Harvard Business Law Review (HBLR)

The Harvard Business Law Review (HBLR) aims to be the premier journal covering the laws of business organization and capital markets. HBLR will publish articles from professors, practitioners, and policymakers on corporate law and governance, securities and capital markets law, financial regulation and financial institutions, law and finance, financial distress and bankruptcy, and related subjects.

Derivatives

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Bitcoin and Virtual Currencies: Welcome to Your Regulator

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Matthew Kluchenek†

I.               Introduction

Among all the U.S. regulators interested in regulating Bitcoin and virtual currencies, the Commodity Futures Trading Commission (CFTC) is determined to be at the forefront. Since the announcement by CFTC Chairman Timothy Massad in late 2014 that Bitcoin derivatives should fall within the scope of the CFTC’s jurisdiction,[1] the CFTC has been aggressive in addressing not only wrongful conduct involving Bitcoin derivatives, but also wrongful conduct involving certain spot Bitcoin transactions.

The CFTC’s actions are a clarion call for market participants to understand the broad breadth of the CFTC’s jurisdiction, and to take notice of the requirements that may apply both to derivatives and to certain physical transactions involving Bitcoin and other virtual currencies.

II.              Scope of CFTC’s Jurisdiction

The U.S. Commodity Exchange Act (CEA),[2] as amended by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act),[3] regulates transactions in “commodity interests.”[4] The CFTC, an independent federal agency, is charged with administering the CEA and has exclusive jurisdiction over transactions involving commodity interests.[5] Throughout the history of the CFTC, and particularly with respect to the Dodd-Frank Act, Congress has ceded broad power to the CFTC to interpret and promulgate rules regarding commodity interest products, transactions, and market participants.[6]

As a general matter, the CFTC’s jurisdiction flows from the definition of a “commodity” under the CEA.[7] At bottom, if a “commodity” is not involved in a contract, agreement, or transaction, the CFTC lacks the statutory basis to regulate the contract, agreement, or transaction.[8] The definition of a “commodity,” however, is exceedingly broad under the CEA. The definition delineates a laundry list of agricultural products, but also sweeps in “all services, rights, and interests (except motion picture box office receipts, or any index, measure, value or data related to such receipts) in which contracts for future delivery are presently or in the future dealt in.”[9] As a result, almost anything except onions[10] and movie box office receipts[11] can constitute a “commodity” under the definition, including bottles of wine, baseball cards, reference rates, indices, mathematical permutations, services, intangibles, and contingencies that would not seemingly fall within the traditional view of a commodity.[12]

If, however, a commodity is involved, then the CFTC may only assert jurisdiction if a “commodity interest” is based on the commodity.[13][ A “commodity interest” refers to the types of instruments that are subject to the CFTC’s regulation, which are: (i) futures contracts, (ii) options on futures contracts, (iii) swaps, (iv) leveraged retail foreign exchange contracts, (v) leveraged retail commodity transactions, and (vi) certain other leveraged products.[14] Importantly, the CFTC’s jurisdiction is thus not—as many assume—limited to “derivatives,” but rather also extends to certain spot, or physical market, transactions.

As a result, in seeking to assert jurisdiction over a contract, agreement, or transaction involving a commodity, the CFTC’s jurisdictional hook is premised upon whether a commodity interest is involved. If so, and assuming that no exclusions or exemptions apply, the CFTC has a basis to assert regulatory authority.

III.             Bitcoin as a “Commodity” under the Commodity Exchange Act

In the context of Bitcoin (and other virtual currencies), the threshold issue is whether Bitcoin is a “commodity.” If Bitcoin is a commodity, then the CFTC may regulate commodity interests based on the commodity. If Bitcoin is not a commodity, then the CFTC lacks the authority to so regulate.

In December 2014, CFTC Chairman Timothy Massad telegraphed the CFTC’s intent to regulate Bitcoin derivatives, stating that “derivatives contracts based on a virtual currency represent one area within [the Commission’s] responsibilit[ies].”[15] Little elucidation was given. However, in September 2015, the CFTC took a significant step in asserting jurisdiction when it issued an order determining that “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.”[16]

The CFTC’s determination did not arise out of a rulemaking or an interpretation, but rather via an enforcement action against an online Bitcoin trading platform called “Derivabit,” which was owned by Coinflip, Inc.[17] Coinflip operated the trading platform, which was designed for risk management purposes, in an effort to bring together buyers and sellers of Bitcoin option contracts.[18] Coinflip was not registered with the CFTC.

In making the pronouncement that Bitcoin is a commodity, the CFTC effectively determined that Bitcoin is not a currency. According to the CFTC, “Bitcoin and other virtual currencies are distinct from ‘real’ currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance.”[19]

Importantly, the CFTC’s determination is not limited to Bitcoin, but extends to “other virtual currencies,” which the CFTC broadly defines as “a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but does not have legal tender status in any jurisdiction.”[20] Thus, the definition of “virtual currency” could also engulf Litecoin and Dogecoin, among others yet to be created.

Based on its determination that Bitcoin is a commodity, the CFTC applied the CEA’s provisions to the Derivabit trading platform, finding that Coinflip unlawfully offered commodity options by operating a facility for the trading of such options without being registered as a designated contract market (that is, a futures exchange) or a swap execution facility (SEF).[21] Importantly, because Coinflip offered commodity options, which are derivatives, the CFTC had an ostensibly clear basis to assert jurisdiction once the agency determined that Bitcoin is a commodity.[22]

Just one week after the Coinflip settlement, and armed with its determination that Bitcoin is a commodity, the CFTC brought its second Bitcoin-related enforcement action, this time against TeraExchange, LLC (Tera), an SEF.[23] In the action, the CFTC alleged that Tera failed to enforce its prohibition on wash trades by facilitating the prearrangement of a single Bitcoin swap transaction.[24]

As with the Coinflip matter, the CFTC’s enforcement action against Tera involved a derivative—that is, here, swaps based on Bitcoin. The presence of the swap, coupled with Tera’s provisional registration with the CFTC as an SEF, provided the CFTC with an unambiguous pathway to assert jurisdiction. Soon thereafter, however, the CFTC’s path would take a different, and more aggressive, turn.

IV.             The CFTC’s Enforcement Action Against Bitfinex

In June 2016, the CFTC filed charges against a Hong Kong-based company called Bitfinex, which operates an online platform for trading in cryptocurrencies, including Bitcoin.[25] Unlike Coinflip and Tera, however, Bitfinex did not list or permit the trading of derivatives, such as futures, options, or swaps.[26] Rather, Bitfinex merely facilitated spot transactions in cryptocurrencies.[27] Generally, a “spot” transaction is the everyday transaction of buying and selling a good, much like one does when purchasing an item on eBay. Payment is made for the item, and the item is promptly delivered to the buyer. The CFTC is generally not authorized to regulate spot transactions.[28] However, by adding a couple of characteristics to an otherwise vanilla spot transaction, the transaction can be transformed into a commodity interest transaction subject to the full panoply of provisions under the CEA.

The basis for the CFTC’s authority to regulate certain spot transactions derives from the jurisdictional hook that the agency has used so successfully to prosecute retail precious metals transactions[29]—the so-called “retail commodity transaction” provision under the CEA.[30] The retail commodity transaction provision is a relatively short provision set forth in CEA section 2(c)(2)(D). It provides:

(D) Retail commodity transactions

(i) Applicability[.] Except as provided in clause (ii), this subparagraph shall apply to any agreement, contract, or transaction in any commodity that is—

(I) entered into with, or offered to (even if not entered into with), a person that is not an eligible contract participant or eligible commercial entity; and

(II) entered into, or offered (even if not entered into), on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.[31]

The elements of a retail commodity transaction are thus threefold—the agreement, contract, or transaction must:

(1)  involve a commodity;

(2)  be entered into with, or offered to, a person that is not an eligible contract participant (ECP);[32] and

(3)  be entered into, or offered, on a leveraged, margined or financed basis.[33]

All three elements must be present for there to be a retail commodity transaction. Any person that deals in commodities subject to the retail commodity transaction provision is required to be registered with the CFTC as a futures commission merchant (FCM).[34]

While a retail commodity transaction is a form of commodity interest, such a transaction is fundamentally different from a derivatives transaction, the latter of which derives its value from an underlying commodity and contains an element of futurity. Critically, where a derivative is not involved, market participants are often caught off-guard with respect to the broad scope of the CFTC’s jurisdiction.

