alleviate concerns about counterparty credit risk. A clearinghouse essentially steps into the middle of a trade, becoming the buyer to the seller and the seller to the buyer through novation.[19] Consequently, the original obligation is transformed into legally independent obligations between the clearinghouse and the counterparties, who are known as clearinghouse members. Clearinghouse members are now only directly exposed to the counterparty credit risk of the clearinghouse. Clearinghouse design incorporates many layers of risk management protection to ensure the institution’s fortress-like robustness even in times of financial crisis. These layers include requiring members to maintain cash or securities in margin accounts to guarantee their obligations; a member contributed-to default insurance fund to cover any payment shortfalls by a defaulting member; and possibly ex-ante arrangements for additional financial assessments from non-defaulting members or for other pre-arranged backup financial resources such as bank lines of credit.[20]

III. The Federal Reserve’s New Mandate to Buttress Clearinghouse Reforms in OTC Derivative Markets

Despite having extensive risk management practices, clearinghouses can, and have, failed.[21] A member default, operational issues, or even investment management practices[22] could trigger a clearinghouse default.[23] The failure of a systemically significant clearinghouse could be catastrophic. It would threaten widespread, domino-like disruptions of critical money flows that its members and other financial institutions count upon to meet their own financial obligations all over the world. Intervention by a government backstop—a last resort clearinghouse—would likely be needed to avert the collapse of a systemically significant clearinghouse. Due to critical but little understood reforms in Title VIII, the Federal Reserve can now assume this role in certain situations. Therefore, the reforms in Dodd-Frank Act’s Title VIII act as an essential complement to better-known clearinghouse reforms in Title VII.[24]

Clearinghouses, however, are not the only financial institutions responsible for the continuation of critical payments in the OTC derivative markets. For this reason, Title VIII’s regulatory reforms give policymakers the discretion to potentially backstop an expansive set of financial institutions and markets. One of Title VIII’s key terms—financial market utility (FMU)—is a broadly defined concept.[25] It includes traditional clearinghouses and securities repositories, but the term FMU could also encompass other systemically important financial institutions that play a critical role in PCS systems such as individual brokers, dealers, investment companies, and clearing banks.[26] Although clearinghouses are the focus of this Article, it is important to note that Title VIII’s reforms are potentially applicable to any financial institution that fits the expansive definition of an FMU.

Title VIII contains many critical regulatory reforms related to PCS systems. These reforms include authority for financial regulators to prescribe risk management standards,[27] enhanced examination and enforcement powers for financial regulators over systemically significant clearinghouses[28] and over other financial institutions engaged in certain PCS system activities.[29] For the first time, systemically significant clearinghouses can be permitted access to Federal Reserve bank accounts and services.[30] Such services include FedWire, a settlement service and also a component of the federal safety net.[31] The Federal Reserve can also pay interest on clearinghouse account balances.[32] The possibility of allowing a systemically significant clearinghouse to have an account at a Federal Reserve Bank is a significant change to the law.[33] Traditionally, such accounts and services generally have been available only to depository institutions. These reforms create a potentially significant risk for the Federal Reserve Bank.[34] For example, a clearinghouse account could incur an inadvertent overdraft.[35]

An important implication of these reforms is that several Federal Reserve services available to regulated banks can now be made available to systemically significant clearinghouses. Yet it is unclear that designated clearinghouses will be regulated as heavily as traditional banks. For example, the Federal Reserve has implemented rules regarding risk management standards for systemically significant clearinghouses under its supervision.[36] But it is unclear that these risk management standards sufficiently incorporate stringent capital requirements paralleling those of regulated banks.[37] Nevertheless, systemically significant clearinghouses are among the most important too-big-to fail financial institutions.

Title VIII’s most important reform is a new, highly expansive lending authority for the Federal Reserve in “unusual or exigent circumstances.”[38] In certain circumstances, the Federal Reserve can use this new lending authority to combat critical disruptions in PCS systems.[39] The Federal Reserve’s discount window lending authority can be thought to exist on a spectrum between the access of regulated banking institutions on one end and the Federal Reserve’s 13(3) emergency power on the other end. The Federal Reserve’s Title VIII lending authority lies between these poles and is arguably much closer to—although certainly not identical to—that of regulated banks.[40] It can be used to assist not only clearinghouses, but any financial institution designated either ex-ante or in an emergency[41] as a systemically significant FMU.

Importantly, this new lending authority of last resort[42] fundamentally transforms the Federal Reserve’s role in financial markets.[43] It also represents a significant expansion of the already expansive[44] federal safety net for financial markets and institutions, which is ultimately backed by taxpayers. Central banks around the world have long acted as lenders of last resort to their traditional banking systems. Lenders of last resort lend to healthy banks facing immediate, short-term funding needs due to the time frame mismatch between a bank’s balance sheet assets and liabilities. The idea that central banks would also act as lenders of last resort for financial markets such as the OTC derivative markets—a role sometimes referred to as a market-maker or dealer of last resort—is more recent and controversial.[45] Yet this is effectively the result of Title VIII’s reforms.

IV. Central Bank Challenges Resulting from Clearinghouse Reforms

Domestic and international reforms to OTC derivative markets will increase the size and systemic significance of certain clearinghouses. As a result of Title VIII’s reforms, the Federal Reserve is positioned to play a critical role in ensuring the financial stability of designated clearinghouses. Yet the very presence of a potential central bank backstop for systemically significant clearinghouses—essentially the possibility of catastrophic liquidity insurance—creates a significant moral hazard. Insurance changes the incentives of economic actors by introducing the risk that persons will engage in excessive risk-taking because a third party will share the potential downside costs of reckless behavior.[46] Yet the benefits of any additional risk-taking will accrue only to the person taking on the risk. For example, AIG’s CDS counterparties likely relaxed their risk management practices because of the “insurance” provided by the AIG parent’s guarantee.[47]

The moral hazard concern in the clearinghouse context is the possibility that a systemically significant clearinghouse may relax traditionally robust risk management practices to improve its competitive position or to increase its revenues. If a designated clearinghouse were to need central bank assistance, the public could absorb the potential cost of this additional risk-taking. Therefore, Title VIII threatens to institutionalize the Federal Reserve’s rescue of AIG by potentially replacing the deep pockets of the AIG parent with those of the U.S. government. As I argue elsewhere, however, the regulatory reforms in Title VIII fall short of effectively addressing this critical issue.[48]

Additionally, the operations of systemically significant clearinghouses are highly complex and can involve multiple jurisdictions.[49] They are in essence “globally systemic financial institutions.”[50] And just as domestic clearinghouses can fail, so too can those located overseas. Avoiding the collapse of a significant overseas clearinghouse might ultimately also require central bank assistance. An interesting twist, however, is that an overseas clearinghouse might need emergency assistance in a foreign currency for settlement purposes. And it might be infeasible to quickly obtain the necessary amounts of this foreign currency—such as U.S. dollars—from financial markets at reasonable rates or from the currency reserves of the home country central bank. In fact, the possibility of an overseas clearinghouse needing emergency euro funding has created a controversy between the U.K. and the European Central Bank (ECB).[51] The ECB insists that any clearinghouses clearing a significant amount of euro-denominated assets, and that consequently could require emergency euro funding, must be physically located in the euro zone so that its financial regulators can supervise these institutions.[52]

If a clearinghouse needed a large infusion of foreign money, the relevant foreign central bank could supply the requisite money flows via mechanisms known as “swap lines.” The Federal Reserve’s swap lines are currency agreements that are, as currently used,[53] effectively secured loans from the Federal Reserve to a foreign central bank. For example, the Federal Reserve loans U.S. dollars to the ECB and these loans are collateralized by euros.[54] Although not widely understood, the Federal Reserve’s swap lines with foreign central banks played a significant role in stabilizing international PCS systems during the financial crisis.[55] Swap lines are controversial and potentially problematic.[56] In effect, they can provide insurance[57] for overseas financial institutions confronting foreign exchange shortages and attendant elevated exchange rates. Central banks might lend to another at a policy rather than a market exchange rate.[58] The swap line function is another example of a central bank acting as a lender of last resort, but this time acting internationally.

Swap line arrangements have traditionally existed between central banks. Yet a swap line could also be put into place between a central bank and nongovernmental overseas third party, such as a clearinghouse.[59] The U.S. dollar is the international currency. It is highly foreseeable that a systemically significant overseas clearinghouse could have an emergency need for substantial amounts of U.S. dollar funding. The potential problems associated with a central bank’s last resort lending to a systemically significant domestic clearinghouse would be multiplied in lending to an overseas clearinghouse over which it has no direct regulatory, supervisory, or enforcement powers.

V. Conclusion

In proactively thinking about both future problems in OTC derivative markets and future financial crises, it is important to focus on possible disruptions to PCS systems. Central banks such as the Federal Reserve are now positioned to ensure the financial stability of domestic and international financial institutions and markets that are critical to the money flows involved in these systems. But before central banks confront this situation in reality, policymakers should realize that much additional thought and regulatory reform remains to be completed. In particular, the management and resolution of a distressed systemically significant domestic or international clearinghouse requires further reflection. As a recent paper by the International Swaps and Derivatives Association soberly cautions, “the contagion risk entailed by central clearing should not be understated, and the risk of multiple defaults across [central counterparties] should not be underestimated.”[60]  In sum, well-intentioned reforms of OTC derivative markets could ultimately create an impossibly interconnected, concentrated, international web of clearinghouses, central banks, and swap lines resulting in a solution potentially worse than the original problem.

 

 

Preferred citation: Colleen Baker, The Federal Reserve’s Supporting Role Behind Dodd-Frank’s Clearinghouse Reforms, 3 Harv. Bus. L. Rev. Online 177 (2013), https://journals.law.harvard.edu/hblr//?p=3283.

* Associate Professor at the University of Notre Dame Law School.

[1] Economist Perry Mehrling’s work focuses on the importance of the “money flows” involved in financial trade and the problems created by insufficient attention to liquidity in financial markets. See generally Perry Mehrling, The New Lombard Street: How the Fed Became the Dealer of Last Resort (2011); Perry Mehrling, Essential Hybridity: A Money View of FX, J. Comp. Econ. (forthcoming 2013) (focusing on a “money view perspective,” that is, the critical role of money market operations in the stability of credit markets).

[2] For a detailed description of post-trade processes for securities and derivatives, see David M. Weiss, After the Trade Is Made: Processing Securities Transactions (2d rev. ed. 2006) and David Loader, Clearing and Settlement of Derivatives (2005).

[3] See Heidi Mandanis Schooner & Michael W. Taylor, Global Bank Regulation: Principles and Policies 36–39 (2010).

[4] See Mehrling, The New Lombard Street: How the Fed Became The Dealer of Last Resort, supra note 1, at 124 (“From this standpoint, what immediately draws attention is the utter breakdown of the underlying system of funding liquidity [during the financial crisis]. This is the plumbing behind the walls, and it failed very dramatically.”).

[5] For example, the Federal Reserve’s significant use of central bank swap lines responded to severe disruptions in international dollar funding markets during the financial crisis. See Michael J. Fleming & Nicholas J. Klagge, The Federal Reserve’s Foreign Exchange Swap Lines, Current Issues Econ. & Fin. (Fed. Reserve Bank of N.Y., New York, N.Y.), Apr. 2010, at 1, 1–4, available at http://www.newyorkfed.org/research/current_issues/ci16-4.pdf.

[6] The Financial Stability Oversight Council is a council of financial regulators established by the Dodd-Frank Act. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 111–23, 124 Stat. 1376, 1392–1412 (2010).

[7] Although different types of clearinghouses exist, this Article uses the term “clearinghouse” to refer to a central counterparty clearinghouse, which is the type of clearinghouse involved in regulatory reforms to OTC derivative markets.

[8] This figure represents the notional amount of outstanding OTC contracts. See Monetary & Econ. Dep’t, Bank for Int’l Settlements, Statistical Release: OTC Derivatives Statistics at End-June 2012 1 (2012), available at http://www.bis.org/publ/otc_hy1211.pdf.

[9] Dodd-Frank Act §§ 801–14.

[10] See Phillip Wood, What is a Central Counterparty in Financial Markets?, Allen & Overy (Aug. 20, 2009), http://www.allenovery.com/publications/en-gb/Pages/What-is-a-central-counterparty-in-financial-markets-.aspx (commenting that central counterparties “really are too big to fail”).

[11] See Press Release, Bd. of Governors of the Fed. Reserve Sys. (Sept. 16, 2008), http://www.federalreserve.gov/newsevents/press/other/20080916a.htm.

[12] See Henny Sender, AIG Saga Shows Dangers of Credit Default Swaps, Fin. Times (Mar. 6, 2009), http://www.ft.com/intl/cms/s/0/aa741ba8-0a7e-11de-95ed-0000779fd2ac.html#axzz2PicxE6S0.

[13] For a thorough account of AIG’s debacle, see generally William K. Sjostrom, Jr., The AIG Bailout, 66 Wash. & Lee L. Rev. 943 (2009) (explaining AIG’s collapse and its subsequent bailout by the U.S. government).

[14] Andrew Ross Sorkin, Lehman Files for Bankruptcy; Merrill Is Sold, N.Y. Times, Sept. 15, 2008, at A1, available at http://www.nytimes.com/2008/09/15/business/15lehman.html?pagewanted=all.

[15] See Peter Norman, The Risk Controllers: Central Counterparty Clearing in Globalised Financial Markets (2011).

[16] See Mark J. Roe, The Dodd-Frank Act’s Maginot Line: Clearinghouse Construction 9 (Mar. 5, 2013) (unpublished working paper), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2224305 (“Post-failure, the thinking ran, AIG might not have failed, or its failure would not have been as consequential if AIG’s obligations had been cleared.”).

[17] See G-20 Leaders Statement After Talks in Pittsburgh (Full Text), Bloomberg (Sept. 25, 2009), http://www.bloomberg.com/apps/news?pid=newsarchive&sid=auIe3UTJncpY.

[18] See Ed Nosal, Clearing Over-the-Counter Derivatives, Econ. Perspectives (Fed. Reserve Bank of Chi., Chicago, Ill.), Fourth Quarter 2011, at 137, available at http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2011/4qtr2011_part1_nosal.pdf.

[19] See generally Norman, supra note 15; Jiabin Huang, The Law and Regulation of Central Counterparties (2010) (providing thorough explanations of central counterparty clearinghouses).

[20] See Norman, supra note 15, at 10.

[21] See Norman, supra note 15, at 131–33, 347–51; Huang, supra note 19, at 122–24.

[22] 12 C.F.R. § 234.4(a)(3) (2013) (“[The central counterparty must] hold[] assets in a manner whereby risk of loss or of delay in its access to them is minimized. Assets invested by a . . . central counterparty are held in instruments with minimal credit, market, and liquidity risks.”). The Bank of England has noted that the default of a central counterparty’s investment counterparty could trigger the financial distress or default of the central counterparty. Financial Stability Report: December 2011, Fin. Stability Rep. (Bank of Eng., London, U.K.), Dec. 2011, at 1, 20–22, available at http://www.bankofengland.co.uk/publications/Documents/fsr/2011/fsrfull1112.pdf.

[23] An increasingly significant source of revenues for OTC derivative market clearinghouses will likely be their investment activities; that is, the investment of the cash and securities collateral held in members’ margin accounts for the safety of the clearinghouse. Clearinghouses could have an incentive to increase profits through lucrative, but risky, investment activities which could be in tension with robust risk management practices. See generally Huang, supra note 19, at 54–56 (describing the central counterparty’s investment of its financial resources such as member margin, default funds, and capital).

[24] See Colleen Baker, The Federal Reserve as Last Resort, 46 U. Mich. J.L. Reform 69, 104–14 (2012).

[25] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 803(6), 124 Stat. 1376, 1805 (2010) (defining financial market utility).

[26] See id.

[27] See id. § 805.

[28] See id. § 807.

[29] See id. § 808.

[30] See id. § 806(a).

[31] See id. (“The Board of Governors may authorize a Federal Reserve Bank to establish and maintain an account for a designated financial market utility and provide the services listed in section 11A(b) of the Federal Reserve Act . . . .”). For a description of FedWire Funds Services, see Fedwire Funds Services, Bd. of Governors of the Fed. Reserve Sys., http://www.federalreserve.gov/paymentsystems/fedfunds_about.htm (last visited Apr. 18, 2013). Other components of the federal safety net include the Federal Reserve’s last resort lending operations and the Federal Deposit Insurance Corporation’s provision of federal deposit insurance. See generally Kenneth Jones & Barry Kolatch, The Federal Safety Net, Banking Subsidies, and Implications for Financial Modernization, 12 FDIC Banking Rev. (Fed. Deposit Ins. Corp., Washington, D.C.), no. 1, 1999, at 1, available at http://www.fdic.gov/bank/analytical/banking/1999may/1_v12n1.pdf (noting the generally accepted components of the federal safety net).

