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),

* 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

[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

[9] Dodd-Frank Act §§ 801–14.

[10] See Phillip Wood, What is a Central Counterparty in Financial Markets?, Allen & Overy (Aug. 20, 2009), (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),

[12] See Henny Sender, AIG Saga Shows Dangers of Credit Default Swaps, Fin. Times (Mar. 6, 2009),

[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

[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 (“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),

[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

[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

[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., (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 (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

[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

[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, (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), 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),

[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

[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; 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, (Jan. 10, 2012),

[52] See Jeremy Grant & Alex Barker, ECB Clearing House Policy Could Stoke Tensions, Fin. Times (Nov. 23, 2011),; Huw Jones, UK Bolsters Clearing Lawsuit Against ECB, Reuters, Feb. 14, 2012, available at

[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 (“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., (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 (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), (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

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

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Sean J. Griffith*


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]


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),

* 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

[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

[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 (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), (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),

[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 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, (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),

[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),

[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).

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.


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.


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),

* 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, (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),

[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

[6] See Fin. Crisis Inquiry Comm’n, The Financial Crisis Inquiry Report 386 (2011), available at

[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,, (last visited Apr. 11, 2013).

[8] See Fin. Stability Bd., Implementing OTC Derivatives Market Reforms 3–4 (2010), available at

[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

[24] See, e.g., Ameritrade, Futures Client Agreement (2013), available at 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, (last visited Apr. 11, 2013).

[25] Sean Walters, One Lehman Lesson: The Perils of Rehypothecation, Wall St. J. (Sept. 25, 2008),

[26] See Harriet Agnew, Rehypothecation Is Being Redefined, Financial News (Sept. 13, 2010),

[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),

[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; Maroan Maizar, et al., Credit and Counterparty Risk: Why Trade Under an ISDA with a CSA?, GesKR, Jan. 2010, at 63, 65, available at

[34] See Int’l Swaps & Derivatives Ass’n, ISDA Margin Survey 2012 14 (2012), available at; The Bilateral World vs The Cleared World, derivatiViews (Apr. 24, 2012),

[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),

[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, (Sept. 20, 2012),; Matt Cameron, Clearing Members Fear $5 Billion Intra-Day Funding Burden, (Nov. 7, 2012),

[44] See Mike Kentz, Costs of Derivatives Clearing Stack Up for Buy-Side, Reuters, Apr. 8, 2013, available at

[45] Id.

[46] See Acceptable Collateral, LCH.Clearnet, (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, (last visited Apr. 11, 2013).

[47] See, e.g., Collateral Management for Centrally Cleared Derivatives, J.P.Morgan (2011), available at

[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, (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.