Like so many requirements under the CEA, however, there are exceptions to the retail commodity transaction provision. One such exception involves the timely “actual delivery” of a commodity to the buyer.[35] If a seller offers to enter, or enters into, a commodity transaction with a non-ECP on a leveraged basis, the transaction will not fall under the retail commodity transaction provision if the seller actually delivers the commodity to the buyer within 28 days of the date that the contract is entered into.[36] The meaning of “actual delivery” has been the subject of extensive interpretation by the CFTC.[37]

In determining that Bitfinex violated the CEA, the CFTC’s order found that the transactions executed on the Bitfinex platform fell within the purview of the retail commodity transaction provision, and that no “actual delivery” occurred. According to the CFTC:

  • Bitcoin is a commodity;
  • Bitfinex did not limit its customers to ECPs, but rather sold Bitcoins to retail persons;
  • Bitfinex facilitated the financing of Bitcoin transactions;[38] and
  • Bitfinex did not actually deliver Bitcoins to the buyers.[39]

In addressing the most controversial aspect of the order—whether actual delivery of the Bitcoins occurred—the CFTC explained that Bitfinex held its customers’ Bitcoins in an omnibus private wallet that was controlled solely by Bitfinex, not the customers.[40] Through the use of a private key, only Bitfinex had access to the omnibus wallet.[41] Consequently, because Bitfinex solely controlled access to the wallet, the CFTC found that Bitfinex’s customers did not actually receive delivery of any Bitcoins.[42] The CFTC’s explanation seems to suggest that satisfying the requirement of “actual delivery” would require that virtual currencies be delivered to a deposit wallet for which the recipient controls the private key.[43] However, neither the CEA, the CFTC’s rules, nor the CFTC’s guidance on “actual delivery” discuss or contemplate the delivery requirements of virtual currencies.[44]

Nonetheless, based on the satisfaction of the elements of the retail commodity transaction provision, coupled with the absence of actual delivery, the CFTC found that Bitfinex violated the CEA’s retail commodity transaction provision by failing to register as an FCM.[45] The CFTC’s action against Bitfinex marks the agency’s initial foray into the regulation of Bitcoin via the retail commodity provision transaction. If the history involving the CFTC’s regulation of retail precious metals transactions is any guide, more enforcement actions should be expected.

V.              What’s Next?

In at least one respect, the CFTC should be given credit for taking the lead in seeking to regulate a novel product under its jurisdiction. With such an effort, however, comes responsibility. The CFTC should clearly articulate, through an interpretation rather than ad hoc enforcement actions, the manner in which the agency intends to apply the actual delivery exception to virtual currencies. Such an interpretation is necessary so as not to stymie innovation.

At the same time, the CFTC should strive to coordinate the regulation of virtual currencies with other federal agencies, some of which have shown an interest in regulating such products.[46] For example, if the Securities and Exchange Commission were to classify Bitcoin or another virtual currency as a “security,” market participants could be compelled to comply with two fundamentally different, and in some ways redundant, regulatory regimes. We have seen dual jurisdiction applied to certain other products—security futures and mixed swaps come to mind—and the outcomes have not been ideal. Here, as before, the CFTC should be aggressive in seeking to address regulatory harmonization.

Finally, for market participants, the CFTC has sounded the bell. In offering virtual currencies to customers, market participants must understand and be sensitive to the scope of the CFTC’s jurisdiction. If a swap or futures contract is involved—including a seemingly innocuous embedded option in which the customer has the right to cancel or offset a purchase—or a retail spot transaction involves any form of financing, margin or leverage, the CFTC has shown its willingness to take action—even in the absence of allegations of fraud or other wrongdoing.

 

† Partner, Global Head of Derivatives, Baker & McKenzie LLP.

[1] The Commodity Futures Trading Commission: Effective Enforcement and the Future of Derivatives Regulation Before the S. Comm. on Agric., Nutrition, and Forestry, 111th Cong. 55 (2014) (statement of Timothy Massad, Chairman of the Commodity Futures Trading Commission).

[2] Commodity Exchange Act of 1936, Pub. L. No. 74–675, 49 Stat. 1491 (codified as amended in scattered sections of 7 U.S.C.) (replacing the Grain Futures Act of 1922).

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

[4] See 17 C.F.R. § 1.3(yy) (2016).

[5] See Commodity Futures Commission Trading Act of 1974 § 101, 7 U.S.C. § 2(a)(1)(A) (2012). When Congress created the CFTC in 1974, it “confer[red] on the CFTC ‘exclusive jurisdiction’ over commodity futures and options thereon, which means that these instruments cannot be regulated by any other federal or state agency (except in certain limited circumstances where the CEA explicitly contemplates shared authority between the CFTC and another agency).” President’s Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act (1999). The purpose of the exclusive jurisdiction provision “was to separate the functions of the new CFTC from those of the SEC and other regulators.” Leist v. Simplot, 638 F.2d 283, 314 (2d Cir. 1980).

[6] See, e.g., Binyamin Appelbaum, On Finance Bill, Lobbying Shifts to Regulation, N.Y. Times (June 26, 2010), http://www.nytimes.com/2010/06/27/business/27regulate.html? (noting that the Dodd-Frank Act is “basically a 2,000-page missive to federal agencies, instructing regulators to address subjects ranging from derivatives trading to document retention” and observing that “it is notably short on specifics, giving regulators significant power to determine its impact—and giving partisans on both sides a second chance to influence the outcome”).

[7] See 7 U.S.C. § 1(a)(9) (2012).

[8] See id. at § 2(a)(1)(A).

[9] See id. at § 1(a)(9).

[10] In 1958, as a result of rife manipulations in the onion market, Congress enacted the Onion Futures Act to ban futures trading in onions. Id. at § 13-1; see also Bd. of Trade of Chi. v. SEC, 677 F.2d 1137, 1142 n.9 (7th Cir. 1982) (discussing the onion carve out from the CEA).

[11] As part of the Dodd-Frank Act, Congress banned—at the urging of associations representing the motion picture industry—the trading of derivatives on motion picture box office receipts. See 7 U.S.C. § 13-1 (2006), amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. 111-190, § 721(e)(10), 124 Stat. 1376, 1672 (2010); see also Daniel Frankel, 10 Key Moments in the Life of Movie Derivatives, THE WRAP (Aug. 13, 2010, 6:53 PM), http://www.thewrap.com/movies/article/10-key-moments-life-movie-derivatives-20122.

[12] See 7 U.S.C. § 1a(9).

[13] See 7 U.S.C. § 2(a)(1)(A).

[14] See 17 C.F.R. § 1.3(yy) (2016) (“Commodity interest . . . means (1) Any contract for the purchase or sale of a commodity for future delivery [a futures contract]; (2) Any contract, agreement or transaction subject to a Commission regulation under section 4c [commodity options] or 19 of the Act [leveraged contracts]; (3) Any contract, agreement or transaction subject to Commission jurisdiction under section 2(c)(2) of the Act [retail foreign exchange and commodity transactions]; and (4) Any swap as defined in the Act, by the Commission, or jointly by the Commission and the Securities and Exchange Commission [a swap as defined in CFTC Rule 1a(47)].”).