[32] See Dodd-Frank Act § 806(c).

[33] See Anna L. Paulson & Kirstin E. Wells, Enhancing Financial Stability: The Case of Financial Market Utilities, Chi. Fed Letter (Fed. Reserve Bank of Chi., Chicago, Ill.), Oct. 2010, at 1, 2, available at http://www.chicagofed.org/digital_assets/publications/chicago_fed_letter/2010/cfloctober2010_279.pdf.

[34] A notice of proposed rulemaking recognizes that the possible extension of Federal Reserve accounts and services to designated FMUs presents credit, settlement and others risks to Federal Reserve Banks. See Financial Market Utilities, 78 Fed. Reg. 14,024 (proposed Mar. 4, 2013) (to be codified at 12 C.F.R. pt. 234).

[35] Id. at 14,025–26 (“FMUs will structure their settlement processes and use of Reserve Bank accounts and services, in a manner that would seek to avoid any intraday account overdraft, and . . . a designated FMU would have the resources to promptly rectify any inadvertent overdraft.”). The proposed rulemaking, however, does not appear to prohibit coverage of an inadvertent overdraft. Id.

[36] See 12 C.F.R. § 234.4 (2013).

[37] See Financial Market Utilities, 78 Fed. Reg. at 14,026 (“[designated FMUs must be] in generally sound financial condition . . . [and i]n general a designated FMU should maintain adequate capital to support its ongoing operations and absorb reasonable business losses”). Ultimately, it is unclear that financial regulators can or will impose substantial capital requirements appropriately parallel to those required for banks. Li Lin and Jay Surti note that central counterparties will “generate the same types of financial risks” as banks and they recommend that regulators take a more prescriptive approach to “risk buffers” to prevent under-capitalization and possible regulatory arbitrage by clearing members. Li Lin & Jay Surti, Capital Requirements for Over-the-Counter Derivatives Central Counterparties 5–6 (Int’l Monetary Fund, Working Paper No. 13/3, 2013) available at http://www.imf.org/external/pubs/ft/wp/2013/wp1303.pdf.

[38] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 806(b). 124 Stat. 1376, 1811 (2010) (emphasis added). The use of “or” contrasts with the more restrictive “unusual and exigent” in the Federal Reserve’s 13(3) emergency authority. 12 U.S.C. § 343(A) (2012).

[39] See Baker, supra note 24, at 109–12 (explaining the statutory prerequisites required for the use of this new Federal Reserve lending authority such as an affirmative vote by a majority of the Board of Governors, and an inability to obtain such funding from other banks).

[40] Both rely on section 10B of the Federal Reserve Act. See id. at 111. See generally id. at 104–14 (explaining Title VIII’s reforms, including the Federal Reserve’s new lending authority).

[41] See Dodd-Frank Act § 804(c)(3) (providing for emergency designations by the Financial Stability Oversight Council).

[42] In a New York University Journal of Law & Business Symposium, Thomas C. Baxter, General Counsel and Executive Vice-President of the Legal Group at the Federal Reserve Bank of New York, remarked: “And we have new lending of last resort powers with respect to financial market utilities in Title VIII of Dodd-Frank.” Symposium, Regulatory Reform and the Future of the U.S. Financial System: An Examination of the Dodd-Frank Regulation, 7 N.Y.U.J.L. & Bus. 427, 492 (2011).

[43] See Baker, supra note 24, at 112.

[44] Researchers at the Federal Reserve Bank of Richmond estimate that the federal financial safety net covered “as much as 57 percent of all financial firm liabilities at the end of 2011.” How Large is the Federal Financial Safety Net?, Fed. Reserve Bank of Richmond, http://www.richmondfed.org/publications/research/special_reports/safety_net/ (last visited Apr. 18, 2013).

[45] See Baker, supra note 24, at 93. See also Schooner & Taylor, supra note 3, at 56 (“Despite initial concerns among central bankers that this course of action [acting as a purchaser of last resort] violated a leading principle of central banking followed for over a century, during the Global Financial Crisis a number of central banks adopted this practice.”). If central banks broadly adopt the role of market-makers of last resort, some economists argue that ex-ante approval of financial institution products that could be potentially purchased by a central bank would be needed. See Martin Wolf, Central Banks Should Not Rescue Fools, Fin. Times (Aug. 28, 2007), http://www.ft.com/intl/cms/s/0/d3db8c86-5564-11dc-b971-0000779fd2ac.html#axzz2OnhkaIzl. For an argument supporting the ex-ante approval of certain financial products, see Saule T. Omarova, From Reaction to Prevention: Product Approval as a Model of Derivatives Regulation, 3 Harv. Bus. L. Rev. Online 98 (2013), https://journals.law.harvard.edu/hblr//?p=3111.

[46] See Schooner & Taylor, supra note 3, at 60–66 (discussing moral hazard in banking).

[47] See Gretchen Morgenson, Behind Insurer’s Crisis, Blind Eye to a Web of Risk, N.Y. Times, Sept. 28, 2008, at A1, available at http://www.nytimes.com/2008/09/28/business/28melt.html?pagewanted=all.

[48] See Baker, supra note 24, at 102–03.

[49] For example, the Chicago Mercantile Exchange, designated as a systemically significant financial market utility, recently began clearing interest rate swaps, an OTC derivative, in London. See Michelle Price, Rate-Swap Clearing Service for Europe Is Opened by CME, Wall St. J., Mar. 19, 2013, at C3, available at http://online.wsj.com/article/SB10001424127887323639604578368322427725166.html; Additionally, the language of rules implementing Title VIII’s regulatory reforms refers to the overseas operations of designated clearinghouses. See, e.g., 12 C.F.R. § 234.4(a)(1) (2013) (“[The] central counterparty has a well-founded, transparent, and enforceable legal framework for each aspect of its activities in all relevant jurisdictions.”).

[50] See Lin & Surti, supra note 37, at 5 (“The market power of . . . major CCPs creates necessary conditions for them to be globally systemic financial institutions.”).

[51] See Michael Watt, How the CCP Location Debate Helped Split the EU, Risk.net (Jan. 10, 2012), http://www.risk.net/risk-magazine/feature/2134744/ccp-location-debate-helped-split-eu.

[52] See Jeremy Grant & Alex Barker, ECB Clearing House Policy Could Stoke Tensions, Fin. Times (Nov. 23, 2011), http://www.ft.com/intl/cms/s/0/6602e2ca-15e2-11e1-a691-00144feabdc0.html#axzz2PicxE6S0; Huw Jones, UK Bolsters Clearing Lawsuit Against ECB, Reuters, Feb. 14, 2012, available at http://www.reuters.com/article/2012/02/14/britain-ecb-court-idUSL5E8DE6DI20120214.

[53] See Michael D. Bordo, Owen F. Humpage & Anna Schwartz, Epilogue: Foreign-Exchange-Market Operations in the Twenty-First Century 10 (Nat’l Bureau of Econ. Research, Working Paper No. 17984, 2012), available at http://www.nber.org/papers/w17984.pdf?new_window=1 (“Unlike most previous swap agreements, the post-2007 lines were not reciprocal. The [Federal Reserve] System did not use (or invest) the foreign exchange that it acquired through the swaps.”).

[54] See Credit and Liquidity Programs and the Balance Sheet, Bd. of Governors of the Fed. Reserve Sys., http://www.federalreserve.gov/monetarypolicy/bst_liquidityswaps.htm (last visited Apr. 18, 2013) (describing the Federal Reserve’s swap lines).

[55] At their height, the amount of this swap line assistance reached more than $580 billion dollars or approximately one-fourth of the Federal Reserve’s 2008 assets. See Fleming & Klagge, supra note 5, at 5. The Federal Reserve’s swap line assistance continues to stand in the billions even today. See generally Colleen Baker, The Federal Reserve’s Use of International Swap Lines, 54 Ariz. L. Rev. (forthcoming 2013), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2226708. (examining the Federal Reserve’s use of swap lines during and after the recent financial crisis and proposing a new statutory framework for these mechanisms).

[56] See generally id. (discussing potential public policy and regulatory and supervisory problems associated with the Federal Reserve’s swap line function).

[57] See generally Alice Ross, BoE Urged to Support Renminbi Trading, Fin. Times (Dec. 4, 2013), http://www.ft.com/intl/cms/s/0/df40d7dc-3d69-11e2-b8b2-00144feabdc0.html#axzz2QC1mnFDd (quoting an unnamed banker stating that “[a] swap line would be an insurance policy”).

[58] Mehrling, Essential Hybridity: A Money View of FX, supra note 1 (manuscript at 14–15) (noting that the rates at which central banks lend to one another could be policy rates).

[59] Section 1103 of the Dodd-Frank Act suggests this possibility because it requires that information about swap line transactions with a nongovernmental third party be publicly disclosed after two years. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 1103, 124 Stat. 1376, 2118–20 (2010).

[60] Int’l Swaps & Derivatives Ass’n, Risk Sensitive Capital Treatment for Clearing Member Exposure to Central Counterparty Default Funds 7 (2013), available at http://www2.isda.org/.

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Unreasonable Delays: CFIUS Reviews of Energy Transactions

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Joshua C. Zive*

I.               Introduction

The role of foreign investment in the U.S. energy sector has changed significantly in recent years. The development of domestic oil and gas resources has resulted in a significant increase in foreign interest in the U.S. as a target for investment in the wide range of industries connected to domestic oil and gas production, transportation, and use.[1] Such investment is important to the continued growth and success of the U.S. energy sector and, in order to facilitate these ventures, the regulatory process surrounding energy transaction investment should not impose unreasonable delays. Unfortunately, delays and burdens associated with the Committee on Foreign Investment in the Unites States (CFIUS) are playing an increasingly significant and frustrating role in energy transactions.

This Article is not intended to discuss the wide range of substantive issues involved in a CFIUS review of energy transactions, but instead to call attention to timing concerns that have received little attention. As a result of legal and regulatory changes, CFIUS reviews of energy transactions are confronting lengthy delays that introduce needless uncertainty and costs into the investment climate. These delays frustrate the intended role of CFIUS review and make it unnecessarily difficult for energy transactions to be designed and executed in an efficient manner.

II.             Living in the Now: CFIUS after FINSA

The U.S. has long struggled with efforts to balance concerns about the national security implications of foreign investment with the economic benefits of encouraging foreign investment in the U.S. CFIUS, an interagency committee chaired by the Department of the Treasury and charged with reviewing foreign acquisitions of U.S. businesses, was created as the tool to help find this balance.[2] CFIUS was created by Executive Order in 1975 and given limited jurisdiction and power to review foreign investment in the U.S., although CFIUS jurisdiction and powers were expanded in 1988 when Congress adopted the Exon-Florio amendment to section 721 of the Defense Production Act.[3] Since 1988, CFIUS has had significant discretion to review foreign investment in the U.S. with almost complete confidentiality and protection from judicial review, providing the public and the investing community with virtually no precedent that can be used to predict CFIUS behavior.[4]

Although the Exon-Florio regime provided CFIUS with broad powers, its process has had a rather narrow substantive scope. These limits resulted from a desire to prevent CFIUS from unduly interfering with foreign investment, and regulations at the time focused on transactions involving “products, services, and technologies that are important to U.S. national defense requirements.”[5]

In addition to having a narrow scope, the review process under Exon-Florio was fairly simple and predictable. Parties would file a notice voluntarily (or CFIUS would require that a notice be filed), and CFIUS would conduct an initial review within 30 days.[6] If CFIUS identified a need for further investigation, the committee could use an additional 45 days to conduct an investigation, and ultimately conclude the investigation with a recommendation for Presidential action.[7] This recommendation was required to be taken or rejected within 15 days of being sent to the President.[8] The CFIUS regulations establishing this process were vague in many respects, but in practice parties to most energy transactions that were unrelated to defense could plan around the CFIUS process knowing that benign transactions would generally be cleared by CFIUS after the initial 30-day review, which began when the parties submitted a formal voluntary notice.[9]

However, for companies involved in the energy sector, CFIUS procedure was fundamentally changed by the controversy surrounding the acquisition of the port management business of Peninsular and Oriental Steam Navigation Company (P&O) by Dubai Ports World (DP World), an entity ultimately owned by the government of the United Arab Emirates.[10] DP World’s acquisition of P&O included a transfer of leases for management of six major U.S. ports.[11] Although CFIUS cleared the DP World transaction, it sparked significant controversy and scrutiny of the CFIUS process that ultimately resulted in DP World selling all of the assets in question to U.S. entities in order to defuse the controversy.[12] In the wake of the DP World transaction, the legal foundation for CFIUS reviews of foreign investment in the U.S. was overhauled by the enactment of the Foreign Investment and National Security Act of 2007 (FINSA) [13] and the promulgation of new regulations by CFIUS in 2008.[14]

FINSA and subsequent regulations made a variety of significant changes to the nature and process of CFIUS review. This Article will discuss the following aspects of the CFIUS review process:

  • Broadening the definition of national security to explicitly include “issues relating to ‘homeland security’, including its application to critical infrastructure” and noting that this review includes “major energy assets.”[15]
  • Creating a three-tiered pre-notice, review, and investigation process that includes an initial pre-notice submission, a 30-day review of a formal notice (either filed voluntarily by parties or required to be filed by CFIUS), followed by a 45-day investigation if certain conditions are met.[16]
  • The creation of a presumption that foreign acquisitions involving critical infrastructure and acquisitions by government-owned investors require a 45-day investigation phase, unless senior CFIUS officials sign off that no investigation is needed.[17]

III.  New Delays: International Energy Transactions Under FINSA

A.   The Unlimited Definition of Critical Infrastructure

Prior to FINSA, determining whether a transaction fell under CFIUS jurisdiction was a simpler task for energy transactions. If the transaction resulted in a foreign-owned or controlled entity obtaining control over an existing U.S. business, and that business was involved with products or services that had a particular relationship to national security, such as materials essential to national defense, then submission to CFIUS review was prudent. CFIUS would review the notice submitted by the parties to the transaction and, if national security issues were identified, a 45-day review could be added to the initial 30-day review period. In the context of most energy transactions, those not involving energy assets connected to the U.S. military or occupying a dominant market share position in a particular energy sector, it was normal to abstain from submitting a transaction for CFIUS review because no national security issues could be identified, and those transactions that were submitted for review were often cleared by CFIUS within the first 30-day review period. The confidentiality of the CIFUS process has made reliable data difficult to obtain, but in 2006 the Congressional Research Service (relying on research conducted by outside sources) reported that CFIUS reviewed approximately 1,500 transactions from 1988 until 2005, with only twenty-five of those transactions being subjected to a full investigation.[18]

Determining how an energy-related notice will be treated by CFIUS is a more complex endeavor now because of FINSA’s treatment of “critical infrastructure.”[19] Critical infrastructure is defined as “systems and assets . . . so vital to the United States that the incapacity or destruction of such systems or assets would have a debilitating impact on national security.”[20] This term is important because FINSA added a new provision to the law requiring that CFIUS take into account “the potential national security-related effects on United States critical infrastructure, including major energy assets” when conducting a review of a transaction.[21]

While it is clear that these changes expand the scope of CFIUS review, it is less clear where that expansion ends. In particular, questions remain as to what sorts of infrastructure are included in the critical infrastructure category, other than “major energy assets,” and what exactly makes an energy asset “major.”[22] These questions remain unanswered, as CFIUS has refused to provide examples of infrastructure that might be considered critical infrastructure in their regulations.[23]

The FINSA language governing critical infrastructure has left the energy sector in the unfortunate position of being the only industry sector mentioned specifically as an example of critical infrastructure, with no indication of the types of energy assets that are considered neither major nor critical.[24] This direct reference to the energy sector is important because, in the author’s experience, spotlighting energy assets has both compelled more parties involved in international energy transactions to file CFIUS notices in order to contain the risk of subsequent CFIUS review of those transactions and has resulted in those notices facing longer delays as a result of the FINSA provisions discussed below.

B.   The New “Pre-Notice” Notice

During the Exon-Florio era of CFIUS, parties could prepare a voluntary notice pursuant to CFIUS regulations and, as long as that notice included all of the information listed in the regulations, the 30-day review period would begin upon filing notice.[25] However, that process has changed substantially in the wake of FINSA.