[15] The Commodity Futures Trading Commission: Effective Enforcement and the Future of Derivatives Regulation Before the S. Comm. on Agric., Nutrition, and Forestry, 111th Cong. 55 (2014) (statement of Timothy Massad, Chairman of the Commodity Futures Trading Commission).

[16] In re Coinflip, Inc., CTFC No. 15-29, 2015 WL 5535736, at *3 (Sept. 17, 2015).

[17] Id. at *2.

[18] Id.

[19] Id. at *n.2.

[20] Id.

[21] Id. at *3–4. A swap execution facility is a trading system or platform, other than a designated contract market, in which multiple participants have the opportunity to enter into swaps by accepting bids and offers made by multiple participants on the facility. See Commodity Exchange Act of 1936 § 1a(50), 7 U.S.C. § 1a(50) (2012).

[22] See id. at *5 (explaining that under the terms of settlement, the defendants agreed to cease and desist from future violations of the CEA and the CFTC’s rules, but no financial penalty was imposed).

[23] In re TeraExchange LLC, CFTC No. 15-33, 2015 WL 5658082 (Sept. 24, 2015).

[24] Like the Coinflip matter, the CFTC and the defendants agreed to a settlement involving a cease and desist order, but no financial penalty. Id. at *8–9.

[25] In re BFXNA Inc., CFTC No. 16-19, 2016 WL 3137612 (June 2, 2016).

[26] See id. at *2.

[27] See id. at *3.

[28] The CFTC staff has defined a spot transaction as one where immediate delivery of the product and immediate payment for the product are expected on or within a few days of the trade date. See CFTC No-Action Letter, CFTCLTR No. 98-73, 1998 WL 754623 (Oct. 8, 1998). The Supreme Court has defined a spot transaction as a purchase or sale agreement for a commodity that is intended to settle in the period that is ordinary for dealings in the relevant type of commodity. See Dunn v. CFTC, 519 U.S. 465, 472 (1997). As noted by the Sixth Circuit, “because the CEA was aimed at manipulation, speculation, and other abuses that could arise from the trading in futures contracts and options, as distinguished from the commodity itself, Congress never purported to regulate ‘spot’ transactions (transactions for the immediate sale and delivery of a commodity) or ‘cash forward’ transactions (in which the commodity is presently sold but its delivery is, by agreement, delayed or deferred).” CFTC v. Erskine, 512 F.3d 309, 321 (6th Cir. 2008). Spot transactions are, however, subject to the anti-manipulation provisions under the CEA and the CFTC’s rules to the extent that such attempted or actual manipulations affect prices in commodity interests. See, e.g., 7 U.S.C. §§ 9, 15 (2012); 17 C.F.R. § 180.1(a) (2016); see also CFTC v. Atlantic Bullion & Coin, Inc., C.A. No. 8:12-1503-JMC (D.S.C. 2010), http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfatlanticcomplaint060612.pdf.

[29] See, e.g., CFTC v. Hunter Wise Commodities, 21 F. Supp. 3d 1317 (S.D. Fl. 2014); CFTC v. Palm Beach Capital, No.14-cv-80636 (S.D. Fl. 2014), http://www.cftc.gov/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfpbeachorderdf073114.pdf.

[30] See 7 U.S.C. § 2(c)(2)(D).

[31] Id.

[32] An ECP is defined to include, among others, (i) an organization with total assets in excess of $10 million; (ii) a corporation that (a) has a net worth in excess of $1 million and (b) uses commodity interests in connection with its business or to hedge commercial risk; (iii) an individual who has amounts invested on a discretionary basis, the aggregate of which is in excess of $10 million; or (iv) an individual who has amounts invested on a discretionary basis, the aggregate of which is in excess of $5 million, where such individual is using the instrument in order to manage the risk associated with an asset owned or liability incurred, or reasonably likely to be owned or incurred, by the individual. 7 U.S.C. § 1a(18). An eligible commercial entity is defined in § 1a(17).

[33] The CFTC takes a broad view of the scope of this element. Essentially, if the purchaser of the commodity is not required to fully pay for the commodity upon purchase, then the CFTC will likely presume that leverage or financing is involved in the transaction. See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426, 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1) (“New CEA section 2(c)(2)(D) of the CEA broadly applies to any agreement, contract, or transaction in any commodity that is entered into with, or offered to (even if not entered into with), a non-eligible contract participant or non-eligible commercial entity on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.”) (emphasis added).

[34] See 7 U.S.C. § 6d.

[35] See Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426, 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1).

[36] See id. at 52,427.

[37] See Retail Commodity Transactions Under Commodity Exchange Act, 76 Fed. Reg. 77,670 (Dec. 14, 2011) (to be codified in 15 C.F.R. pt. 922); Retail Commodity Transactions Under Commodity Exchange Act, 78 Fed. Reg. 52,426 (Aug. 23, 2013) (to be codified in 17 C.F.R. pt.1).

[38] The Bitfinex platform permitted maximum leverage of 3.33-to-1 (that is, a 30% initial margin requirement). See In re BFXNA Inc., CFTC No. 16-19, 2016 WL 3137612, at *2 (June 2, 2016).

[39] Id. at *5.

[40] Id.

[41] A “private key” is a secret number associated with a deposit wallet that allows Bitcoins in that wallet to be accessed and spent. The private keys, which are randomly assigned, are mathematically related to all Bitcoin addresses generated for the wallet. See Private Key, Bitcoin Wiki, https://en.bitcoin.it/wiki/Private_key (last visited Oct. 26, 2016).

[42] See In re BFXNA Inc., 2016 WL 3137612, at *5.

[43] See Letter from Steptoe & Johnson LLP to Commodity Futures Trading Comm’n (July 1, 2016) (on file with author).

[44] Cf. In re BFXNA Inc., 2016 WL 3137612. The Bitfinex order prompted a petition that requests the CFTC to clarify the “actual delivery” requirements in the context of virtual currencies. See Letter from Steptoe & Johnson LLP to Commodity Futures Trading Comm’n (July 1, 2016) (on file with author).

[45] Under the terms of the settlement, Bitfinex agreed to pay a civil money penalty of $75,000 and cease and desist from further violations of the subject CEA provisions. Id. at *6.

[46] See, e.g., Investor Alert: Bitcoin and Other Virtual Currency-Related Investments, U.S. Sec. & Exch. Comm’n (May 7, 2014), https://www.sec.gov/oiea/investor-alerts-bulletins/investoralertsia_bitcoin.html.

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An Evaluation Of The U.S. Regulatory Response to Systemic Risk and Failure Posed by Derivatives

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Kimberly Summe*

Derivatives, understood by few but disparaged by many, are often blamed for the collapse of the United States economy in the wake of Lehman Brothers’ bankruptcy in September 2008.[1] A legislative response to the crisis was inescapable and on July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)[2] was signed into U.S. law. While the Dodd-Frank Act addresses many aspects of the financial markets, this Article will focus on Titles II and VII in order to examine how transacting in derivatives has changed in the aftermath of this legislation and to assess how the bankruptcy of a systemically important financial institution engaged in derivative transactions will be approached.

A Bid to Limit Systemic Risk and Failure

The Dodd-Frank Act has two primary objectives that relate to derivatives: first, to limit the systemic risk of modern finance, in part by changing the locus of trading in derivatives and the conduct of derivatives market participants; second, to limit the damage caused by the failure of a systemically important financial institution.[3] With respect to the first objective, the Dodd-Frank Act’s principal strategy required that certain derivatives be “cleared.” With respect to the second objective, the Dodd-Frank Act singled out the entities most likely to cause systemic problems if they failed and subjected them to a new bankruptcy process. This Article will focus on the second objective of the Dodd-Frank Act and in particular on how the failure of a systematically important financial institution would relate to the treatment of derivatives.

Reducing Systemic Risk

The estimated $632 trillion notional over-the-counter derivatives market[4] is in the early transformational stage of where and how such transactions are executed. Title VII of the Dodd-Frank Act requires that all eligible derivatives be cleared through a central clearinghouse, known colloquially as a “central counterparty” or “CCP.” Unlike an over-the-counter derivative transaction where each of the two parties face the risk that its counterparty might fail to perform its obligations, a cleared derivative transaction mitigates this risk of performance failure by having a third party, the CCP, stand between the two parties and absorb that risk.[5]

Two years after the passage of the Dodd-Frank Act, the Commodity Futures Trading Commission (CFTC) proposed that certain credit default swaps and interest rate swaps be cleared. The CFTC’s decision to focus initially on these two products was a function of their importance in the market and the fact that a significant percentage of those swaps were already being cleared. End users of derivatives, such as corporations, are not, however, required to clear swaps if such entities can demonstrate that the swap is being used to hedge or to mitigate commercial risk, the CFTC (or the Securities and Exchange Commission (SEC)) was notified as to how the end user generally meets the financial obligations associated with entering into uncleared swaps, and the entity’s Board of Directors approved such an approach.

Clearinghouses perform a valuable function in their mitigation of counterparty risk. To sustain this function, the clearinghouse’s financial resources must be sufficiently robust to meet its members’ obligations notwithstanding the default of one of its members. Given that J.P. Morgan Chase Bank, Citibank, Goldman Sachs Bank USA, and Bank of America are the four largest derivative counterparties in the United States, the collapse of any one of those institutions could mean the termination of anywhere between a $42.67 and $71.28 trillion notional derivatives portfolio—roughly seven to eleven percent of global notional derivatives value.[6] In addition to the financial resources marshaled by each clearinghouse, another critical component of the clearing model is the provision requiring collateral. The requirement that the parties post collateral every day underpins the purported safety of the clearing model.

Policymakers were correct to focus on collateralization as a risk-mitigation technique. The collateralization of over-the-counter derivative transactions has existed for twenty years, so the posting of collateral for cleared and uncleared transactions to mitigate exposure is not new. Before the economic crisis began, the International Swaps and Derivatives Association (ISDA) reported in its 2006 Margin Survey that the gross amount of collateral in use for over-the-counter derivative transactions was $1.335 trillion, with fifty-nine percent of mark-to-market credit exposure covered by collateral.[7] Today, large dealers reported that eighty percent of over-the-counter derivatives are subject to collateral arrangements, with ninety-six percent of credit derivatives exposure being collateralized.[8] The type of collateral is important as well. Cash has long been the preferred form of collateral. At the end of 2006, nearly eighty percent of collateral was cash, mostly provided in U.S. dollars, and nearly seven years later, similar percentage is true today.[9]

What shifted under the Dodd-Frank Act is that the CCP’s calculation of required collateral is substituted for the individual counterparty’s assessment of its risks. Counterparties to cleared swaps will be required to post initial (or upfront) collateral to the CCP based on the CCP’s assessment of the risk profile of that transaction.[10] In addition, each day the CCP will set the variation margin associated with each transaction by recalculating the value of the transaction and accordingly calling for or releasing collateral, ensuring that counterparties have neutral risk positions in relation to the value of the underlying asset. In other words, the goal is that the CCP receives margin payments every day from counterparties whose contracts moved against them to ensure that the CCP and those that participate through the CCP always have funds to satisfy their obligations under contracts.

The posting of collateral is closely related to how the derivative transactions of an insolvent clearinghouse member are handled. For example, LCH. Clearnet Group’s contract and related rules state that upon a clearing member’s default, the clearinghouse may close out and terminate the cleared transactions and will not transfer such positions. CME Clearing and ICE Trust, by contrast, allow cleared transactions and associated collateral to be transferred to another consenting clearinghouse member.[11] Had Lehman Brothers been a clearing member of CME Clearing, for example, upon its insolvency its $35 trillion notional derivatives portfolio (and associated collateral) would have been ported to another clearinghouse member. The concern in a marketplace where major participants such as Bank of America, Citibank and Morgan Stanley, among others[12] were vulnerable at that same time means that the portability of Lehman Brothers’ derivatives portfolio may not have allayed counterparty risk to the non-defaulting party population because arguably an equally unstable counterparty was receiving those transactions. Alternatively, a stronger clearing member may have rejected the transactions being proposed for transfer without some sort of government backstop for the unknowable counterparty risk being assumed.

Albeit one of the Dodd-Frank Act’s goals was to reduce systemic risk through clearing and collateralization of derivatives, little has changed in terms of how collateralization operates both before and after Lehman Brothers’ bankruptcy. A clearinghouse will determine the collateral required for cleared trades while for over-the-counter derivatives, the counterparties will agree to the extent of such collateralization. As the OCC Quarterly Reports demonstrate, there have actually been very limited counterparty credit losses incurred from over-the-counter derivatives trading activity by U.S. banks. At the end of June 30, 2013, eighteen U.S. banks (out of 1,400) reported a total of $61 million in charge-offs of over-the-counter derivatives exposures, down from $84 million in the first quarter of 2013.[13] Net current credit exposure or the netted amounts of contracts with positive values against those with negative values was reported as $339 billion at the end of the second quarter of 2013—a figure that peaked at $800 billion at the end of 2008.[14] These figures reflect the importance of collateralization and netting in the over-the-counter context and indicate that a very small fraction of the gross notional outstanding of derivatives held at U.S. banks is subject to net current credit exposure. Even with these high collateralization rates in place, at least as reported by U.S. banks, it should be noted that no consensus has formed as to whether there is sufficient collateral in place to mitigate counterparty loss. Researchers at the International Monetary Fund estimated that under-collateralization of derivatives relative to risks in the financial system may be $2 trillion.[15] The TABB Group contended that interest rate and credit derivative transactions’ migration to a clearinghouse would require an additional $240 billion in collateral.[16]

Dealing with Failure

If the Dodd-Frank Act’s first objective was to limit risk before an institution collapses, the second objective was to limit destruction after a systemically important financial institution has failed or is in danger of failing. To accomplish this second objective, the Dodd-Frank Act introduced a new framework in Title II to facilitate the “orderly liquidation” of systemically important financial institutions.[17] The population of systemically important financial institutions includes bank holding companies that have at least $50 billion in assets and nonbank financial institutions such as investment banks or insurance holding companies that the new Financial Stability Oversight Council (Council) deems to be systemically important.[18] At present, there are eight U.S. banks deemed systemically important, along with three Japanese banks, seventeen European banks, and one Chinese bank. Before the Title II orderly liquidation authority procedures apply, however, it must be demonstrated that the use of the U.S. Bankruptcy Code would not be appropriate in the resolution of the institution without the destabilization of the U.S. financial system or a resort to a taxpayer bailout being likely.

It seems certain that all systemically important financial institutions will transact in derivatives and those transactions are more likely today than in 2008 to be booked with a U.S. commercial bank. U.S. banks dominate as derivatives counterparties. The most recent OCC Quarterly Report on Bank Trading and Derivatives Trading reported that out of the 1,400 U.S. banks engaged in derivatives trading, four U.S. commercial banks hold ninety-three percent of that exposure.[19] The concentration of a small number of financial institutions in the derivatives market has not shifted much in many years, including prior to Lehman Brothers’ bankruptcy.[20] The vast majority of this derivatives trading activity focuses on interest rate swaps: in the OCC’s First Quarter Report in 2008, that figure was seventy-nine percent, whereas in the OCC’s Second Quarter Report in 2013, it was eighty-one percent.[21] Interest rate swaps are perhaps the least complicated derivative instrument, particularly as compared to the challenges historically associated with credit derivatives in terms of credit event triggers and settlement, the complex calculations and dependencies of equity derivatives, and the inherent volatility of commodity derivatives, so presumably there is less risk in trading interest rate swaps than other derivatives. In addition, the OCC reports that fifty-nine percent of the top four commercial banks’ net current credit exposure is to other banks and securities firms, with corporates representing thirty-two percent and hedge funds, the most overly collateralized group at 325 percent, being two percent of net credit exposure.[22]

Thus, our financial landscape is dominated by the world’s largest banks, which in turn are among the world’s largest derivatives counterparties. While these banks will be more closely regulated under Title I of the Dodd-Frank Act, the way in which their insolvency will be handled has shifted.