Although FINSA made no mention of any pre-notice consultations, CFIUS promulgated regulations in which pre-notice consultations assumed a new and formal role in the CFIUS process. The language included in the post-FINSA CFIUS regulations provides that parties to transactions are “encouraged to consult” with CFIUS in advance of filing a notice and to file a draft notice in “appropriate cases.”[26] The regulatory language further states that all pre-notice materials must be provided to CFIUS “at least five business days before the filing of a voluntary notice.”[27]

The pre-notice process has been described by CFIUS as a tool to help CFIUS “understand the transaction and to suggest information that the parties may wish to include in their notice to assist [CFIUS] in addressing any national security considerations as efficiently as possible.”[28] While this objective seems reasonable, in practice the pre-notice period has become a functionally mandatory process that introduces new and unpredictable delays into the CFIUS review process. Although the CFIUS regulations indicate that a draft notice should be filed when appropriate, the reality is that CFIUS expects a draft notice in all cases. Once CFIUS receives the draft notice, CFIUS will often call for explanations or information beyond that required by regulations,[29] and it has become common practice for CFIUS to require early submission of the Personal Identifier Information (PII).[30] CFIUS has made it clear to filers that notices found to be insufficiently clear or complete will be rejected[31], and in practice this has meant that only after CFIUS deems a pre-notice sufficiently clear and complete will CFIUS recommend that a formal voluntary notice be filed. If parties were to act without such a recommendation, they risk having the formal notice rejected by CFIUS as incomplete, meaning that the formal review process would never begin.[32]

The creation of a technically voluntary, but functionally mandatory, pre-notice process has added a significant amount of time to the CFIUS approval process, particularly for complex energy transactions. Not accounting for the time required to prepare the initial draft notice, the pre-notice consultation process can often drag on for weeks as parties scramble to collect all the individual bits of data requested by CFIUS. For complex energy transactions that involve multiple international parties, a variety of subsidiaries, and complex, geographically dispersed assets, the pre-notice process often involves scores of request and fact-finding missions at the behest of CFIUS. During this entire period, there is no clock running on the CFIUS pre-notice process and the formal review clock is not yet started. For energy transactions that operate under tight timelines as a result of tax periods or other exogenous factors, these weeks can sometimes make the difference between a transaction being viable or not.

C.   Mandatory 45-day Investigation for Critical Infrastructure

The virtually unlimited definition of critical infrastructure may capture any substantial energy asset, and it creates an additional layer of delays during CFIUS reviews of energy transactions in the post-FINSA world.[33]

The normal period of review for a non-controversial transaction prior to the adoption of FINSA was 30 days.[34] By regulation, a CFIUS review only moves to an additional 45-day investigation if CFIUS finds that national security risks necessitate the additional investigation.[35] However, FINSA altered those procedures because Congress included a requirement in FINSA that a 45-day investigation be conducted for any transaction that “would result in control of any critical infrastructure of or within the United States by or on behalf of any foreign person” if that transaction could “impair national security.”[36]

This aspect of CFIUS has had direct consequences on the timing of CFIUS reviews of energy transactions. As discussed, under the broad and ambiguous definition in FINSA, which CFIUS has declined to narrow, virtually any energy-related asset can be considered critical infrastructure, the destruction of which could arguably impair national security in some manner, however small.[37] Accordingly, CFIUS is able to use this provision to justify adding an additional 45 days to the review of practically any notice concerning energy assets, meaning that the formal review period is actually a minimum of 75 days for most energy related transactions. As such, the notion that CFIUS is bound to a 30-day review period is simply not the case for most energy transactions.

IV.          Conclusions

Although the energy sector was not the focus of the DP World controversy or FINSA, many benign energy transactions are confronting the type of CFIUS delays that one would expect to be associated only with uniquely sensitive assets such as cutting-edge technology or defense equipment. Changes in timing and cost expectations can often make the difference between success or failure in complex international energy deals and, even under the best of conditions, negotiating and closing energy transactions is a difficult and time-consuming endeavor. While the role of foreign investment in the U.S. energy sector is increasingly important, the changes FINSA made to the CFIUS process have introduced delays and unnecessary uncertainty for foreign investors and U.S. energy companies.

While every transaction poses unique substantive and analytical issues related to CFIUS, there are common problems faced by most international energy transactions that trigger CFIUS jurisdiction. As a result of the breadth of the term “critical infrastructure,” the creation of a new pre-notice mandate, and the statutory imposition of an additional 45-day investigation period for transactions involving critical infrastructure, many parties must simultaneously struggle to escape CFIUS review and plan for a review period that has become as long 90 days when the pre-notice period is included. Given that the ability to provide details necessary for a formal notice means parties cannot file until they have agreed to the details of a transaction,[38] and that CFIUS informs counsel that they prefer that notice is filed prior to closing,[39] many energy transactions are required to wait in limbo for up to three months pending CFIUS review.[40]

The unnecessary delays faced by energy transactions can discourage important foreign investment and create unexpected problems that result in aborted transactions as result of events that occur during the long CFIUS review period. As such, there is risk going forward that an increasing number of parties might consider choosing to avoid these delays by not filing a voluntary notice, which leaves a lingering risk of a transaction being reviewed and potentially unwound by CFIUS after it has closed.

Decisions regarding whether to file a voluntary notice with CFIUS should be motivated by reasonable evaluations of national security issues and risks and not by the costs associated with delays. If parties choose not to file notices due to concerns about delays, it is likely that some transactions that may raise real or perceived national security issues will be not be reviewed by CFIUS before closing. When the media later reports on either the actual or alleged risks of these transactions, the risk of more controversies like DP World becomes more pronounced. Such controversies undermine the confidence that foreign investors have in the U.S., harming the economy and the energy sector. Furthermore, it is possible that some of the transactions that seek to avoid CFIUS review, in order to avoid delays, may pose actual national security risks if those transactions result in substantive—and not merely hypothetical—security vulnerabilities.

U.S. national security, the U.S. energy sector, and the larger U.S. economy would be well served if CFIUS would treat energy transactions in a more rational manner. CFIUS should promulgate guidance regarding the types of energy assets that are likely to be considered critical infrastructure and should be willing to terminate reviews after the initial 30-day review for assets that are outside of the defined scope of critical infrastructure. Additionally, the pre-notice process should be more clearly defined and should not include requests for information outside of what is required by CFIUS regulations. If these changes were made, it would allow CFIUS to focus their resources on transactions that raise legitimate national security risks and would allow parties involved in most energy transactions to submit a notice to CFIUS with confidence that the review could be completed in a reasonable timeframe.

 

 

Preferred citation: Joshua C. Zive, Unreasonable Delays: CFIUS Reviews of Energy Transactions, 3 Harv. Bus. L. Rev. Online 169 (2013), https://journals.law.harvard.edu/hblr//?p=3271.

* Senior Counsel, Bracewell & Giuliani LLP.

[1] See, e.g., Foreign Investors Play Large Role in U.S. Shale Industry, U.S Energy Info. Admin. (Apr. 8, 2013), http://www.eia.gov/todayinenergy/detail.cfm?id=10711.

[2] See 50 U.S.C. app. § 2170(k) (2012).

[3] See generally Stephen K. Pudner, Moving Forward from Dubai Ports World—The Foreign Investment and National Security Act of 2007, 59 Ala. L. Rev. 1277, 1278–81 (2008); James F.F. Carroll, Back to the Future: Redefining the Foreign Investment and National Security Act’s Conception of National Security, 23 Emory Int’l L. Rev. 167, 167–68 (2009) (describing historical origins of CFIUS regulatory mandate).

[4] See Pudner, supra note 3, at 1281; 50 U.S.C. app. § 2170(e).

[5] Regulations Pertaining to Mergers, Acquisitions, and Takeovers by Foreign Persons, 56 Fed. Reg. 58,774, 58,775 (Nov. 21, 1991) (to be codified at 31 C.F.R. pt. 800).

[6] Id. at 58,786.

[7] Id.

[8] Id. at 58,787.

[9] Id. at 58,784–87.

[10] See Deborah M. Mostaghel, Dubai Ports World Under Exon-Florio: A Threat to National Security or a Tempest in a Seaport?, 70 Alb. L. Rev. 583, 583 (2007).

[11] See id. at 606.

[12] See id. at 607.

[13] Foreign Investment and National Security Act of 2007, Pub. L. No. 110-49, 121 Stat. 246 (2007).

[14] Regulations Pertaining to Mergers, Acquisitions, and Takeovers by Foreign Persons, 73 Fed. Reg. 70,702 (Nov. 21, 2008) (to be codified at 31 C.F.R. pt. 800).

[15] 50 U.S.C. app. § 2170(a)(5), (f)(6) (2012).

[16] Id. § 2170(b).

[17] Id.

[18] James K. Jackson, Cong. Research Serv., RS22197, The Exon-Florio National Security Test for Foreign Investment 4 (2006).

[19] 50 U.S.C. app. § 2170(a)(6).

[20] Id.

[21] Id. § 2170(f)(6) (emphasis added).

[22] Id.

[23] See 31 C.F.R. § 800.208 (2012)

[24] 50 U.S.C. app. § 2170(f)(6).

[25] See Mostaghel, supra note 10, at 595.

[26] 31 C.F.R. § 800.401(f) (2012).

[27] Id.

[28] Regulations Pertaining to Mergers, Acquisitions, and Takeovers by Foreign Persons, 73 Fed. Reg. 70,702, 70,711 (Nov. 21, 2008) (to be codified at 31 C.F.R. pt. 800).

[29] 31 C.F.R. § 800.402 (2012).

[30] Id. § 800.402(c)(6)(vi).

[31] See Filing Instructions, U.S. Dep’t of Treasury, http://www.treasury.gov/resource-center/international/foreign-investment/Pages/cfius-filing-instructions.aspx (last visited April 12, 2013).

[32] See Committee on Foreign Investment in U.S. (CFIUS), U.S. Dep’t of Treasury, http://www.treasury.gov/resource-center/faqs/CFIUS/Pages/default.aspx (last visited April 12, 2013) (“The time that it takes for the Staff Chairperson to determine that the notice complies with §800.402 after it has been submitted by the parties depends upon a variety of factors, including the notice itself and whether parties have submitted a draft notice before submitting the formal notice.”).

[33] See U.S.C. app. § 2170(a)(6) (2012).

[34] See Mostaghel, supra note 10, at 595.

[35] See 31 C.F.R. § 800.501(a)(2) (2012).

[36] 50 U.S.C. app. § 2170(b)(2)(B).

[37] See id. § 2170(a)(6).

[38] See 31 C.F.R. § 800.402 (2012) (listing all of the information regarding a transaction required for a complete notice).

[39] This practice is not reflected in any formal regulations or guidance, but in the author’s experience CFIUS treats post-closing filings with more skepticism, and will require a fulsome explanation of why the notice was not filed prior to closing.

[40] While the specifics of all such transactions are confidential, one need only to review the recent acquisition of Nexen Inc. by CNOOC to see an example where CFIUS approval took over six months. See Roberta Rampton & Scott Haggett, CNOOC-Nexen Deal Wins U.S. Approval, Its Last Hurdle, Reuters, Feb. 12, 2013, available at http://www.reuters.com/article/2013/02/12/us-nexen-cnooc-idUSBRE91B0SU20130212.

By

Clearinghouse Hope or Hype? Why Mandatory Clearing May Fail to Contain Systemic Risk

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Sean J. Griffith*

Introduction

The global financial crisis of 2007–2008 revealed faults in the ability of regulators worldwide to contain systemic risk. Blaming much of the crisis on derivatives, complex financial contracts that allow counterparties to trade positions on an underlying risk, world policy-makers called for increasing the regulation of finance generally and of derivatives in particular. A policy consensus quickly formed around mandatory central counterparty clearing as a solution to the problem of systemic risk posed by derivatives transactions.[1]

This Article briefly sketches how central counterparty clearing confronts the problem of systemic risk. It then focuses on weaknesses of mandatory clearing, offering two sets of criticisms. The first set of critiques is structural, articulating reasons why mandatory clearing may fail as a solution to the problem of systemic risk. The second set of critiques is based on the incentives of the parties most likely to be involved in clearinghouse governance and management, arguing that even if clearinghouses are not structurally deficient, they are likely to be plagued with incentive problems that prevent them from operating optimally. All of this suggests that clearinghouses may not be the last and best solution to the problem of systemic risk and that further regulatory experimentation may be desirable.

I.      The Clearinghouse Hope

Systemic risk refers to the linkages and interdependencies between participants in the financial market, such that a significant loss initially touching only a small number of participants can spread and threaten the entire system.[2] Systemic risk is an appropriate target for regulatory attention because private actors lack appropriate incentives to control it. [3]

Derivatives transactions create systemic risk generally by serving as a node of financial interconnection. More specifically, derivatives increase systemic risk through the creation of counterparty credit risk—the risk that the party with whom one is trading will be insolvent or otherwise unable to pay when an obligation comes due. The failure of a large derivative counterparty spreads loss throughout the financial system because other institutions hold unhedged positions precisely when they most need protection, potentially leading to further financial institution failures and a contraction in the real economy.

Central counterparty clearing addresses the problem of systemic risk by promising a means of minimizing counterparty credit risk. Rather than leaving derivatives counterparties to provide for risk and collateral management in their contractual arrangements, these functions are centralized by means of a “central counterparty” that interposes itself, through contractual novation, between the buyer and seller on a given contract. All transactions are thus run through the clearinghouse, which effectively becomes “the buyer to every seller and the seller to every buyer.”[4] Through central counterparty clearing, the previously disorganized world of bilateral derivatives trading comes to resemble an orderly hub-and-spoke arrangement, with the clearinghouse at the center of every trade.

Several apparent advantages come with the creation of a central counterparty. First, the clearinghouse becomes a nexus for collecting information about the derivatives market and can facilitate access to that information for regulators or the public. Second, the clearinghouse becomes a central monitoring station of counterparty credit quality that may be more efficient than the duplicative monitoring efforts of diffuse counterparties. Finally, central counterparties provide an easy point of entry for regulators seeking to determine whether and how to intervene in the market.

It is worth pointing out that a clearinghouse is not necessary to accomplish any of these things. Pricing transparency could be accomplished through a system of mandatory reporting of prices. Likewise, information about credit quality could be centrally collected and evaluated by other means, such as a third-party credit monitor similar to a credit-rating agency. Finally, regulators seeking access to the inner workings of the derivatives market could simply require prompt reporting of relevant information directly to them.

Clearinghouses, however, are critical in relieving contracting parties of counterparty credit risk. The clearinghouse effectively undertakes all counterparty credit risk through novation, leaving transacting parties with zero exposure to their original counterparties and, as long as the clearinghouse remains solvent, no exposure to counterparty credit risk. Whether clearinghouses will be able to remain solvent and thereby contain counterparty credit risk thus becomes the all-important question. The next Part offers several reasons to doubt the ability of clearinghouses to do so.

II.    The Clearinghouse Hype

It is possible to level two different kinds of critiques at central counterparty clearing. The first kind of critique, what I will refer to here as “structural,” offers reasons to believe that clearinghouses cannot possibly function as hoped to mitigate or eliminate systemic risk. The second, what I will refer to as “incentives-based,” suggests that independently of whether clearinghouses are structurally sound, they are plagued with governance problems that may render them fundamentally unable to do the job regulators have delegated to them.

A.   Structural Critiques

This section summarizes three structural critiques of central counterparty clearing as a solution to the problem of systemic risk: (1) the fragmentation of netting, (2) the amplification of asset bubbles, and (3) the externalization of systemic risk.

1.    Clearinghouses Increase Systemic Risk by Fragmenting Netting

A core advantage claimed for central counterparty clearing is increased efficiency in netting. Netting mitigates the shock of a dealer default by providing counterparties with a means of offsetting losses in some positions with gains in others. Its effect is most powerful in a system in which all major counterparties participate across all of their positions so that the greatest number of transactions is available to offset a dealer default. Netting would thus be at its most powerful if all trades were cleared through a single world clearinghouse.

This, unfortunately, is not the way central counterparty clearing has evolved. Instead, multiple clearinghouses have arisen in multiple jurisdictions, with each clearinghouse typically clearing only a subset of derivatives or only a single derivatives product.[5] The rise of multiple clearinghouses means fragmented netting. In a world of fragmented netting, the only trades available to a clearinghouse to offset losses from a dealer’s default are positions cleared by that particular clearinghouse, a subset of all open positions with the defaulting dealer. Fewer open positions, of course, means greater residual loss for the clearinghouse to absorb, a problem that will be repeated for each clearinghouse in which the defaulting member participates.