Banks have historically been excluded from application of the U.S. Bankruptcy Code[23] and instead bank insolvencies were addressed under the Federal Deposit Insurance Act (FDIA). The FDIA provides that the Federal Deposit Insurance Corporation (FDIC) may operate as a conservator to preserve the value of a failing bank and return it to financial health or the FDIC may operate as a receiver in order to liquidate a failed bank.[24] Unlike a proceeding under the U.S. Bankruptcy Code, an FDIC receivership or conservatorship is not subject to direct supervision by the courts.[25] In large part, this policy choice was designed to ensure that bank failures were not subjected to the assumed-to-be lengthy proceedings under Chapter 11 of the U.S. Bankruptcy Code and placed more discretion with the FDIC to act expeditiously.

Under an FDIC regime, upon bankruptcy the FDIC has limited repudiation and avoidance powers with respect to derivatives. For example, regardless of whether the FDIC is acting as a conservator or a receiver, it must either disaffirm or repudiate all or none of the qualified financial contracts (derivatives) between the failed bank and the same counterparty, together with associated credit support or collateral.[26] In addition, the FDIC has the right to transfer qualified financial contracts to creditworthy bridge depository institutions.[27] If the FDIC is acting as receiver, it must provide notice of the transfer by 5:00 p.m. EST on the business day after its appointment as receiver.[28] At that time, the counterparty to the failed bank may elect to terminate the qualified financial contract (that is, the non-defaulting counterparty to the failed bank could follow the termination and close-out provisions in Section 6 of the ISDA Master Agreement for derivative transactions). If the FDIC is acting as conservator, there is no time limit on its right to transfer qualified financial contracts and the counterparty may not terminate the qualified financial contracts unless the conservator defaults to a degree that would permit termination under applicable non-insolvency law.[29]

From available reports, it appears that in every recent case where a large U.S. bank has become subject to a receivership proceeding, all qualified financial contracts and associated collateral of the failed bank were transferred in their entirety to a single bridge bank or third party acquirer. When the assets of Washington Mutual Bank, the largest U.S. bank failure to date, were sold in September 2008 to J.P. Morgan Chase, the FDIC transferred to J.P. Morgan Chase all qualified financial contracts to which Washington Mutual Bank was a party. While that process seemed to go well, Washington Mutual was not exactly a powerhouse derivatives market participant. Thus, it is not known whether the FDIC is resourced effectively to be able to handle a systemically important financial institution’s bankruptcy, a clearinghouse’s bankruptcy or multiple simultaneous bankruptcies. To date, the FDIC has fortunately not had the opportunity to deal with a derivatives portfolio approaching anything even near the size of Lehman Brothers’ derivatives portfolio—and Lehman Brothers was not as significant a derivatives market participant as the four largest U.S. commercial banks that trade derivatives.

While it is impossible to know whether the FDIC could effectively administer the bankruptcy of a systemically important financial institution, it is known that Title II’s orderly liquidation authority shifts away from the legal certainty of the bankruptcy processes under the U.S. Bankruptcy Code by permitting the FDIC to engage in ad hoc interventions under Title II. In addition, Title II allows the FDIC to discriminate among similarly situated secured creditors in a bankruptcy. Under Section 506(a)(1) of the U.S. Bankruptcy Code, a creditor’s secured status is determined when the collateral securing the claim is sold or when the Chapter 11 plan is judicially confirmed.[30] In contrast, under the regulations implementing the Dodd-Frank Act, the collateral securing the debt of the covered financial company is valued as of the date of the receiver’s appointment.[31] If the FDIC is unable to find a third party to purchase the collateral, the FDIC may transfer that collateral to a bridge financial company that the FDIC has organized.[32] While the bankruptcy process under the U.S. Bankruptcy Code mandates that the use or sale of the debtor’s property can only occur after there has been due notice and hearing, thereby ensuring the highest price is paid for such assets, Title II allows the FDIC to be on both sides of the transaction and to determine the consideration paid for the assets, with no court or creditor oversight.

The deficiencies of Title II resulted in the development of a proposed new U.S. Bankruptcy Code Chapter 14.[33] Chapter 14 offers two distinct approaches: either a conventional reorganization or a two entity recapitalization of a holding company. Under the Dodd-Frank Act, the FDIC focused on a two entity recapitalization, with a systemically important financial institution’s holding company being recapitalized through the transfer of its assets and liabilities to a new bridge financial company, and this bridge financial company in turn dealing with its operating subsidiaries. By contrast, Chapter 14 provides that if a motion is approved for the transfer of assets and liabilities in the first forty-eight hours of a bankruptcy, then the systemically important financial institution’s operations and ownership of subsidiaries shifts to a new bridge company that is not in bankruptcy. Qualified financial contracts such as derivatives would be kept intact and transferred to the bridge company. Through the transfer, the new bridge company will be effectively recapitalized by leaving the long-term unsecured debt behind in the bankruptcy proceeding.

Conclusion

It was a foregone conclusion that policymakers would respond to the economic crisis in the aftermath of Lehman Brothers’ bankruptcy and the near-collapse of other financial institutions. While it is arguable that the effort to prevent systemic risk through the mandate of clearing derivatives is a useful step, it is not a prophylactic. It remains entirely possible that a clearinghouse itself is capable of failure, as several have failed in the past, and the concentration of derivatives trading in the largest global financial institutions has exacerbated this possibility. Certainly, having the clearinghouse as the counterparty mitigates counterparty credit risk, but there may be costs involved if we have simply migrated to a more focused nucleus of systemically important financial institutions that could possibly fail. In addition, addressing the potential or eventual failure of a systemically important financial institution could have been addressed in a more judicially sound manner than the ad hoc approach policymakers chose to burden the FDIC with. There are attractive features of Title II, such as coordination with foreign regulators, but not at the expense of due process and judicial review. While the markets have already moved to accommodate the clearing of mandated derivative transaction types, it is hoped that efforts can be made to revise Title II as it relates to how the failure of a systemically important financial institution is handled.

 

Preferred citation: Kimberly Summe, An Evaluation of the U.S. Regulatory Response to Systemic Risk and Failure Posed by Derivatives, 4 Harv. Bus. L. Rev. Online 76 (2014), https://journals.law.harvard.edu/hblr//?p=3779.

[*] Kimberly Summe is the Chief Operating Officer and General Counsel at a multi-billion dollar San Francisco based investment advisor, Partner Fund Management, LP. She previously served as a Managing Director at Lehman Brothers and General Counsel at the International Swaps and Derivatives Association. Ms. Summe is a lecturer in law at the Stanford Law School and is a member of the Resolution Working Group at the Hoover Institution, which focuses on bankruptcy reform.

[1] On April 20, 2010, U.S. Treasury Secretary Timothy Geithner testified to the House of Representatives Financial Services Committee that “the market turmoil following Lehman’s bankruptcy was in part attributable to uncertainty surrounding the exposure of Lehman’s derivatives counterparties.” See Treasury Secretary Tim Geithner Written Testimony before the House Financial Services Committee, U.S. Dept. Treasury, (Apr. 20, 2010) http://www.treasury.gov/press-center/press-releases/Pages/tg645.aspx.

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

[3] See id at 1376.

[4] Bank for Int’l Settlements, Quarterly Review, Table 19, (June 2013), http://www.bis.org/statistics/dt1920a.pdf. Notional, of course, does not reference the amount that is at risk and does not account for the effect of netting and the provision of collateral.

[5] See Dodd-Frank Act §723(h) at 1676.

[6] See Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013 (2013) available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq213.pdf.

[7] Int’l Swaps and Derivatives Ass’n, ISDA Margin Survey 2007, 4, (Apr. 15, 2007) available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/. The ISDA Margin Survey covers U.S. and non-U.S. market participants. In 2007, for example, twenty-five percent of respondents were based in the United States, while fifty-two percent were based in Europe or South Africa. The OCC Quarterly Reports, by contrast, only cover U.S. national banking associations. Id.

[8] International Swaps and Derivatives Association, ISDA Margin Survey 2013, 2, (Jun. 21, 2013) available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/.

[9] See id at 9; International Swaps and Derivatives Association, ISDA Margin Survey 2006, 4, (Apr. 15, 2006), available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys.

[10] As it relates to uncleared swaps, the Dodd-Frank Act requires swap dealers and major swap participants to notify their uncleared swap counterparties of their right to segregate their initial margin with an independent third-party custodian. See Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. 6336-01 (Feb. 7, 2012).

[11] See CME Clearing Financial Safeguards, CME Group, (2012), http://www.cmegroup.com/clearing/files/financialsafeguards.pdf.

[12] Federal Reserve chairman Ben Bernanke testified to the U.S. Financial Crisis Inquiry Commission: “If you look at the firms that came under pressure in that period . . . out of . . . thirteen of the most important financial institutions in the United States, twelve were at risk of failure within a period of a week or two.” See Thomas Russo and Aaron J. Katzel, The 2008 Financial Crisis and Its Aftermath: Addressing the Next Debt Challenge, Group of Thirty 7, 11 (2011).

[13] See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6 at 8.

[14] Id at 6.

[15] Manmohan Singh and James Aitken, Counterparty Risk, Impact on Collateral Flows and Roles for Central Counterparties, (International Monetary Fund, Working Paper 09/173, 2009).

[16] E. Paul Rowady Jr., The Global Risk Transfer Market: Developments in OTC and Exchange Traded Derivatives, TABB Group, 6 (November 2010), http://www.world-exchanges.org/files/statistics/pdf/V08-030%20Global%20Risk%20Transfer%20Market.pdf.

[17] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §204, 123 Stat. 1376 1454 (2010).

[18]  Title II is not limited to financial companies already designated as “systemically important” but can apply to any potentially failing entity the Council determines is systemically important and “in default or in danger of default.”

[19] Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6, at Graph 4.

[20] In the OCC Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, the five largest commercial banks represented ninety-seven percent of the total banking industry notional amount of derivatives trading activity. In order by notional, those institutions were JPMorgan Chase Bank, Bank of America, Citibank, Wachovia Bank, and HSBC Bank USA. In the OCC Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, Table 1, the five largest commercial banks in order by notional were JPMorgan Chase Bank, Citibank, Goldman Sachs Bank USA, Bank of America and HSBC Bank USA. The number of insured U.S. commercial banks engaged in derivatives trading has increased: at the end of the first quarter of 2008 there were 1,003 banks, see Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, 7, (2008) available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq108.pdf, whereas at the end of the second quarter of 2013, there were 1,400. See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6.

[21] See Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2013, supra note 6, at 1; Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008, supra note 20, at 1.

[22] See id. at 7.

[23] See 11 U.S.C. § 109(b)(2) (2010).

[24] See 12 U.S.C. § 1821(c)(1) (2013).

[25] See § 1821(c)(6).

[26] See § 1821(e)(1)-(3).

[27] See § 1821(e)(9), (10)(C).

[28] See § 1821(10)(B)(i)(I).

[29] See § 1821(10)(B)(ii).

[30] See 11 U.S.C. §506(a)(1) (2005).

[31] See 12 C.F.R. § 380.1-380.53 (2011).

[32] See 12 U.S.C. §5390(h)(1) (2010).

[33] The Hoover Institution established a Resolution Project Working Group in 2009 (of which this author is a member) to develop an alternative approach to bankruptcy and related issues.

By

The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime

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James Schwartz*

The derivatives market was seen as having contributed substantially to the financial crisis of 2007–08.[1] This led to efforts to regulate derivatives in many of the countries in which their use was commonplace.[2] Historically, the swaps market consisted primarily of bilateral transactions agreed upon by telephone or electronic messages, which, in the absence of any reporting or clearing requirement, remained known only to the two principals.[3] At a September 2009 summit in Pittsburgh, however, G-20 leaders agreed in concept to wholesale reforms.[4] These reforms included the requirements that by the end of 2012, “all standardized OTC [over-the-counter] derivative contracts should be traded on exchanges or electronic trading platforms[] where appropriate,” “cleared through [a] central counterpart[y]” standing between the two original parties, and “reported to [a] trade repositor[y].”[5]

The G-20’s original timeframe did not hold, and today, almost a year after the G-20’s 2012 year-end target date, implementation of the contemplated reforms remains problematic.[6] Many of the delays reflect issues on the national level—mainly that the derivatives market is large, complex, and not especially familiar to many policymakers. However, beyond the need for action at the national level, the regulation of the swaps market, in which transactions between counterparties in wide-ranging jurisdictions have long been routine, requires international coordination and cooperation. If this were lacking, the consequences could include regulatory arbitrage, outsized compliance costs for, or incomplete compliance by, market participants, the fracturing of liquidity among different jurisdictions, and perhaps even political tensions.

The most aggressive regulator of the swaps market to date has been the U.S. Commodity Futures Trading Commission (CFTC), the primary U.S. regulator of derivatives. The CFTC is empowered to regulate the swaps market under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).[7] The CFTC’s rules are significantly closer to being implemented than those of many regulators outside the U.S.[8] As a result of the CFTC’s guidance regarding the extraterritorial application of its regulations[9] and the timeframe that the CFTC has set for implementation of that guidance, December 21 of this year may be a key date for many market participants.[10] On that day, according to the CFTC’s current timetable, many of the CFTC’s rules may become applicable to many transactions involving U.S. counterparties acting through non-U.S. offices or non-U.S. swap dealers registered with the CFTC by reason of their substantial U.S.-facing swap activities.[11]

Under the terms of the CFTC exemptive order issued on July 22, 2013, many such market participants are exempted from compliance with a number of the CFTC’s rules until the earlier of December 21, 2013 or thirty days following the issuance of an applicable substituted compliance determination.[12] As detailed below, a substituted compliance determination is an assessment by the CFTC that the relevant foreign jurisdiction’s rules are sufficiently comprehensive and comparable to the CFTC’s own rules to be followed in lieu of the CFTC’s rules.[13]

The CFTC’s timeframe, and the uncertain prospects of such substituted compliance determinations,[14] have put many market participants in an uncomfortable position. Because foreign swaps regulations are generally in a less advanced state than the CFTC’s own rules, the extent to which substituted compliance determinations may even be possible by December 21 is not entirely clear. Where the corresponding non-U.S. rules are in place, it is unclear whether the CFTC will actually make substituted compliance determinations related to those rules. Where the corresponding foreign rules are not yet in place, these could come into effect shortly after December 21. If the CFTC on December 21 requires compliance with U.S. rules, this could mean that market participants will be required to comply with both sets of rules. Moreover, the CFTC’s cross-border guidance contemplates requirement-by-requirement determinations on comparability of non-U.S. swaps regulatory regimes.[15] This mix-and-match approach makes it likely that many market participants will be required to comply both with certain (as yet unspecified) elements of the CFTC’s rules and certain (as yet unspecified) elements of non-U.S. regulatory regimes.