2.    Clearinghouse Segmentation Produces Destructive Coordination

Because clearinghouses specialize in specific asset classes—for example, foreign exchange, interest rate swaps, or credit default swaps (CDSs)—they are likely to be susceptible to asset bubbles in the underlying asset. This is a case of “destructive coordination” brought on by regulation.[6] Consider the situation of a clearinghouse specializing in CDSs whose member has suffered severe losses after the bubble in mortgage backed securities burst. Because of its investment loss, the member will face capital calls from the clearinghouse, forcing it to sell assets. This sale of assets will flood the market at a time when the value of the assets is low, thereby weakening other members of the clearinghouse exposed to the same asset class, who will themselves face capital calls from the clearinghouse, thereby raising the specter of further fire-sales and further sharp declines in asset value.

3.    Clearinghouses Do Not Eliminate Systemic Risk—They Merely Shift It

The standard reasoning supporting central clearing is that clearinghouses mitigate systemic risk by controlling counterparty credit risk. But the control of counterparty credit risk, even when it is optimally effective, is not the same as the elimination of systemic risk. Fundamentally, central clearing guarantees that clearinghouse members will be paid when another member defaults. This works largely as a result of bankruptcy rules that protect margin collateral and more broadly provide derivatives counterparties with preferential treatment in bankruptcy.[7] This recreates the classic bankruptcy “setoff” problem, where transfers outside of the bankruptcy estate result in less recovery to creditors, who are forced to seek recovery through the estate.[8] The clear parallel is that clearinghouses mitigate counterparty credit risk among clearinghouse members by imposing that risk on prospective creditors outside of the clearinghouse.[9]

The imposition of credit risk outside the clearinghouse might be defensible from a policy standpoint if all systemically important institutions transact all systemically important business through the clearinghouse. This, however, is clearly not the case. Derivatives dealers are typically part of massive and deeply interconnected financial institutions, many of whose dealings do not involve transactions that are cleared by central counterparties.[10] Because systemically important institutions engage in important transactions that are not centrally cleared, the imposition of risk outside of the clearinghouse may have dangerous systemic effects.

B.   Incentive Problems

            The fundamental purpose of the clearinghouse is to amass risk in hopes of containing it. In doing so, of course, the clearinghouse itself is likely to become an important node of systemic risk, the failure of which would immediately spread contagion throughout the economy. Clearinghouses have failed before and, if mismanaged, could fail again.[11] Clearinghouse governance thus becomes a core concern. Getting clearinghouse governance wrong seems likely to lead to future crises and future bailouts because of clearinghouses’ “too-big-to-fail” status. The question thus becomes: who will have a hand in clearinghouse governance? Are these parties likely to manage the clearinghouse in a way that successfully mitigates systemic risk? Unfortunately, as I have explored in greater deal elsewhere, there is much to be concerned about in clearinghouse governance.[12]

1.    Dealer Incentives

Derivatives trading volume is in the hands of a relatively small number of banks acting as “dealers.” Two frequently cited statistics from a report by the Office of the Comptroller of the Currency reveal that five banks—JPMorgan Chase, Bank of America, CitiGroup, Goldman Sachs, and HSBC—account for 96% of the notional amounts and 83% of the net credit exposure of the U.S. banking industry.[13] The market, in other words, is highly concentrated.[14]

Volume, from the dealers’ perspective, means profitability—first, because many trades, even at slim margins, translate into large profits, and second, because clearinghouses and other market-infrastructure providers prize liquidity and are willing to offer large dealers significant discounts to bring trading volume to their platforms. In addition to their command of volume, dealers profit by designing customized, or “bespoke,” instruments that they can offer at significantly higher profit margins.

Dealers are problematic managers of systemic risk for at least three reasons. First, dealers are likely to understand that, regardless of what politicians might say to the contrary, the federal government will not be able to resist bailing out a failing clearinghouse. Knowing that they are thus the implicit beneficiaries of a federal guarantee, dealers may seek to impose excess risk on the clearinghouse in order to reap the benefits of higher fees through trading volume. This is a classic case of moral hazard, and it has the predictable effect of inducing dealers to take excessive risk through the clearinghouse.[15]

Second, it is important to remember that dealers are not cohesive, monolithic entities but are far-flung institutions suffering from agency costs in the same way as any other large business. Agency costs harm organizations as a result of the disconnect between the incentives of the actors and the interests of those for whom they are acting. In this case, the trading activity of major dealers is likely to be undertaken by a relatively small group of individuals who, because they have a history of producing large profits for the institution, are likely to be well-regarded and highly compensated. In fact, these traders are customarily paid through incentive compensation arrangements that award them for their productivity—the more trading profits they generate, the more highly they are paid. It does not take much effort to see that these traders may not have the same incentives as the organization as a whole because they may be able to maximize their personal compensation by taking on excessive trading risk that will be borne by the institution, not themselves personally.[16]

Third, and quite apart from accounts suggesting that excessive risk taking is a mistake that dealers would like to avoid, but are somehow unable to side-step, there is the possibility that dealers act in their shareholders’ interests by taking on excessive risk, which in the new regulatory environment, they will impose on clearinghouses. This is the theory of “correlation-seeking,” in which firms may seek to correlate their firm’s contingent debt obligations with insolvency risk in order to maximize shareholders’ upside return while imposing the downside return on creditors.[17] If dealers were to engage in correlation-seeking, they would not mistakenly underestimate risk but intentionally undertake large amounts of contingent risk correlated to other events likely to lead to their insolvency. Although such a strategy might perversely benefit a dealer’s shareholders, it would also have the clear effect of imposing excessive risk on the dealer’s contractual counterparties—in this case, the clearinghouse—and thereby increasing systemic risk.[18]

2.    End Users

End users are dealers’ customers. They are the parties who buy and sell derivatives instruments in order to hold the risk for a period of time. End users may thus be corporations or financial institutions seeking to hedge various exposures—to currencies or interest rates, for example. However, in terms of trading volume, they are more likely to be hedge funds and other financial investors seeking to speculate on a particular risk. Moreover, because commercial firms engaging in hedging transactions will likely be exempt from the clearing requirement, the real end-user with a stake in clearinghouse governance is the financial end user, often, a hedge fund.[19]

End users are likely to push clearinghouses to reduce their trading costs. A TIAA-CREF comment letter makes the point explicitly, arguing that “the primary function of the [c]learinghouse is to provide fair, open and transparent access to reasonably priced swap contracts.”[20] Reducing customer costs, of course, means reducing producer (in this case, dealer) revenue, at least on a per-trade basis. Insofar as this is a zero-sum game, the more success end users have in reducing fees, the greater the dealers’ needs will be to seek revenue elsewhere.

Dealers may seek to make up this lost revenue either by increasing volume or by innovating new products that are sufficiently customized to trade bilaterally where spreads are higher.[21] As noted above, either of these responses is problematic from the perspective of systemic risk. Thus, although end-users do not themselves have incentives that are adverse to the containment of systemic risk, the accomplishment of their principal interest—the reduction of trading costs—may push dealers to take steps that are inconsistent with the reduction of systemic risk.

3.    Governance Incentives Generally: Collective Action and Systemic Risk

Another, perhaps simpler way of analyzing the incentive problems infecting clearinghouse governance is to view protection from systemic risk as a public good. All citizens would suffer if the systemic risk inherent in derivatives transactions breached the confines of the clearinghouse—either as a result of the havoc such an outbreak would wreak upon the financial system or as the ultimate payers in taxpayer-funded bailout aimed at keeping the clearinghouse afloat. The parties with commercial interests in derivatives trading—dealers and end users—would suffer, too. But because some of their suffering would be borne by third parties (and because they stand to benefit from transactions in derivatives instruments), they are not induced to internalize the entire burden of controlling systemic risk. The management of systemic risk thus has the character of a public good, the basic consequence of which, economic theory teaches, is a pervasive free-rider problem.[22] Leaving governance largely to private actors, as the current clearinghouse architecture does, is necessarily problematic.[23]

Conclusion

What then are we to do? Elsewhere I have outlined a governance structure to respond to the unique incentive problems clearinghouses face.[24] However, even if clearinghouse governance were optimized and dealer incentives perfectly constrained, central counterparty clearing would remain subject to the structural critiques outlined above. All of this suggests that the clearinghouse is likely not the last and best solution to the problem of systemic risk inherent in derivatives transactions.

Perhaps the best that we can hope for is a regulatory structure that remains flexible and open to experimentation and change as other potential solutions come into view. Unfortunately, the top-down worldwide imposition of mandatory clearing suggests the regulatory architecture is moving in the other direction—towards uniformity and inflexibility built around the principle of mandatory central counter-party clearing.[25] Even if central counterparty clearing is the best idea we currently have to manage the systemic risk inherent in derivatives transactions, its apparent flaws should stop us from allowing it to become entrenched. Policy-makers should strive instead for a regulatory structure that fosters diversity and experimentation in containing systemic risk.[26] We should not wait for the next crisis.

 

Preferred citation: Sean J. Griffith, Clearinghouse Hope or Hype?: Why Mandatory Clearing May Fail to Contain Systemic Risk, 3 Harv. Bus. L. Rev. Online 160 (2013), https://journals.law.harvard.edu/hblr//?p=3261.

* T.J. Maloney Chair and Professor of Law, Fordham Law School. This Article is an extension of the analysis in Sean J. Griffith, Governing Systemic Risk: Towards a Governance Structure for Derivatives Clearinghouses, 61 Emory L.J. 1153 (2012), available at http://www.law.emory.edu/fileadmin/journals/elj/61/61.5/Griffith.pdf.

[1] A regulatory agenda advocating a clearinghouse solution to the problem of systemic risk was articulated during a G-20 summit in Pittsburgh in 2009:

All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.

G-20, Leaders’ Statement: The Pittsburgh Summit (Sept. 24–25, 2009), available at http://www.g20.utoronto.ca/2009/2009communique0925.html.

[2] This basic theme is captured with greater formality by a leading scholar in the area, who defines systemic risk as:

[T]he risk that (i) an economic shock such as market or institutional failure triggers (through a panic or otherwise) either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (ii) resulting in increases in the cost of capital or decreases in its availability, often evidenced by substantial financial-market price volatility.

Steven L. Schwarcz, Systemic Risk, 97 Geo. L.J. 193, 204 (2008).

[3] See generally Robert O. Keohane, After Hegemony: Cooperation And Discord in the World Political Economy 65–69 (1984) (discussing coordination failures as a justification for regulation). See also Mark J. Roe, The Dodd-Frank Act’s Maginot Line: Clearinghouse Construction 36 (Mar. 5, 2013) (unpublished working paper), available at http://ssrn.com/abstract=2224305 (noting that “[w]hen guarding against their own failure, [financial institutions] do not account for the costs that their failure will inflict on the rest of the economy” and providing a numerical example).

[4] See Bank for Int’l Settlements, Comm. on Payment and Settlement Sys. & Int’l Org. of Sec. Comm’ns, Technical Comm., Recommendations for Central Counterparties, at 1 (Nov. 2004).

[5] See, e.g., Jeremy Grant, Singapore Warns on Clearing Houses, Fin. Times (Mar. 15, 2013), http://www.ft.com/cms/s/0/48100a5c-8d34-11e2-82d2-00144feabdc0.html (describing regulator’s warning that a “proliferation” of clearinghouses “may also increase risk and lead to higher costs”).

[6] See Charles K. Whitehead, Destructive Coordination, 96 Cornell L. Rev. 323 (2011).

[7] See, e.g., Franklin R. Edwards & Edward R. Morrison, Derivatives and the Bankruptcy Code: Why the Special Treatment?, 22 Yale J. on Reg. 91 (2005).

[8] See Roe, supra note 3, at 15–24.

[9] See id. at 29–31.

[10] See id.

[11] Financial clearinghouses have failed in France (the Caisse de Liquidation, in 1974), Kuala Lumpur (the Commodities Clearing House, in 1983), and in Hong Kong (the Futures Exchange, in 1987). See Tracy Alloway, A Glimpse at Failed Central Counterparties, FT Alphaville (June 2, 2011, 2:14 PM), http://ftalphaville.ft.com/2011/06/02/583116/a-glimpse-at-failed-central-counterparties/.

[12] See Sean J. Griffith, Governing Systemic Risk: Towards a Governance Structure for Derivatives Clearinghouses, 61 Emory L.J. 1153, 1189–1226 (2012). See also Yesha Yadav, The Problematic Case of Clearinghouses in Complex Markets, 101 Geo. L.J. 387 (2013) (questioning the clearinghouse paradigm).

[13] See Office of the Comptroller of the Currency, OCC’s Quarterly Report on Bank Trading and Derivatives Activities First Quarter 2011 1, available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq111.pdf. A competing study measuring the market from a global perspective not limited to banking companies puts the market share of the five largest U.S.-based dealers at 37%, rather than 96%, reflecting the fact that a significant portion of the derivatives business is offshore. See Int’l Swaps & Derivatives Ass’n, 2010 Mid-Year Market Survey, http://www.isda.org/statistics/recent.html#2010mid (last visited Apr. 16, 2013) (reporting results of a survey of seventy-one participants).

[14] Even considering the market from a global perspective, trading volume remains highly concentrated, with 82% of the total notional amount outstanding ($354.6 trillion of $466.8 trillion) in the hands of 14 dealers. See Int’l Swaps & Derivatives Ass’n, supra note 13.

[15] See Griffith, supra note 12, at 1201–02.

[16] See id. at 1202.

[17] Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 Harv. L. Rev. 1151, 1184–90 (2010).

[18] See Griffith, supra note 12, at 1203–04.

[19] On the exemption of non-financial end-users from clearing, see Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 723(a)(3), 124 Stat. 1376, 1679 (2010) (providing exceptions to the clearing requirement for swaps); id. § 763(a) (providing exceptions to the clearing requirement for security-based swaps); End-User Exception to Mandatory Clearing of Swaps, 75 Fed. Reg. 80,747 (proposed Dec. 23, 2010) (to be codified at 17 C.F.R. pt. 39); End-User Exception to Mandatory Clearing of Security-Based Swaps, 75 Fed. Reg. 79,992 (proposed Dec. 21, 2010) (to be codified at 17 C.F.R. pt. 240).

[20] Letter from Jon Feigelson, Senior Vice President, Gen. Counsel & Head of Corporate Governance, TIAA-CREF, to Elizabeth M. Murphy, Sec’y, SEC, and David A. Stawick, Sec’y, Commodity Futures Trading Comm’n 4 (Mar. 7, 2011) (emphasis added), http://www.sec.gov/comments/s7-27-10/s72710-110.pdf.

[21] See Griffith, supra note 12, at 1208.

[22] Public goods are goods that are either non-excludable (i.e., non-payors cannot be denied access), non-rival (i.e., one person’s consumption does not diminish the amount of the good available for others), or both. See Tyler Cowen, Introduction to Public Goods & Market Failures: A Critical Examination 1, 3–4 (Tyler Cowen ed., 1999). Paradigmatic examples are lighthouses and national defense. See R.H. Coase, The Lighthouse in Economics, 17 J.L. & Econ. 357, 358 (1974).

[23] For current rulemaking on these points, see Risk Management Requirements for Derivatives Clearing Organizations, 76 Fed. Reg. 3698, 3701 (proposed Jan. 20, 2011) (to be codified at 17 C.F.R. pt. 39); Ownership Limitations and Governance Requirements for Security-Based Swap Clearing Agencies, Security-Based Swap Execution Facilities, and National Securities Exchanges with Respect to Security-Based Swaps Under Regulation MC, 75 Fed. Reg. 65,882, 65,886 (proposed Oct. 26, 2010) (to be codified at 17 C.F.R. pt. 242). For a critique of these proposals, see Griffith, supra note 12, at 1218–26.

[24] See Griffith, supra note 12, 1226–39.

[25] See, e.g., David Felsenthal & Lily Chu, Regulation of Cross-Border Swaps, 3 Harv. Bus. L. Rev. Online 142 (2013), https://journals.law.harvard.edu/hblr//?p=3232.

[26] See Sean J. Griffith, Substituted Compliance and Systemic Risk: How to Make a Global Market in Derivatives Regulation, 98 Minn. L. Rev. (forthcoming 2013) (further developing a paradigm for regulatory experimentation aimed at containing systemic risk).

By

Margin Costs of OTC Swap Clearing Rules

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Paul Watterson, Joseph Suh, and Craig Stein*

Regulators of several countries, including the United States Commodity Futures Trading Commission (CFTC), have introduced or proposed rules requiring clearing of over-the-counter (OTC) derivatives through central counterparties. Clearing requirements in turn affect margin requirements, which are one key mechanism used by parties to mitigate counterparty risk. Although clearing rules help shield collateral from the insolvency of the secured party, they also may substantially increase financial and operational costs for the users of cleared derivatives because of the higher margin delivery requirements applicable to such transactions.