Issues in the cross-border market brought about by the CFTC’s mandatory clearing requirement, which went into effect on October 9 of this year for many market participants,[16] indicate that a significant delay in substituted compliance determinations could be the worst outcome for the U.S. swaps market. Upon the CFTC’s clearing requirement becoming effective, the absence of a substituted compliance determination with respect to clearing prompted certain non-U.S. market participants to avoid dealing with U.S. swap dealers.[17] This has moved swap trading activities with non-U.S. market participants into non-U.S. affiliates.[18] A further, related concern that may be limiting trading by swap dealers through their non-U.S. branches, in the absence of a substituted compliance determination, is that if transactions entered into by such branches are subject to mandatory clearing, they may soon also be subject to U.S. rules which in certain cases will likely require execution on a swap execution facility.[19]

The CFTC’s approach to cross-border matters is complex and nuanced. It divides the CFTC’s requirements into two separate categories: Transaction-Level Requirements and Entity-Level Requirements.[20] It then splits each of these categories into two subcategories.[21] The Transaction-Level requirements are split into Category A Transaction-Level Requirements (which include clearing and swap processing, trade execution, swap trading relationship documentation, and real-time public reporting of swap data) and Category B Transaction-Level Requirements (which consist of the CFTC’s external business conduct standards).[22] Similarly, the Entity-Level Requirements are divided into First Category Entity-Level Requirements (which include capital adequacy, chief compliance officer, risk management, and most swap data recordkeeping) and Second Category Entity-Level Requirements (which include, among others, swap data repository reporting and reporting for large traders of swaps linked to certain commodities).[23]

The CFTC’s regime, with respect to the Transaction-Level Requirements, may be summarized—albeit in a vastly simplified manner—as a continuum.[24] At one end of the spectrum such requirements will apply to swaps involving a CFTC-registered swap dealer (whether or not a U.S. Person[25]) acting through a U.S. branch or a U.S. Person other than a swap dealer.[26] Contrariwise, at the other end of the spectrum, such requirements will not apply (unless one party is a swap dealer acting through a U.S. branch[27] or a U.S. Person[28]) to swaps involving a party that is not a U.S. Person and not otherwise linked to the U.S. as a “guaranteed affiliate”[29] or an “affiliate conduit.”[30] With respect to swaps that do not fall at either end of the spectrum, such as swaps involving a CFTC-registered swap dealer acting through a non-U.S. branch, a substituted compliance determination is possible in relation to many such requirements.[31] With respect to the Entity-Level Requirements, for U.S. dealers, such requirements will apply, and for non-U.S. CFTC-registered swap dealers, substituted compliance determinations will be possible for many such requirements.[32]

On its face, this approach has a certain logic to it—the more closely linked to the U.S. a counterparty or transaction is, the more likely it is that the CFTC’s rules or similar rules, by way of substituted compliance, should apply. In practice, however, the approach seems likely to cause significant issues in the absence of substantial and close coordination among regulators—which, to date, does not appear overly abundant.[33]

These issues can be illustrated using the first cross-border example above, a transaction involving a U.S. swap dealer acting through a U.S. branch. If the swap were transacted between, for example, the New York head office of a U.S. swap dealer and the Paris head office of a French swap dealer, the EU’s rules should presumably govern the transaction to the same extent the U.S. rules do. If the EU were to take a position parallel to that of the CFTC and require the application of the EU’s rules to a transaction involving an EU swap dealer, the transaction would be governed by both U.S. and EU rules. Any material differences between these two sets of rules could be a significant issue for the parties to such a transaction and, by extension, for the swaps market as a whole.

Even in this relatively straightforward case, some understanding among relevant regulators with regard to cross-border swaps would seem highly desirable. The genius of the CFTC’s approach is that, by implementing its rules first and, by means of substituted compliance determinations, setting a bar for other regulators to reach, it has claimed the power to shape significantly discussions in foreign jurisdictions regarding the substance of swaps regulations. On the other hand, by making its own rules without agreements from other regulators and then delaying compliance dates, the CFTC is putting pressure on other regulators to fall into line to avoid causing conflict.[34] Given the need for cooperation, this approach seems incongruous and even slightly imperious.[35] There is a distinct lack of an institutional framework for making international regulatory swaps determinations,[36] in the absence of which the CFTC contemplates that foreign regulators, industry groups and even individual market participants may request a substituted compliance determination.[37]

Even for requirements in which substituted compliance is possible, the CFTC’s guidance is unclear. It offers scant insight into whether the CFTC will in fact make a substituted compliance determination, and, if it does make such a determination, what conditions it may impose on market participants seeking to rely on such determination. In order for a party to a swap to substitute compliance with the requirements of a non-U.S. jurisdiction for compliance with the CFTC’s own requirements, the CFTC must determine that the foreign jurisdiction’s requirements “are comparable with and as comprehensive as the corollary area(s) of regulatory obligations encompassed by the Entity- and Transaction-Level Requirements.”[38] However, they need not be “identical requirements to those established under the Dodd-Frank Act.” [39] In cases where the CFTC does not find foreign laws and regulations to merit substituted compliance, the relevant non-U.S. Person or foreign branch of a U.S. Person “may be required to comply” with the applicable CFTC regulations.[40]

The CFTC may consider both swap-specific regulations of the relevant foreign regulator and other provisions that may “achieve comparable and comprehensive regulatory objectives as the Dodd-Frank Act requirements, but on a more general, entity-wide, or prudential, basis.”[41] Moreover, the CFTC may vary its approach depending on the particular foreign jurisdiction.[42] In certain cases it may seek to influence the contents of foreign regulations by “coordinating with the foreign regulators in developing appropriate regulatory changes or new regulations, particularly where changes or new regulations already are being considered or proposed by the foreign regulators or legislative bodies.”[43] In other cases, the CFTC “may include conditions that take into account timing and other issues related to coordinating the implementation of reform efforts across jurisdictions”[44] or otherwise “include in its substituted compliance determination a description of the means by which certain swaps market participants can achieve substituted compliance within the construct of the foreign regulatory regime.”[45]

The CFTC does not intend to make substituted compliance determination with respect to foreign regulations as a whole, but instead with respect to particular foreign regulations.[46] Partly because “many foreign jurisdictions” are in the process of implementing derivatives market reforms “in an incremental manner,” a “comparability analysis will be based on a comparison of specific foreign requirements against specific” provisions of the Dodd-Frank Act and CFTC regulations for each of the categories of regulatory obligations for which substituted compliance may be available.[47] As a result, the swap counterparties to whom substituted compliance may apply will likely be expected to comply with a mixture of U.S. and non-U.S. regulations.

At the same time, however, the CFTC, somewhat puzzlingly, has stated that it expects to “rely upon an outcomes-based approach to determine whether these requirements achieve the same regulatory objectives of the Dodd-Frank Act.”[48] In this context, “outcomes-based” is often understood to refer not to what regulations state, but instead to the actual consequences that they cause.[49] It is not clear why an outcomes-based approach would necessitate a requirement-by-requirement review such as the CFTC contemplates. The SEC, in contrast to the CFTC, stated in its proposed cross-border rules that it would not focus on “a rule-by-rule comparison” but instead “on regulatory outcomes” with a “holistic approach.”[50]

If the CFTC guidance regarding substituted compliance sounds vague enough to support whatever ad hoc arrangement the regulator believes is warranted in any particular case, perhaps that is exactly the point. A commitment to the substituted compliance regime did not prevent the CFTC from agreeing to another approach entirely just days before the release of its cross-border guidance.[51] In one of the relatively few concrete signs of cooperation with foreign regulators, the CFTC and EU authorities agreed in July of 2013 to an understanding known as the “path forward.”[52] In that understanding, they agreed to a “stricter-rule-applies” approach with regard to mandatory clearing, one of the fundamental reforms sought by the G-20.[53] This approach, not referenced in the CFTC’s cross-border guidance, would be applicable “where exemptions from mandatory clearing would exist in one jurisdiction but not in the other.”[54] Although this approach may indeed “prevent loopholes and any potential for regulatory arbitrage,”[55]imposing stricter regulations on cross-border swap transactions than on transactions undertaken in a single jurisdiction would seem not to promote a liquid international market.