Background

A derivative is a contract between two parties that transfers risks related to one or more underlying assets (such as equity securities, bonds, loans, or commodities), underlying market factors (such as interest rates or currency exchange rates) or underlying events (such as natural disasters or man-made disasters). It requires one or both parties to make agreed upon payments or deliveries of assets to the other party upon the occurrence of a specified event or on a specified date.[1] Until recently, the regulatory regime and market practices for bilaterally negotiated OTC derivatives have been starkly different than for exchange-traded derivatives such as oil futures and other commodity futures.[2] However, the financial crisis of 2008 has resulted in what many refer to as the “futurization” of the OTC derivatives markets.[3]

The financial crisis that began in 2008 with the failures and near-failures of large financial institutions generated a great deal of scrutiny of OTC derivatives and their role in the demise of such companies.[4] Although OTC derivatives were not the only cause of the financial crisis, there was international consensus that certain types of OTC derivatives contributed to the crisis[5] and that more regulation and transparency was needed to diminish the risk they pose to the global financial system.[6] This consensus manifested itself in an agreement by the leaders of the Group of 20 (G-20)[7] in September 2009 that included a commitment by the participating countries to pass laws and regulations requiring (i) standardized OTC derivatives to be cleared through central counterparties by the end of 2012 and (ii) non-cleared OTC derivatives to be subject to higher capital requirements.[8] Many regulators have since adopted or proposed central clearing rules in accordance with the G-20 commitments.[9]

Clearing Rules in the United States

In the United States, OTC derivatives clearing requirements were part of the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[10] Title VII of the Dodd-Frank Act imposes comprehensive changes in the regulatory framework for derivatives and includes amendments to the Commodity Exchange Act (CEA)[11] and the Securities Exchange Act of 1934.[12] Under the Dodd-Frank Act, the Securities and Exchange Commission (SEC) has the authority to regulate certain OTC derivatives called “security-based swaps” and the CFTC has the authority to regulate all other swaps, except for mixed swaps, which are under the joint jurisdiction of the SEC and the CFTC.[13] Although the SEC has not yet imposed any clearing mandates with respect to security-based swaps, the CFTC imposed its first clearing mandate on December 13, 2012.[14]

The CEA, as amended by the Dodd-Frank Act, prohibits a counterparty from entering into a swap that the CFTC has required to be cleared unless that counterparty submits the swap for clearing to a derivatives clearing organization (DCO).[15] The DCO can make a submission to the CFTC or the CFTC can directly initiate a review of a swap—or group, category, type, or class of swaps—and determine whether it should be required to be cleared.[16]

On February 1, 2012, the CFTC requested DCOs that were already clearing OTC derivatives to submit all swaps that they were accepting for clearing as of that date.[17] In its first swap clearing mandate, the CFTC required that four classes of interest rate swaps and two classes of credit default swaps (CDSs) be cleared by DCOs while meeting certain basic specifications:[18] (1) fixed-to-floating swaps; (2) basis swaps; (3) forward rate agreements; (4) overnight index swaps; (5) North American untranched CDS indices; and (6) European untranched CDS indices.[19] The clearing mandate became effective on February 11, 2013[20] and requires swap counterparties to submit for clearing by a DCO any swap covered by the rules as soon as technologically practicable and no later than the end of the day of execution, unless one of the counterparties is an entity that is eligible for an exemption from the clearing requirements.[21]

Margin Requirements and Their Sources

One of the key mechanisms used by parties to an OTC derivative transaction to reduce counterparty risk is the posting of margin. Typically, one or both of the parties will be required to deliver collateral to secure its payment obligations. If a party defaults by failing to make a payment or becoming subject to an insolvency proceeding, the other party has the right to terminate the OTC derivative and use the posted collateral to pay any termination payment owed by the defaulting party. A party may be required to deliver margin at the outset of the transaction (referred to as “initial margin”) and may also be required to deliver margin periodically as the potential termination payment of the parties changes over the life of the transaction (referred to as “variation margin”).

Margin requirements for a typical non-cleared OTC derivative are set forth in a bilateral agreement between the parties. OTC derivatives are typically documented under industry-standard master agreements, which are printed forms prepared by the International Swaps and Derivatives Association (ISDA).[22] Margin requirements for such transactions are set forth in a credit support annex (CSA) to the agreement.[23]

In contrast, margin requirements for a cleared OTC derivative spring from two sources. First, the DCO that clears the derivative will require both initial and variation margin based on the rules of the DCO and any government regulations applicable to the DCO. Second, since a counterparty to a cleared OTC derivative needs to gain access to a DCO through a Futures Commission Merchant (FCM), which is a member of the DCO, the counterparty will need to enter into a futures account client agreement with the FCM.[24] Under this futures account client agreement, the FCM may require the counterparty to deliver margin in addition to the margin required by the DCO.

Clearing Rules Help Protect Collateral

Parties to a non-cleared OTC derivative can choose in the CSA how collateral delivered by a party must be held. For instance, the CSA may allow the pledgee of the collateral to use all the collateral posted to it in other transactions (that is, the right of “re-hypothecation”) and commingle such collateral with collateral posted by other parties. Although a counterparty typically prefers that the collateral it posts be held by a bank custodian and not re-hypothecated, dealers will insist on holding the collateral directly and having the right to re-hypothecate the collateral because this generates significant revenues for them. Such commingling and re-hypothecation of collateral were partially responsible for losses suffered by Lehman’s OTC swap counterparties on the collateral they had posted to Lehman.[25] Following the Lehman insolvency, some buy-side clients negotiated prohibitions on re-hypothecation and required third-party custody for posted collateral to prevent commingling.[26] The Dodd-Frank Act mandates that a dealer is obligated to segregate initial margin if requested by its counterparty.[27]

Under a cleared OTC derivative transaction, a counterparty’s collateral is better protected from the insolvency risk of the FCM or DCO because re-hypothecation of collateral is prohibited and the ability of the FCM or DCO to commingle the collateral is restricted.[28] On February 7, 2012, the CFTC published a final rule adopting a new margin segregation model for cleared swaps that the CFTC termed the “legal segregation with operational commingling” model (LSOC Model).[29] Under the LSOC Model, FCMs and DCOs must segregate, on their books and records, collateral posted by each cleared swap customer and treat such collateral as belonging solely to that customer.[30] However, they are permitted, for operational purposes, to commingle the collateral deposited by all cleared swap customers in one account[31] that is “separate from any account holding FCM or DCO property or holding property belonging to non-cleared swaps customers.”[32]

Costs Related to Margin Requirements for Cleared Swaps

Although the LSOC Model imposed by the CFTC helps to safeguard collateral posted for cleared OTC derivatives from the counterparty risks of the FCM and DCO, the margin requirements may increase the financial and operational costs for such transactions compared to non-cleared OTC derivatives.

The CSA governing non-cleared OTC derivatives gives counterparties flexibility to negotiate the initial and variation margin to be posted by each party, the types of collateral that may be accepted, and any valuation haircuts to be applied to the collateral.[33] The amount of collateral required, especially the initial margin, often depends on the type of counterparty. For example, an ERISA benefit plan will likely be required to post lower initial margin (if any) than a distressed asset hedge fund.[34] In addition, a counterparty may not be required to post collateral at all until the dealer’s exposure to the counterparty exceeds a certain “Threshold Amount” specified in the CSA.[35] Even if the exposure exceeds the Threshold Amount, the counterparty may not be required to post collateral unless the amount required to be delivered exceeds a “Minimum Transfer Amount” (to avoid nuisance transfers).[36] Both the Threshold Amount and the Minimum Transfer Amount are negotiated between the dealer and the counterparty and will vary depending on the creditworthiness of the counterparty. Additionally, the parties can specify the frequency of collateral calls, the terms of the return of collateral and interest thereon, and valuation dispute resolution.[37]

In contrast to a non-cleared OTC derivative, a counterparty has more stringent requirements and much less flexibility to negotiate the margin requirements for cleared OTC derivatives.

  • CFTC rules prescribe minimum levels of initial margin that a DCO must collect from its FCM members.[38] Therefore, the DCO collects margin from all FCMs[39] and FCM members pass on the margin delivery requirements to their customers,[40] regardless of their creditworthiness or trading relationships.[41] Even a very creditworthy counterparty or a counterparty with a longstanding relationship with the FCM will need to post initial margin, thereby increasing the trading costs.[42]
  • DCOs will make daily, or even intraday, margin calls on the FCMs, which in turn could pass the same daily or intraday calls on to their customers.[43] Unlike a counterparty under a CSA for a non-cleared OTC derivative that may have as many as two business days to meet a margin calls, a counterparty to a cleared OTC derivative will need to have the operational capability and eligible assets available to deliver daily or intraday margin. Dealers expect that some counterparties will not be able to fund daily margin calls on cleared trades and will need their dealers to temporarily fund margin calls on their behalf.[44] Although some dealers are willing to extend credit to their clients for this purpose, the additional cost of such credit will increase the overall costs of trading in cleared OTC derivatives and may drive some counterparties out of the market. [45]
  • Unlike dealers, which may be willing to accept many different types of securities as collateral in non-cleared OTC derivative transactions, many DCOs accept only cash and U.S. treasuries as collateral.[46] Although financial institutions have begun to offer their clients “collateral transformation” services, whereby they engage in a repurchase transaction with a customer, accepting the customer’s securities in exchange for suitable collateral that the customer may post as cleared swaps margin, this type of service imposes an additional cost on counterparties.[47] Sourcing eligible collateral will be a challenge to counterparties and will increase the financial cost of using cleared OTC derivatives.
  • An FCM may collect additional margin beyond what is required to be posted to the DCO.[48] This excess margin may be retained by the FCM or posted to the DCO. The combination of the margin required by the DCO and the margin required by the FCM may be substantially higher than the margin required by a dealer under an equivalent non-cleared OTC derivative. The more creditworthy counterparties will be the ones most affected by these increased margin requirements.
  • Although a dealer under a CSA for a non-cleared OTC derivative may be required to post collateral to the counterparty, collateral posting for cleared swaps is a one-way obligation that is imposed only on the counterparty and neither a DCO nor an FCM will post collateral to the counterparty.[49] This means that if an FCM or DCO becomes insolvent, a counterparty will not have any collateral posted to cover the obligation of the FCM or DCO in respect of the cleared swap positions.

Conclusion

The unprecedented regulatory response to the perceived dangers of the OTC derivatives markets is transforming clearing requirements in these multi-trillion dollar markets. The impact of regulatory changes on collateralization requirements and, more generally, on how counterparties to OTC derivatives mitigate counterparty risk cannot be overstated. Although margin delivered by counterparties to cleared OTC derivatives may be better protected from the insolvency risk of the pledgee under the new regulatory regime, counterparties to cleared swaps will also be subject to more stringent collateral delivery requirements that will be more expensive and more difficult to implement operationally.

 

 

Preferred citation: Paul Watterson, Joseph Suh & Craig Stein, Margin Costs of OTC Swap Clearing Rules, 3 Harv. Bus. L. Rev. Online 152 (2013), https://journals.law.harvard.edu/hblr//?p=3248.

* Paul Watterson Partner, Schulte Roth & Zabel LLP; Joseph Suh Partner, Schulte Roth & Zabel LLP; Craig Stein Partner, Schulte Roth & Zabel LLP. Thanks to Jacob Wentworth Associate, Schulte Roth & Zabel LLP for his contributions to this article.

[1] Product Descriptions and Frequently Asked Questions, ISDA, http://www.isda.org/educat/faqs.html#1 (last visited Apr. 11, 2013).

[2] Prior to the financial crisis, OTC transactions were largely conducted without regulatory supervision. See Matthew Philips, Traders Take Their Swaps Deals to Futures Exchanges, Bloomberg Businessweek (Jan. 24, 2013), http://www.businessweek.com/articles/2013-01-24/traders-take-their-swaps-deals-to-futures-exchanges.

[3] See id.

[4] See, e.g., Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74,284, 74,284–85 (Dec. 13, 2012) (to be codified at 17 C.F.R. pts. 39, 50).

[5] See Letter from Carl Levin, Chairman, Permanent Subcomm. on Investigations, to Elizabeth M. Murphy, Sec’y, Sec. & Exch. Comm’n (Dec. 20, 2010), available at http://www.sec.gov/comments/s7-27-10/s72710-101.pdf.

[6] See Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report 386 (2011), available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.

[7] The G-20 includes Argentina, Australia, Brazil, Canada, China, European Union, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom, and the United States. See What Is the G20, G20.org, http://www.g20.org/docs/about/about_G20.html (last visited Apr. 11, 2013).

[8] See Fin. Stability Bd., Implementing OTC Derivatives Market Reforms 3–4 (2010), available at http://www.financialstabilityboard.org/publications/r_101025.pdf.

[9] Regulators in Japan, Singapore, Hong Kong, and the European Union have all taken steps to advance central clearing in their respective jurisdictions. See id. at 50–51.

[10] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[11] 7 U.S.C. §§ 1–27f (2012).

[12] 15 U.S.C. §§ 78a–78pp (2012).

[13] See Dodd-Frank Act §§ 722, 761–62.

[14] Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74,284 (Dec. 13, 2012) (to be codified at 17 C.F.R. pts. 39, 50).

[15] 7 U.S.C. § 2(h)(1)(A).

[16] See id. § 2(h)(2).

[17] Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74,287.

[18] See id. at 74,336.

[19] Id. at 74,331.

[20] Id. at 74,284.

[21] Id. at 74,335–36.

[22] See Dietmar Franzen, Design of Master Agreements for OTC Derivatives 17–19 (2001).

[23] See, e.g., Credit Support Annex to the Schedule to the Master Agreement dated as of Dec. 14, 2009 Between JP Morgan Chase Bank, N.A. and Arcos Dorados B.V., Exhibit 10.20, in Arcos Dorados Holdings Inc., Amendment No. 1 to Registration Statement (Form F-1/A) (Apr. 8, 2011), available at http://www.sec.gov/Archives/edgar/data/1508478/000119312511077213/dex1020.htm.

[24] See, e.g., Ameritrade, Futures Client Agreement (2013), available at https://www.tdameritrade.com/retail-en_us/resources/pdf/TDA600.pdf. The counterparty will also need to enter into an addendum that modifies the futures account client agreement to address cleared OTC derivatives and an execution agreement that addresses the processing of cleared OTC derivatives, including the submission and acceptance of OTC derivatives into central clearing and consequences of failure of trade submissions. See ISDA Cleared Swap Documentation, ISDA, http://www.isda.org/publications/isda-clearedswap.aspx (last visited Apr. 11, 2013).

[25] Sean Walters, One Lehman Lesson: The Perils of Rehypothecation, Wall St. J. (Sept. 25, 2008), http://online.wsj.com/article/SB122226999067271415.html.

[26] See Harriet Agnew, Rehypothecation Is Being Redefined, Financial News (Sept. 13, 2010), http://www.efinancialnews.com/story/2010-09-13/rehypothecation-is-being-redefined.

[27] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 724, 124 Stat. 1376, 1682–85 (2010).

[28] LSOC It to Me, derivatiViews (Jan. 17, 2012), http://isda.derivativiews.org/2012/01/17/lsoc-it-to-me/.

[29] Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. 6336, 6339–40 (Feb 7, 2012) (to be codified at 17 C.F.R. pts. 22, 190).

[30] Id.

[31] The final rule defines commingling as holding “such items in the same account, or to combine such items in a transfer between accounts.” 17 C.F.R. § 22.1 (2012).

[32] Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. at 6339.

[33] See Int’l Swaps & Derivatives Ass’n, et al., Independent Amounts 3–4 (2010), available at https://www.managedfunds.org/wp-content/uploads/sites/87/2013/02/Independent-Amount-WhitePaper-Final.pdf; Maroan Maizar, et al., Credit and Counterparty Risk: Why Trade Under an ISDA with a CSA?, GesKR, Jan. 2010, at 63, 65, available at http://www.baerkarrer.ch/upload/publications/08_33_2608_Maizar_Jacquet_Spillmann3.pdf.

[34] See Int’l Swaps & Derivatives Ass’n, ISDA Margin Survey 2012 14 (2012), available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/; The Bilateral World vs The Cleared World, derivatiViews (Apr. 24, 2012), http://isda.derivativiews.org/2012/04/24/the-bilateral-world-vs-the-cleared-world/.

[35] See Int’l Swaps & Derivatives Ass’n, et al., Independent Amounts, supra note 33, at 3–4.

[36] See id. at 36 n.7.

[37] Parties to an ISDA Master Agreement with a New York law CSA memorialize their negotiated collateral terms by modifying paragraph 13 of the CSA. See, e.g., Credit Support Annex to the Schedule to the Master Agreement dated as of Dec. 14, 2009 Between JP Morgan Chase Bank, N.A. and Arcos Dorados B.V., supra note 23.

[38] See Derivatives Clearing Organization General Provisions and Core Principles, 76 Fed. Reg. 69,334, 69,439 (Nov. 8, 2011) (to be codified at 17 C.F.R. pts. 1, 21, 39, 140).

[39] Id.

[40] Counterparties do not post this margin directly to the DCO. Instead, they post such collateral to their FCMs which, in turn, post the collateral to the DCOs. See Protection of Customer Funds: Frequently Asked Questions, Futures Indus. Ass’n 2–4 (June 2012), http://www.futuresindustry.org/downloads/PCF-FAQs.PDF.

[41] See The Bilateral World vs The Cleared World, supra note 34.

[42] Id.

[43] See Nick Sawyer, OTC Derivatives Clearing Summit: Joint Solution Needed on Intraday Margin Calls, Says Panel, Risk.net (Sept. 20, 2012), http://www.risk.net/risk-magazine/news/2206841/otc-derivatives-clearing-summit-joint-solution-needed-on-intraday-margin-calls-says-panel; Matt Cameron, Clearing Members Fear $5 Billion Intra-Day Funding Burden, Risk.net (Nov. 7, 2012), http://www.risk.net/risk-magazine/feature/2221963/clearing-members-fear-usd5-billion-intraday-funding-burden.

[44] See Mike Kentz, Costs of Derivatives Clearing Stack Up for Buy-Side, Reuters, Apr. 8, 2013, available at http://www.reuters.com/article/2013/04/08/us-credit-derivatives-idUSL2N0CV0TD20130408.

[45] Id.

[46] See Acceptable Collateral, LCH.Clearnet, http://www.lchclearnet.com/risk_management/ltd/acceptable_collateral.asp (last visited Apr. 11, 2013). Some DCOs also accept certain highly rated sovereign securities and other fixed income securities as collateral. See, e.g., Securities Collateral, Eurex Clearing, http://www.eurexclearing.com/clearing-en/collateral-management/securities-collateral/ (last visited Apr. 11, 2013).

[47] See, e.g., Collateral Management for Centrally Cleared Derivatives, J.P.Morgan (2011), available at http://bit.ly/13O3Nnq.

[48] See Protection of Customer Funds: Frequently Asked Questions, supra note 40, at 6.

[49] The Basics on Futures & Options, Kan. City Bd. of Trade, http://www.kcbt.com/trading_basics.html (last visited Apr. 11, 2013). The existing regime of the commodity futures trading business was the basis for the CFTC’s scheme of regulating the clearing of OTC derivatives.

By

Regulation of Cross-Border Swaps

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David Felsenthal and Lily Chu*

I. Introduction

At a recent Washington roundtable on derivatives regulation, a senior staff member of the European Commission took the unusual step of publicly telling U.S. regulators: “Washington, we have a problem.”[1] The problem is U.S. regulation of cross-border swaps. Specifically, the U.S. Commodity Futures Trading Commission (CFTC) has issued proposed rules that subject any swap between a U.S. person and a non-U.S. person to U.S. swap regulation generally. This presents obvious conflicts with foreign regulation. For example, a cross-border swap cannot be cleared in both a U.S.-registered clearinghouse and separately in a different clearinghouse registered in the European Union (EU). We suggest below an alternative regulatory approach to cross-border swaps: U.S. regulators should consider each transaction-level requirement (including clearing and margin) and propose specific cross-border solutions that recognize both the U.S. policy goals and the potential for conflicts with foreign laws and regulations.

II. International Swap Regulation

A. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)

The Dodd-Frank Act amended section 2(i) of the Commodity Exchange Act (CEA) and section 30(c) of the Securities Exchange Act of 1934 (Exchange Act) to address jurisdiction over swaps and security-based swaps (SB Swaps).[2] However, the provisions do not provide clear guidance as to how the Dodd-Frank Act and related regulation govern derivatives trades between U.S. persons and non-U.S. persons, which we refer to as “cross-border swaps.” Section 2(i) provides that regulation under the Dodd-Frank Act does not apply to swap activity conducted outside the United States, unless that activity has a “direct and significant connection with activities in, or effect on, commerce of the United States.”[3] Similarly, section 30(c) of the Exchange Act provides that regulation adopted under the Dodd-Frank Act does not apply to SB Swaps transactions executed “without the jurisdiction” of the United States unless the activity contravenes other regulation enacted to counter evasion of Dodd-Frank Act provisions.[4] While the language of these amended sections of the CEA and the Exchange Act recognizes that there should be limits on the extraterritorial reach of these statutes, it does not define “outside” or “without” the U.S. or give guidance as to how the relevant statutes should be interpreted in the specific case where a swap trade is between a U.S. person and a non-U.S. person.[5]

B. Treatment of Cross-Border Transactions Before the Dodd-Frank Act

Prior to the adoption of the Dodd-Frank Act, there was no U.S. regulation of swaps. U.S. regulation of similar financial products (such as futures and options) offers helpful insights in fashioning a workable approach to cross-border swaps. For example, the CFTC has adopted rules under the CEA that govern the sale of foreign exchange-traded futures and options to U.S.-based investors.[6] Under section 30.5 of these rules, a non-US broker involved in foreign futures and options transactions with U.S. persons may apply to the CFTC for an exemption from otherwise applicable registration requirements.[7] Similarly, Rule 15a-6 adopted by the Securities Exchange Commission (SEC) provides that foreign broker-dealers engaging in securities transactions with U.S. investors may be exempt from SEC registration if the foreign broker-dealer complies with specified requirements (such as selling only to registered U.S. broker-dealers or banks).[8] These exemptions demonstrate acknowledgement by the CFTC and the SEC that some aspects of cross-border transactions ought not be subject to full U.S. regulation.

Just prior to the enactment of the Dodd-Frank Act, the U.S. Supreme Court ruled on a case regarding the scope of extraterritorial application of U.S. securities regulation. In Morrison v. National Australia Bank Ltd., the Supreme Court held that the anti-fraud provisions of U.S. securities laws do not apply to purchases by non-U.S. investors of securities of a foreign issuer traded on a foreign exchange—despite the investors’ claim that the fraud was committed in the United States.[9] The Court adopted a transactional test to determine whether section 10 of the Exchange Act applied: “whether the purchase or sale is made in the United States, or involves a security listed on a domestic exchange.”[10] In this case, the Court rejected the notion that the Exchange Act governs conduct taking place in the United States that affects exchanges or transactions abroad based in part on “[t]he probability of incompatibility with the applicable laws of other countries.”[11] While Morrison does not address whether U.S. regulation under the CEA should apply to a swap between a U.S. person and a non-U.S. person, it does discuss considerations that should limit the extraterritorial reach of U.S. regulators.

C. Regulation Under the Dodd-Frank Act

Transaction-Level Requirements: The CFTC has proposed and adopted a number of requirements directly applicable to swaps transactions (transaction-level requirements) as well as rules applicable to regulated entities such as swap dealers (entity-level requirements). Because entity-level requirements do not apply directly to cross-border swaps (except with respect to reporting, as described further below), this Article focuses on transaction-level requirements. The transaction-level requirements are: (i) mandatory clearing of swaps; (ii) mandatory execution (i.e. trading) on a centralized exchange or swap execution facility; (iii) collection of margin on uncleared swaps; (iv) requirements for swap documentation; (v) requirements regarding portfolio reconciliation and portfolio compression; (vi) real-time public reporting of swaps activity; (vii) requirements regarding confirmation of trades; (viii) retention of daily trading records; and (ix) standards for business conduct between swap dealers and their counterparties.[12]

Reporting: In addition to the transaction-level requirements, the CFTC has adopted rules requiring regular and timely reporting of swaps transactions and life-cycle information.[13] While these rules are listed among the entity-level requirements, they clearly affect cross-border transactions and are therefore discussed below.

CFTC interpretive guidance and exemptive order: The CFTC has issued several interpretative guidances and orders related to cross-border swaps. In July 2012, the CFTC issued proposed guidance on extraterritorial application of swap regulation.[14] This was accompanied by a proposed exemptive order to provide relief from certain requirements for cross-border swaps.[15] In December, the CFTC issued a final exemptive order and further proposed guidance regarding cross-border swaps.[16]

The effect of the proposed guidance is that all U.S. transaction-level rules apply, with one exception, to any swap to which a U.S. person is a party.[17] The exception is that non-U.S. branches of U.S. swap dealers that face non-U.S. persons are exempt from transaction-level requirements at least until July 2013.[18]

The broad extraterritorial reach of these requirements has resulted in considerable criticism. In her concurring statement at the time the final exemptive order providing cross-border relief was adopted, CFTC Commissioner Jill Sommers commented that the CFTC’s extraterritorial reach seemed to have been guided by the “Intergalactic Commerce Clause.”[19] In October 2012, ministerial-level representatives of the U.K., Japan, France, and the European Commission sent a joint letter to the Chairman of the CFTC expressing concerns about the CFTC’s regulation of cross-border swaps and urging the CFTC to “take the time to ensure that US rulemaking works not just domestically but also globally.”[20] They advocated coordination among their respective regulatory agencies to adopt cross-border rules that would avoid fragmentation of global markets.[21] More recently, Michel Barnier, a Member of the European Commission, publicly criticized the reach of U.S. derivatives regulation as follows: “expanding interpretation of home-grown rules to [derivatives] transactions that are already covered by equally solid foreign rules will only lead to legal conflicts. It will create uncertainty, increase costs and push trade to less well regulated places.”[22]

This international criticism is troubling in light of the international cooperation mandate found in section 752 of the Dodd-Frank Act.[23] This provision requires relevant U.S. regulators, including the CFTC and the SEC, to consult and coordinate with foreign regulatory authorities on the establishment of consistent international standards with respect to the regulation of swaps, SB Swaps, swap entities, and SB Swap entities as appropriate to promote effective and consistent global regulation of swaps and SB Swaps.[24] To address the likely incompatibility of U.S. derivatives regulation of cross-border swaps with other countries’ derivatives regulations, the extraterritorial reach of the CFTC swap considerations should be reconsidered.

SEC: The SEC has authority over SB Swaps similar to that of the CFTC has over swaps.[25] At the time of writing, however, the SEC has not yet finalized its regulations governing SB Swaps under the Dodd-Frank Act and has yet to address the treatment of cross-border SB Swaps.

D. Proposal

We do not believe that there is any simple, one size-fits-all remedy for regulation of cross-border swaps. We recognize that some U.S. regulatory oversight is appropriate for cross-border swaps involving a U.S. person as a party. Obviously, harm can be inflicted on the U.S. economy and U.S. market participants through swaps between a U.S. person and a non-U.S. person.[26] The CFTC cites the collapses of AIG and Lehman Brothers as examples of such harm.[27] AIG, an insurance company incorporated in the U.S., suffered enormous financial losses related to credit default swaps entered into with non-U.S. counterparties via its operations in London.[28] Similarly, Lehman Brothers was forced into bankruptcy at least in part due to losses on swaps positions held by its European subsidiary, Lehman Brothers International (Europe), positions that were guaranteed by the U.S. parent company, Lehman Brothers Holding Inc.[29] At the same time, other countries also have an interest in regulating cross-border swaps. Simply requiring that all U.S. requirements apply to any cross-border swap that involves a U.S. person will result in inevitable conflicts with other laws and would effectively terminate, or at least sharply reduce, the cross-border swap market. To repeat the example given above, a swap can only be cleared once and therefore cannot be cleared in both a U.S. clearinghouse and a European clearinghouse. Imposing U.S. requirements without regard to foreign rules would also conflict with the international cooperation mandate found in Title VII of the Dodd-Frank Act.[30]

We propose therefore that each transaction-level requirement be considered separately, and that specific rules be adopted for each type of transaction-level requirement. These rules, when applied to cross-border swaps involving a U.S. person as a party, should reflect the objectives of the relevant transaction-level requirement while taking into account the likelihood (and likely practical impact) of conflict with other countries’ laws. We set out our specific suggestions below.

1. Clearing

Requirement: If the CFTC designates a swap as subject to mandatory clearing, the swap must be cleared through a derivatives clearing organization (DCO) registered with the CFTC or a DCO that is exempt from registration.[31]

Proposal: In two recent no-action letters, the CFTC has recognized clearinghouses in Singapore and Japan as eligible to clear U.S. swaps.[32] The no-action relief granted by these letters is conditioned on a requirement that the non-U.S. clearinghouses apply to be registered with the CFTC as DCOs. We suggest that the CFTC establish an application procedure for recognizing other non-U.S. clearing organizations. Under section 2(h)(1) of the CEA, mandatory clearing can occur through a clearing organization that is exempt from registration.[33] In addition, section 5b(h) of the CEA provides that the CFTC may exempt a DCO from registration if it is subject to “comparable, comprehensive supervision and regulation . . . in the home country of the [DCO].”[34] As a result, the CFTC need not require registration as a DCO in all cases where non-U.S. clearinghouses propose to clear U.S. swaps.

2. Margin for Uncleared Swaps

Requirement: The Dodd-Frank Act requires swap dealers to comply with margin requirements for uncleared swaps as prescribed by the applicable regulators.[35] The CFTC, the SEC, U.S. prudential regulators,[36] and the BCBS/IOSCO Working Group on Margining Requirements (WGMR) have proposed margin requirements, [37] which have not yet been finalized.

Proposal: The margin requirements for uncleared swaps will impose standards on the amount of collateral, the models used to determine amounts, the eligible types of collateral, the time for posting of collateral and other issues. Given the many different detailed operational requirements for collateral positing, it will become difficult, if not impossible, for either party in a cross-border transaction to comply with margin requirements imposed by two jurisdictions.

The most recent WGMR release supports the idea of using only the margin requirements applicable to the collecting entity.[38] In addition, the release suggests that if the relevant regulators for each party find the other jurisdiction’s rules to be consistent, then the regulators should allow the parties to choose the margin rules of one jurisdiction or another.[39]

The WGMR’s suggestion appears to be a sensible idea of dealing with a difficult issue. The CFTC should establish a procedure for reviewing margin requirements of other jurisdictions as they are adopted. Such a procedure could recognize the different categories of swap counterparties—inter-dealer, between dealer and financial users, and between dealer and corporate end-users—and check for consistency within each category.

3. Trade Execution

Requirement: Swaps subject to the mandatory clearing requirement must be executed on a centralized trading facility, which may be a designated contract market (DCM), a registered swap execution facility (SEF), or a SEF that is exempt from registration.[40]

Proposal: As with clearing, if the parties to a swap are subject to trade execution requirements in different jurisdictions, an impossible situation can arise. The swap cannot be executed in both jurisdictions. We propose a similar cross-border approach to the approach suggested above for clearinghouses. U.S. regulators can propose a procedure for approving individual foreign DCMs or SEFs. For SEFs, like DCOs, the swaps can be executed through exempted SEFs as well as registered SEFs. The CEA specifically permits the CFTC to exempt a SEF from registration if it is subject to “comparable, comprehensive supervision and regulation . . .  in the home country of the facility.”[41] This would be consistent with the approach taken in part 30 of the CFTC’s rules under the CEA, which exempts a broker who trades in foreign futures and options that are executed on a foreign board of trade from certain requirements under the CEA.[42]

4. Swap Documentation and Confirmation

Requirement: Pursuant to CEA section 4s(i), the CFTC has adopted rules that prescribe standards for documentation of the swap counterparty relationship and trade confirmations.[43] These rules specify which documents and information must be exchanged between counterparties to a swap. The required documentation includes trade confirmations and the rules establish time frames during which confirmations must be executed.[44]

Proposal: Conflicting requirements regarding swap documentation in the respective jurisdictions of the counterparties will hinder trade execution and market liquidity. These requirements are primarily driven by the need for dealers to maintain appropriate records. As a result, we propose the following: if only one counterparty to the swap is a swap dealer, defer to the regulation of the swap dealer’s jurisdiction. If both parties are swap dealers, regulators should apply a similar rule to that proposed by the WGMR with respect to margin regulations: the U.S. should evaluate and identify other jurisdictions that have rules that are consistent with U.S. rules. For cross-border swaps involving a U.S. party and a party in such a jurisdiction, the parties should be able to choose which rules will apply.

5. Business Conduct

Requirement: Pursuant to section 4s(h) of the CEA, the CFTC has adopted standards for business conduct by swap dealers entering into swaps with counterparties.[45] These standards include disclosure and due diligence requirements regarding counterparty eligibility and institutional suitability.[46]

Proposal: The application of divergent business conduct requirements to cross-border swaps exposes swap dealers to greater risk of violating regulatory requirements and the potential for compliance costs to outweigh the economic benefits of entering into swaps. We propose that the applicable business conduct standards should be those of the jurisdiction of the party that is not a swap dealer. This approach provides the non-dealer counterparty the assurance that it will receive the protections afforded by its home jurisdiction.

6. Recordkeeping

Requirement: All parties to swaps are required to retain records related to swaps transactions under parts 45 and 46 of the CFTC’s rules under the CEA.[47] According to these rules, parties are to retain records of certain historical swaps and new swaps for the life of the swap and for a period of at least five years after the termination of the swap.[48]

Proposal: Swap dealers are required to keep records as prescribed by the rule. However, the language of the recordkeeping rule is unclear as to its application to counterparties that are not swap dealers and are not U.S. persons. The rule states that counterparties that are not swap dealers but that are “subject to the jurisdiction of” the CFTC shall keep records as required under the rule.[49] It is not clear from this language whether a party outside the U.S. would be required to keep records under these CFTC regulations. Because the recordkeeping requirements apply to any swap party (and not just dealers), applying this requirement to non-U.S. parties is potentially very onerous. To alleviate this and other issues that are likely to arise with cross-border trades, we propose that the applicable recordkeeping requirements should be those of the jurisdiction of the party keeping the records.

7. Swap Data Repository Reporting and Real-Time Public Reporting

Requirement: Information on swaps transactions must be reported to a swap data repository (SDR) within time frames specified in the CFTC’s SDR reporting rules.[50] The CFTC’s rules also require SDRs to disseminate specified trade information to the public on a real-time basis.[51]

Proposal: If different reporting requirements apply to a cross-border trade, issues may arise if counterparties report inconsistent information to SDRs. In addition, market participants may have difficulty in accessing and analyzing complete trade records if information is reported to and housed in different SDRs in different jurisdictions. We suggest that for swaps executed on an SEF or cleared through a DCO, the rules of the jurisdiction of the SEF or DCO apply. For all other swaps, we suggest that the regulators make every effort to harmonize their reporting requirements so that the same information can be used for U.S. and non-U.S. SDRs.

8. Portfolio Reconciliation and Compression

Requirement: Swap dealers are required to reconcile with their counterparties on a regular basis, with minimum frequencies established by the CFTC’s rules.[52] Swap dealers are also required to establish procedures to perform portfolio compression exercises.[53]

Proposal: These portfolio-related requirements generally require participation and cooperation of both counterparties to a swap. If parties to a cross-border trade are subject to inconsistent portfolio-related requirements, compliance may not be possible. We propose that, if only one party to the cross-border swap is a swap dealer, the rules of the swap dealer’s jurisdiction apply. If both parties to the cross-border swap are swap dealers, then we suggest, as for margin and swap documentation, that the U.S. regulators determine which foreign jurisdictions have rules consistent with U.S. rules. For cross-border swaps involving a U.S. party and a party in such a jurisdiction, the parties should be able to choose which rules will apply.

III. Conclusion

The broad extraterritorial reach currently espoused by the CFTC for cross-border swaps is inconsistent with the Dodd-Frank Act’s international cooperation mandate and has the potential to significantly disrupt the swaps markets. If a cross-border swap were made to comply with divergent regulations of two countries, it would expose swap dealers to the risk of violating regulatory requirements and could make compliance cost outweigh the economic benefits of entering into swaps.

We recognize that some U.S. regulatory oversight is appropriate for cross-border swaps that involve a U.S. person and acknowledge that there is no simple, one size-fits-all approach for regulating cross-border swaps. To avoid significant practical obstacles to cross-border swap transactions, we suggest a framework that applies each type of transaction-level requirement to non-U.S. persons on a rule-by-rule basis, taking into account the objectives of the relevant transaction-level requirement and the likelihood of incompatibility with other countries’ regulations.

 

 

Preferred citation: David Felsenthal & Lily Chu, Regulation of Cross-Border Swaps, 3 Harv. Bus. L. Rev. Online 142 (2013), https://journals.law.harvard.edu/hblr//?p=3232.

* David Felsenthal Partner, Clifford Chance US LLP and Lily Chu Associate, Clifford Chance US LLP. Thanks to Mary Johannes, Rebecca Hoskins and Chris Bates for their assistance.

[1] Patrick Pearson, Head of Unit, Fin. Mkt. Infrastructure, European Comm’n, Remarks at Global Market Advisory Committee Meeting (Nov. 7, 2012) (transcript available at http://www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/gmac_110712_transcript.pdf).

[2] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 722, 772, 124 Stat. 1376, 1672–75, 1801–02 (2010).

[3] Id. § 722(d).

[4] Id. § 772(b).

[5] There is also a question of who is a “U.S. person” for these purposes. This question, which has been extensively discussed in CFTC releases, is beyond the scope of this Article.

[6] 17 C.F.R. §§ 30.1–.13 (2012).

[7] Id. § 30.5.

[8] Id. § 240.15a-6.

[9] 130 S. Ct. 2869, 2888 (2010).

[10] Id. at 2886.

[11] Id. at 2885.

[12] Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41,214, 41,225 (proposed July 12, 2012) (to be codified at 17 C.F.R. ch. I).

[13] See Swap Data Recordkeeping and Reporting Requirements, 77 Fed. Reg. 2136 (Jan. 13, 2013) (to be codified at 17 C.F.R. pt. 45); Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, 77 Fed. Reg. 35,200 (June 12, 2012) (to be codified at 17 C.F.R. pt. 46).

[14] See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, supra note 12.

[15] Exemptive Order Regarding Compliance with Certain Swap Regulations, 77 Fed. Reg. 41,110 (proposed July 12, 2012).

[16] Final Exemptive Order Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg 858 (Jan. 7, 2013); Further Proposed Guidance Regarding Compliance with Certain Swap Regulations, 78 Fed. Reg. 909 (proposed Jan. 7, 2013) (to be codified at 17 C.F.R. ch. I).

[17] This result is indicated in the summary tables at the end of the Proposed Guidance and the Final Order. See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, supra note 12, at 41,237 (Category B table).

[18] Final Exemptive Order Regarding Compliance with Certain Swap Regulations, supra note 16, at 861.

[19] Jill E. Sommers, Comm’r, U.S. Commodity Futures Trading Comm’n, Statement of Concurrence: (1) Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, Proposed Interpretive Guidance and Policy Statement; (2) Notice of Proposed Exemptive Order and Request for Comment Regarding Compliance with Certain Swap Regulations (June 29, 2012) (transcript available at http://www.cftc.gov/PressRoom/SpeechesTestimony/sommersstatement062912).

[20] Letter from George Osborne, Chancellor of the Exchequer, UK Gov’t, et al., to Gary Gensler, Chairman, U.S. Commodity Futures Trading Comm’n (Oct. 17, 2012), available at http://www.fsa.go.jp/inter/etc/20121018-2/01.pdf.

[21] Id.

[22] Michel Barnier, Member responsible for Internal Mkt. & Servs., European Comm’n, Why Global Markets Require Global Rules—and US-EU Cooperation (Feb. 15, 2013) (transcript available at http://europa.eu/rapid/press-release_SPEECH-13-125_en.htm).

[23] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 752, 124 Stat. 1376, 1749–50 (2010).

[24] Id.

[25] Id. § 712.

[26] We believe there are also significant issues in defining the term “U.S. person” for these purposes, but those issues go beyond the scope of this Article.

[27] Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, supra note 12, at 41,215.

[28] Id.

[29] Id.

[30] Dodd-Frank Act § 752.

[31] 7 U.S.C. § 2(h) (2012).

[32] Japan Sec. Clearing Corp., CFTC No-Action Letter, CFTC Letter No. 12-56, (Dec. 17, 2012), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-56.pdf; Singapore Exch. Derivatives Clearing Ltd., CFTC No-Action Letter, CFTC Letter No. 12-63, (Dec. 21, 2012), available at http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/12-63.pdf.

[33] 7 U.S.C. § 2(h).

[34] Id. § 7a-1(h).

[35] Id. § 6s(e).

[36] The “prudential regulators” include the Treasury Department (Office of the Comptroller of the Currency), Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Farm Credit Administration and the Federal Housing Finance Agency. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 731, 764, 124 Stat. 1376, 1703–12, 1784–96 (2010); 7 U.S.C. § 6s(e).

[37] Basel Comm. on Banking Supervision & Bd. of the Int’l Org. of Sec. Comm’ns, Consultative Document: Margin Requirements for Non-Centrally-Cleared Derivatives (July 2012), available at http://www.bis.org/publ/bcbs226.pdf; Basel Comm. on Banking Supervision & Bd. of the Int’l Org. of Sec. Comm’ns, Second Consultative Document: Margin Requirements for Non-Centrally Cleared Derivatives (Feb. 2013), available at http://www.bis.org/publ/bcbs242.pdf.

[38] Basel Comm. on Banking Supervision & Bd. of the Int’l Org. of Sec. Comm’ns, Second Consultative Document, supra note 37, at 19–21.

[39] Id.

[40] See 7 U.S.C. § 7b-3.

[41] Id.

[42] See 17 C.F.R. § 30.3(a) (2012).

[43] Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, 77 Fed. Reg. 55,904 (Sep. 11, 2012) (to be codified at 17 C.F.R. pt. 23).

[44] Id. at 55,945–46.

[45] Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties, 77 Fed. Reg. 9734 (Feb. 17, 2012) (to be codified at 17 C.F.R. pts. 4, 23).

[46] Id. at 9823–24.

[47] Swap Data Recordkeeping and Reporting Requirements, supra note 13; Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, supra note 13.

[48] See Swap Data Recordkeeping and Reporting Requirements, supra note 13, at 2197–99; Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, supra note 13, at 35,226–28.

[49] See Swap Data Recordkeeping and Reporting Requirements, supra note 13, at 2198.

[50] See id. at 2199–2202; Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps, supra note 13, at 35,227–28.

[51] See 7 U.S.C. § 2(a)(13) (2012); Real-Time Public Reporting of Swap Transaction Data, 77 Fed. Reg. 1182 (Jan. 9, 2012) (to be codified at 17 C.F.R. pt. 43).

[52] Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, supra note 43, at 55,927–28.

[53] Id. at 55,932–36.

By

Credit Default Swaps: Dubious Instruments

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Charles W. Murdock *

Introduction

The past thirty to forty years have witnessed fundamental changes in the nature of our economy, arguably not for the better. At one time, financial institutions were intermediaries; they allocated capital among competing users to ensure the most efficient use of capital. Today, financial institutions are consumers of capital more than allocators of capital. From 1994 to 2009, the assets of the six largest banks in the U.S. grew from 14.8% of gross domestic product (GDP) to 62.1% of GDP.[1] Forty years ago, a major trading day on the New York Stock Exchange involved twenty million shares being traded.[2] In the past three years, daily trading volume has generally ranged from one billion to two billion shares and, at times, has exceeded four billion shares.[3] This increase is due, at least in part, to the fact that institutions have gone from being investors to being traders. Portfolios are turned over, not every seven years, but every seven months.[4]

Derivatives and other “innovative” financial instruments such as collateralized debt obligations (CDOs) and synthetic CDOs were largely responsible for the collapse of the economy in 2008.[5] The development of these instruments has also contributed to increased trading activity. Prior to 2000, derivatives were a minor factor in the economy. In June 2000, the notional volume of derivatives was $94 trillion.[6] By June 2011, derivative volume had risen to $706.884 trillion, before falling back to $638.928 trillion in June 2012.[7] This is an eight-fold to nine-fold increase in such volume. Although correlation certainly does not imply causation, it is fairly clear that the economy performed far better in the late 1990s.

The Faulty Rationale of Credit Default Swaps

In a global economy, there are understandable rationales for derivatives such as foreign exchange contracts.[8] A party to a contract in one country who transacts with a party in another country may not want to take the risk of currency fluctuations. Similarly, with respect to interest rate contracts,[9] a person holding a contract with a variable rate might prefer the security of a fixed rate return. However, there is little justification for the existence of credit default swaps (CDSs),[10] and particularly for “naked” CDSs. The financial industry is quick to defend CDSs on the basis that they reduce risk; naked default swaps are justified on the basis that they provide liquidity and price discovery.[11] These assertions are supposedly self-evident but there is another side to the story.

Consider a classic example of how CDSs reduce risk. A customer requests very substantial financing from her bank. The bank wishes to please its customer, but does not want to assume a large credit risk. With the advent of CDSs, the bank can purchase protection to reduce its overall risk exposure. In the past, the bank in question could have accomplished the same objective by putting together a syndicated loan or a consortium of banks. While this continues to be a possibility, advocates of CDSs would argue their approach is faster and more efficient. There are, however, many tradeoffs to speed and efficiency. One such opportunity cost is diligence.[12] The recent history of the banking industry epitomizes a lack of due diligence.[13]

An additional concern is the difficulty in adequately pricing CDSs. Since each transaction is unique, there is a dearth of market information about each particular transaction. Reference could be made to the general default swap market, but such information is no more accurate than that which could be obtained from the bond or other market. Where there is a market for the underlying bonds and CDSs, supposedly the CDS market leads the cash bond market in price discovery. But, as Richard Portes has pointed out, “‘leadership’ may be the result not of better information, but of the effect of CDS prices on the perceived creditworthiness of the issuer.”[14] This result obtains because a small group of firms dominates the derivatives market,[15] thereby raising questions about pricing efficiency. Moreover, studies from the European Union (EU) suggest that speculation in CDSs may, at least in the short run, lead to mispricing.[16]

Finally, there is a question of how much liquidity exists in a thin market. JPMorgan Chase was supposedly expert in managing risk. Thus, it came as a shock when it announced that its chief investment office (CIO) had lost $2 billion in trading.[17] As a further surprise, it next reported a $4.4 billion loss.[18] Its own estimate rose to almost $6 billion and there was speculation that it could go as high as $9 billion.[19] This dramatic increase was caused, at least in part, because of the difficulty that JPMorgan was having in unwinding its positions.[20]

An Introduction to Naked Credit Default Swaps

While there are issues generally with regard to covered CDSs, these are magnified when considering naked CDSs.[21] With covered CDSs, even though the buyer of protection has an interest in the underlying obligation, she faces a moral hazard problem. This problem arises because the holder of the obligation with respect to which protection is sought has, or at least should have, an informational advantage over the party furnishing protection and thus could take advantage of the person providing protection. It is the holder of the instrument who should be responsible for due diligence. Compared to the party furnishing protection, the holder has the relationship, the access, and the leverage to properly assess credit risk. Thus, to use a gambling analogy, CDSs are like gambling with loaded dice since the buyer of protection has better information than the provider of protection.

Despite the exacerbated moral hazard issues engendered by CDSs, they are permitted because the financial industry lobbied to ensure CDSs would not be treated as insurance under the Dodd-Frank Wall Street Reform and Consumer Protection Act.[22] If they were treated as insurance, the purchaser would need to have an insurable interest in the subject of insurance.[23] Since holders of naked CDSs have not extended credit to the debtor, they have no insurable interest. As an example, when homeowners buy protection against their house burning down, it is in their best interest that their house does not burn down. Similarly, in a covered CDS, the buyer would prefer that the debt be repaid and purchases insurance to protect against an event that the buyer of protection does not want to occur; namely, the debtor’s default. Conversely, in a naked CDS, the “investor” who purchases protection wants the credit default to occur in order to get paid. Otherwise, the “premiums” that the purchaser of protection pays would be wasted.[24]

The moral hazard in this latter situation is illustrated by the Abacus 2007-AC1 synthetic CDO that Goldman Sachs assembled at the instance of Paulson & Co. (Paulson), which wanted to bet against the housing market.[25] In marketing the CDO to investors, Goldman Sachs failed to disclose that Paulson participated in choosing the mortgage-based securities against which the investors would provide protection. It was in Paulson’s interest to choose securities that were likely to default so that the parties on the other side of the transaction, who were providing protection, would pay the firm billions of dollars upon default. Goldman Sachs initially argued that Paulson’s role was not material, and thus the failure to disclose was not fraudulent, since any seller of protection of necessity must recognize that there is a counterparty on the other side, who is buying protection with an expectation of default.[26] Nevertheless, Goldman Sachs settled with the Securities and Exchange Commission and paid a $550 million fine.[27]

Regulation of Naked Credit Default Swaps

While Congress rejected a proposal by Senator Dorgan (D-ND) to ban naked CDSs,[28] a proposal heavily criticized in this country,[29] last year the EU adopted such a ban on sovereign debt.[30] This regulation was prompted by studies indicating that short selling and CDSs enabled speculators to distort the creditworthiness of some nations.[31] A European economics professor summarized the concern as follows:

The rise in sovereign and banking CDSs premia changes the market’s expectations about the country’s default probability. Market participants sell bonds and banking stocks in the belief that default risk is greater. The market shifts to a pessimistic equilibrium and, in fact, sovereign default becomes more likely. Accounting for shifts in market sentiment explains the sudden eruption of the crisis in countries like Portugal or Spain, where the fundamentals have deteriorated only progressively.[32]

Professor Delatte was critical of the regulation, which excluded banking CDSs and exempted market makers, because it did not go far enough.[33] She noted that large dealers in CDSs, such as JPMorgan, dominate the market.[34] Similarly, Richard Portes has argued for a broad ban on naked CDSs.[35]

On the other hand, not all economists favor banning naked CDSs.[36] A paper by Camera and Capponi argues that a ban on CDSs decreases liquidity and does not necessarily lower credit spreads in a well functioning market.[37] These arguments overlook a fundamental question: when is the market well functioning and when is it dominated by speculation or manipulation? Professor Portes has offered the following scenario:

Naked CDS, as a speculative instrument, may be a key link in a vicious chain. Buy CDS low, push down the underlying (e.g., short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity—it normally cannot issue at a rate that won’t cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this.[38]

The foregoing leads us into another problematic aspect of CDSs. The alleged fraud of Goldman Sachs has already been discussed[39] and Portes suggests the possibility of manipulation.[40] Consider insider trading and manipulation. The federal government faces substantial difficulties in proving insider trading cases, despite the fact that structurally they are fairly simple.[41] For the government to bring a stock manipulation case is extremely rare since manipulation usually involves multiple transactions, often encompassing more than one market, thereby exacerbating the problems of proof and making it more difficult to explain the case to the ordinary person. The ease of manipulation and the difficulty of proving it increase as the security interacts with more markets. The naked CDS market further adds to this complexity.

The London Whale episode at JPMorgan[42] demonstrates another dark side of CDSs:[43] how capital is diverted from productive uses to speculation. These trading losses occurred in the CIO, which supposedly manages excess cash and which should be conservatively run. Instead, Jamie Dimon, CEO of JPMorgan, turned the office into a profit center. In 2009 and 2010, the CIO made a total profit of almost $8 billion.[44] Hedging, which seeks protection against loss, should be a loss center, not a profit center. Financial statements from the second quarter of 2012 also showed that deposits exceeded loans by $423 billion.[45] Where is this excess found? It can be found in the CIO, where the funds are apparently used not just for speculation but also for deception. JPMorgan’s 8-K report, in revising earnings, stated:

The restatement results from information that has recently come to the Firm’s attention in connection with management’s internal review of activities related to CIO’s synthetic credit portfolio . . .

However, the recently discovered information raises questions about the integrity of the trader marks, and suggests that certain individuals may have been seeking to avoid showing the full amount of the losses being incurred in the portfolio during the first quarter. As a result, the Firm is no longer confident that the trader marks used to prepare the Firm’s reported first quarter results (although within the established thresholds) reflect good faith estimates of fair value at quarter end.[46]

The primary purpose of a bank is to make loans, not speculate. However, Jamie Dimon still asserts that the CIO London Whale transactions were hedging, not speculating transactions.[47] The impact of CDSs on the economy as a whole does not receive sufficient attention when discussing CDSs. This issue is clearly implicated in the activities of JPMorgan’s CIO operation. Institutions are no longer investors, but rather traders.[48] While trading may create wealth for certain few, it does not create value for the general economy. Both homeowners and small businesses are in need of additional credit.[49] To the extent the capital is devoted to trading, it is unavailable for growth producing investment.[50] People are better off fixing up their homes, and businesses are better off investing in new equipment, than going to Las Vegas and gambling. The same holds true in the financial realm. But, as discussed earlier, the lure of the fast buck is irresistible.

Conclusion

Unfortunately, as Dominic Barton observed, our focus on short-term profits instead of long-term planning is a substantial barrier to long-term growth. [51] The issue of CDSs needs to be examined in light of how these instruments add or detract from our overall long-term prosperity.

 

Preferred citation: Charles W. Murdock, Credit Default Swaps: Dubious Instruments, 3 Harv. Bus. L. Rev. Online 133 (2013), https://journals.law.harvard.edu/hblr//?p=3216.

* Charles W. Murdock is currently a professor of law at Loyola University Chicago School of Law, where he formerly served as Dean. From 1982 to 1985, he was the Deputy Attorney General for Illinois. Prior to that, he served as a consultant to the Securities and Exchange Commission. He is also the author of a two-volume treatise on Illinois business law.

[1] Angie Drobnic Holan, Six Largest Banks Getting Bigger, Brown Said, PolitiFact (Apr. 27, 2010), http://www.politifact.com/truth-o-meter/statements/2010/apr/27/sherrod-brown/six-largest-banks-getting-bigger-brown-said/ (citing Federal Reserve Bank of Philadelphia data).

[2] Daily Share Volume in NYSE Listed Issues from 1970 through 1979, NYSE Euronext, http://www.nyse.com/marketinfo/stats/vol70-79.dat (last visited Mar. 25, 2013).

[3] Daily NYSE Group Volume in NYSE Listed, 2010–Current, NYSE Euronext, http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=table&key=3141&category=3 (last visited Mar. 25, 2013).

[4] Dominic Barton, Capitalism for the Long Term, Harv. Bus. Rev., Mar. 2011, at 85, 87 (“In the 1970s the average holding period for U.S. equities was about seven years.”). See also John C. Bogle, Restoring Faith in Financial Markets, Wall St. J. (Jan. 18, 2010), http://online.wsj.com/article/SB10001424052748703436504574640523013840290.html (“[T]he folly of short-term speculation has replaced the wisdom of long-term investing as the star of capitalism. A rent–a-stock system has replaced the earlier own-a-stock system.”).

[5] See Charles W. Murdock, The Dodd-Frank Wall Street Reform and Consumer Protection Act: What Caused the Financial Crisis and Will Dodd-Frank Prevent Future Crises?, 64 S.M.U. L. Rev. 1243 (2011). A recent comment by George Osborne, Britain’s Chancellor of the Exchequer, is equally applicable to the United States: “Irresponsible behavior was rewarded, failure was bailed out, and the innocent—people who have nothing whatsoever to do with the banks—suffered.” Mark Scott, Plan Could Allow Forced Splits of British Banks, N.Y. Times, Feb. 5, 2013, at B4, available at http://dealbook.nytimes.com/2013/02/04/osborne-promises-more-regulatory-power-to-split-up-big-banks/.

[6] See Press Release, Bank for Int’l Settlements, The Global OTC Derivatives Market Continues to Grow (Nov. 13, 2000), http://www.bis.org/press/p001113.htm.

[7] See Bank for Int’l Settlements, BIS Quarterly Review Statistical Annex A141 tbl.19 (Dec. 2012), available at http://www.bis.org/publ/qtrpdf/r_qa1212.pdf.

[8] In June 2012, foreign exchange contracts had a notional value of $66.645 trillion. Id.

[9] In June 2012, interest rate contracts had a notional value of $494.018 trillion. Id.

[10] In June 2012, credit default swaps had a notional value of $26.931 trillion. Id.

[11] See Dave Mason, The Senator Has No Clothes: Why a Ban on “Naked” Credit Default Swaps Is Ill-Advised and Impractical, Heritage Foundation (May 5, 2010), http://www.heritage.org/research/reports/2010/05/the-senator-has-no-clothes-why-a-ban-on-naked-credit-default-swaps-is-ill-advised-and-impractical.

[12] According to Monish Pabrai, who runs a $500 million fund, when you see what looks like a good deal, “[y]ou go into greed mode.” Atul Gawande, The Checklist Manifesto: How to Get Things Right 163 (2010). According to neuroscientists, making money stimulates the same primitive reward circuits in the brain as cocaine. Id. Consequently, Pabrai asserts that this is when it is critical to focus on a systematic approach to dispassionate analysis, avoiding both irrational exuberance and irrational panic; otherwise, “[y]ou get seduced. You start cutting corners.” See id. at 164.

[13] See Murdock, supra note 5, at 1271–81, 1287–1301. Keith Johnson, the former President of Washington Mutual’s Long Beach Mortgage testified before the Financial Crisis Inquiry Committee that “[s]everal of these factories were originating, packaging, securitizing and selling at the rate of $1 billion a day. The quality control process failed at a variety of stages during the manufacturing, distribution and on-going servicing.” Id. at 1273.

[14] Richard Portes, Ban Naked CDS, EuroIntelligence (Mar. 18, 2010), http://www.eurointelligence.com/news-details/article/ban-naked cds.html?cHash=8d1cdb3c68fcffb16fd8c0b1c0ad10f3.

[15] See Office of the Comptroller of the Currency, OCC’s Quarterly Report on Bank Trading and Derivatives Activities Fourth Quarter 2011 11, available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq411.pdf.

[16] See infra text accompanying note 31.

[17] See Stephen Gandel, JPMorgan’s Trading Debacle: Why $2 Billion Is Just the Start, CNNMoney (May 13, 2012), http://finance.fortune.cnn.com/2012/05/11/jpmorgan-2-billion-just-start/.

[18] Dawn Kopecki & Michael J. Moore, JPMorgan’s $4.4 Billion CIO Loss Drives Profit Down 9%, Bloomberg (July 13, 2012), http://www.bloomberg.com/news/2012-07-13/jpmorgan-s-4-4-billion-cio-loss-drives-profit-down-9-percent.html.

[19] See Jessica Silver-Greenberg & Susanne Craig, JPMorgan Trading Loss May Reach $9 Billion, N.Y. Times (June 28, 2012), http://dealbook.nytimes.com/2012/06/28/jpmorgan-trading-loss-may-reach-9-billion/.

[20] See Gandel, supra note 17. See also Maureen Farrell, JPMorgan Chase Loss Only Going to Get Worse, CNNMoney (May 20, 2012), http://money.cnn.com/2012/05/18/markets/jpmorgan-loss/index.htm (“As soon as it becomes clear that JPMorgan Chase is unwinding its position, it will be obvious to players on every major trading desk. Hedge funds will immediately start piling into that index and buying protection, driving up the bank’s losses.”).

[21] A “covered CDS” refers to a CDS in which the purchaser of protection has a creditor interest in the underlying obligation while with a “naked CDS,” the purchaser of protection does not have a creditor interest in the underlying obligation.

[22] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 722(b), 124 Stat. 1376, 1673 (2010).

[23] See Parliament & Council Regulation 236/2012, Short Selling and Certain Aspects of Credit Default Swaps, 2012 O.J. (L 86) 3 (EU) (“Sovereign credit default swaps should be based on the insurable interest principle whilst recognising that there can be interests in a sovereign issuer other than bond ownership.”).

[24] For a history of the evolution from covered CDSs to naked CDSs and the economics of naked CDSs, see Richard R. Zabel, Credit Default Swaps: From Protection to Speculation, Robins, Kaplan, Miller & Ciresi L.L.P. (Sept. 2008), http://www.rkmc.com/publications/articles/credit-default-swaps-from-protection-to-speculation.

[25] See SEC v. Goldman Sachs & Co., 790 F. Supp. 2d 147, 150 (S.D.N.Y. 2011).

[26] See Liz Moyer, Goldman: In 2006, Paulson Was a Nobody, Forbes.com (Apr. 21, 2010), http://www.forbes.com/sites/streettalk/2010/04/21/goldman-in-2006-paulson-was-a-nobody/.

[27] Press Release, SEC, Goldman Sachs to Pay Record $550 Million to Settle SEC Charges Related to Subprime Mortgage CDO (July 15, 2010), http://www.sec.gov/news/press/2010/2010-123.htm.

[28] See Ronald D. Orol, Senate Rejects Ban of Naked Credit Default Swaps, MarketWatch (May 18, 2010), http://articles.marketwatch.com/2010-05-18/markets/30711928_1_credit-default-swaps-bank-reform-end-debate.

[29] See Mason, supra note 11. The author suggests that not just creditors of a corporation, but also suppliers and landlords, may need CDS protection. Id. However, it seems unlikely that an empirical study of suppliers and landlords would find many who were participants in the CDS market.

[30] See Parliament & Council Regulation 236/2012, Short Selling and Certain Aspects of Credit Default Swaps, 2012 O.J. (L 86) 10–14 (EU). See also Noam Noked, Europe Restricts “Naked” Credit Default Swaps and Short Sales, Harv. L. Sch. F. on Corp. Governance & Fin. Reg. (Dec. 27, 2011), http://blogs.law.harvard.edu/corpgov/2011/12/27/europe-restricts-naked-credit-default-swaps-and-short-sales/.

[31] See, e.g., Catherine Bruneau et al., Is the European Sovereign Crisis Self-Fulfilling? Empirical Evidence About the Drivers of Market Sentiments (July 24, 2012) (working paper), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2116240.

[32] Anne-Laure Delatte, The European Ban on Naked Sovereign Credit Default Swaps: A Fake Good Idea, Vox (July 23, 2012), http://www.voxeu.org/article/european-ban-naked-sovereign-credit-default-swaps-fake-good-idea.

[33] Id.

[34] Id.

[35] Richard Portes, Credit Default Swaps: Useful, Misleading, Dangerous?, Vox (Apr. 30, 2012), http://www.voxeu.org/article/credit-default-swaps-useful-misleading-dangerous. See also Portes, supra note 14.

[36] See Jonathon Boyd, No Evidence to Support EU Ban on Naked CDS, Investment Europe (Feb. 14, 2013), http://www.investmenteurope.net/investment-europe/news/2244090/no-evidence-to-support-eu-ban-on-naked-cds-forum. See also Carlos Tavares, The CDS-Bond Spreads Debates Through the Lens of the Regulator, Vox (Jan. 12, 2011), http://www.voxeu.org/article/under-regulator-s-microscope-credit-default-swaps.

[37] Gabriele Camera & Agostino Capponi, Liquidity Impact of a Ban on Naked Credit-Default Swaps (Sept. 10, 2012) (working paper), available at https://engineering.purdue.edu/Capponi/DynamicsNakedCDS_Sep10.pdf.

[38] Portes, supra note 14.

[39] See supra text accompanying notes 21–27.

[40] See Portes, supra note 35.

[41] The notion is straightforward: someone trades ahead of the market based upon non-public information.

[42] See supra text accompanying notes 17–20.

[43] JPMorgan invested not only in CDSs but also in credit indices and credit index tranches. A credit index is a more complicated form of credit derivative in which the index references a basket of selected credit instruments, typically credit default swaps or similar credit instruments. See U.S. Senate Permanent Subcomm. on Investigations, JPMorgan Chase Whale Trades: A Case History of Derivatives Risks and Abuses 29–34 (Mar. 15, 2013), available at http://www.hsgac.senate.gov/subcommittees/investigations/reports. JPMorgan had asserted that its Synthetic Credit Portfolio operated as a hedge, meaning that they were “covered CDSs.” However, the Subcommittee investigation revealed that JPMorgan had “failed to identify the assets or portfolios being hedged, test the size and effectiveness of the alleged hedging activity, or show how the SCP lowered rather than increased bank risk.” Id. at 15. In addition, the very fact that it was named the Synthetic Credit Portfolio shows that JPMorgan recognized that it did not hold a creditors interest in the underlying securities.

[44] See JPMorgan Chase & Co., Presentation Slides on 2012 Second Quarter Financial Results 14 (July 13, 2012), available at http://www.sec.gov/Archives/edgar/data/19617/000001961712000248/jpmc2q12exhibit992.htm.

[45] Id. at 24 (showing that there were deposits of $1.116 trillion and loans of $693 billion).

[46] JPMorgan, Current Report (Form 8-K), at 3 (July 13, 2012).

[47] See Agustino Fontevecchia, Dimon’s Volcker Rule Contradiction: On Hedging, Prop Trading, and the London Whale, Forbes.com (June 13, 2012), http://www.forbes.com/sites/afontevecchia/2012/06/13/dimons-volcker-rule-contradiction-on-hedging-prop-trading-and-the-london-whale/.

[48] See supra text accompanying notes 1–3.

[49] See The Path to Job Creation: The State of American Small Business: Hearing Before the H. Comm. On Small Bus., 112th Cong. 7–9 (2012) (statement of Martin Neil Baily, Senior Fellow, The Brookings Institution), available at http://congressional.proquest.com.ezp-prod1.hul.harvard.edu/congressional/docview/t29.d30.hrg-2012-smb-0001?accountid=11311.

[50] Cf. Yeon-Koo Che & Rajiv Sethi, Economic Consequences of Speculative Side Bets: The Case of Naked CDS, Vox (Sept. 4, 2010), http://www.voxeu.org/article/economic-consequences-speculative-side-bets-case-naked-cds.

[51] See Barton, supra note 4, at 86–88.