In the longer run, it seems likely that the swaps regulations of the major jurisdictions will converge. For the foreseeable future, however, both before and after December 21, questions will continue to abound, and the swaps market will continue to be burdened by regulatory uncertainty. As it was the G-20 process that delineated and put in process the swaps market reforms in G-20 member nations, international bodies such as the Basel Committee on Banking Supervision and the Financial Stability Board could likely play a productive role in minimizing confusion and disruption and in bringing much needed clarity to the swaps market.[56]

 

Preferred citation: James Schwartz, The CFTC’s Cross-Border Guidance for Swaps and Substituted Compliance Regime, 4 Harv. Bus. L. Rev. Online 52 (2013), https://journals.law.harvard.edu/hblr//?p=3676.

* Of Counsel, Morrison & Foerster LLP.

[1] See, e.g., Colin Barr, Geithner to Rein in Derivatives, CNNMoney (May 13, 2009), http://money.cnn.com/2009/05/13/news/derivatives.fortune/.

[2] See, e.g., G-20, Leaders’ Statement: The Pittsburgh Summit (September 24–25, 2009) [hereinafter Leaders’ Statement], available at http://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf.

[3] See, e.g., Randall Dodd, Derivative Study Center, The Structure of OTC Derivatives Markets 2 (2002), http://www.financialpolicy.org/dscotcstructure.pdf.

[4] See Leaders’ Statement, supra note 2.

[5] Leaders’ Statement, supra note 2.

[6] See, e.g., James K. Jackson & Rena S. Miller, Cong. Research Serv., Comparing G-20 Reform of the Over-the-Counter Derivatives Markets (2013), http://www.fas.org/sgp/crs/misc/R42961.pdf.

[7] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 701–74, 124 Stat. 1376, 1641–802 (2010) (codified as amended in scattered sections of 7, 12 and 15 U.S.C. (2012)). The Dodd-Frank Act permits the U.S. Commodity Futures Trading Commission (CFTC) to exercise authority with respect to activities outside of the United States if those activities “have a direct and significant connection with activities in, or effect on, commerce of the United States” or “contravene such rules or regulations as the [CFTC] may prescribe [] as are necessary or appropriate to prevent the evasion of any provision of [the Dodd-Frank Act]”. Id. at § 722(d) (codified at 7 U.S.C. § 2(1)). Title VII of the Dodd-Frank Act gives the CFTC jurisdiction over “swaps” and the U.S. Securities and Exchange Commission (SEC) jurisdiction over “security-based swaps.” Id. at §§ 722(a), 761(a) (codified at 7 U.S.C. § 2(a)(1), 15 U.S.C. § 78c(a)). The Dodd-Frank Act defines each term, id. at §§ 721(a), 722(a), and a joint rulemaking by the CFTC and the SEC has further defined them. See Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208 (Aug. 13, 2012) (to be codified at 17 C.F.R. pts. 1, 230, 240, and 241). Unlike the CFTC, the SEC has not yet finalized its rules regarding extraterritoriality, and its proposed cross-border rules are outside the scope of this article. See Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249). More broadly, in contrast with the CFTC, the SEC has finalized few of its rulemakings under the Dodd-Frank Act, and has postponed the application of many provisions that would treat security-based swaps as “securities” or would otherwise subject security-based swaps to the Dodd-Frank Act. See Extension of Exemptions for Security-Based Swaps, 78 Fed. Reg. 7,654 (February 4, 2013); Order Extending Temporary Exemptions Under the Securities Exchange Act of 1934 in Connection With the Revision of the Definition of “Security” to Encompass Security-Based Swaps, and Request for Comment, 78 Fed. Reg. 10,218 (February 13, 2013); Temporary Exemptions and Other Temporary Relief, Together With Information on Compliance Dates for New Provisions of the Securities Exchange Act of 1934 Applicable to Security-Based Swaps, 76 Fed. Reg. 36,287 (June 22, 2011).

[8] As the CFTC has noted, “many foreign jurisdictions have been implementing OTC derivatives reforms in an incremental manner,” and “because many jurisdictions are in the process of finalizing and implementing their derivatives reforms incrementally,” the CFTC’s determinations, discussed infra text accompanying notes 38–50, as to which foreign rules are sufficiently comprehensive and comparable to the CFTC’s own rules “may need to take into account the timing of regulatory reforms that have been proposed or finalized, but not yet implemented.” Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,343–44 (July 26, 2013) (to be codified at 17 C.F.R. § 1). For an analysis of one area in which there is a significant difference in timing between U.S. rules and analogous foreign rules, see James E. Schwartz, Marissa N. Golden & Robert J. Dilworth, First Steps on the Path Forward, 32 Int’l Fin. L. Rev. 36, 36–37 (2013), available at http://www.iflr.com/Article/3247985/The-path-forward-for-EU-US-derivatives-regulation.html (analyzing the status of the trade execution mandate in the U.S. and the EU, and noting that while the CFTC’s mandate will be in effect shortly, the EU’s is not expected to be in place until possibly as late as 2016).

[9] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292.

[10] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 43,785, 43,794–95 (July 22, 2013) (stating that numerous requirements for certain non-U.S. market participants and certain non-U.S. branches of U.S. swap dealers will go into effect on the earlier of December 21, 2013 or 30 days after the issuance of an applicable substituted compliance determination).

[11] See id.

[12] See id.

[13] See id. at 43,789.

[14] Even close followers of regulatory matters could be forgiven for not recognizing the words “substituted compliance” when the CFTC used and defined the term in its 2012 proposed interpretive guidance regarding cross-border matters. See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. 41214, 41229 (proposed July 12, 2012). The term appears to have its origins in a seminal 2007 article in the Harvard International Law Journal, in which the authors argued that foreign stock exchanges and broker-dealers should be able to provide services in the United States “based on their compliance with substantively comparable foreign securities regulations and laws and supervision by a foreign securities regulator with oversight powers and a regulatory and enforcement philosophy substantively similar to the SEC’s,” instead of based on compliance with U.S. securities regulations and SEC supervision. Ethiopis Tafara & Robert J. Peterson, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework, 48 Harv. Int’l L.J. 31, 32 (2007). Although the SEC signed a “mutual recognition agreement” with Australian regulators in 2008, it apparently shelved its plans to increase mutual recognition activities shortly thereafter, driven partly by the financial crisis. See Jerry Ellig & Houman B. Shadab, Talking the Talk, or Walking the Walk? Outcome-Based Regulation of Transnational Investment, 41 N.Y.U. J. Int’l L. & Pol. 265, 268 (2009).

[15] See Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act, 77 Fed. Reg. at 41,229.

[16] See Exemptive Order Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 43,794.

[17] See, e.g., Anish Puaar, EU Firms Forced to Take Action to Avoid US Clearing Rules, Financial News (October 10, 2013), http://www.efinancialnews.com/story/2013-10-10/eu-firms-forced-to-take-action-to-avoid-us-clearing-rules?ea9c8a2de0ee111045601ab04d673622 (“[S]ome European buyside firms are not prepared to clear their swap trades, leading them to either switch to US banks’ European entities or stop trading with them altogether.”).

[18] See id.

[19] The Dodd-Frank Act amended the Commodity Exchange Act, 7 U.S.C. §§ 1–27f (2012), to provide that swaps that the CFTC subjects to mandatory clearing must be executed on either a swap execution facility or a designated contract market, unless no swap execution facility or designated contract market makes the swap available to trade. See Dodd-Frank Act at § 723(a)(8); 7 U.S.C. § 2(h)(8). Mandatory execution on a swap execution facility for certain transactions is expected to commence in the near future, as swap execution facilities have started submitting “made available to trade” determinations, which the CFTC will consider pursuant to its rules. See Process for a Designated Contract Market or Swap Execution Facility To Make a Swap Available to Trade, Swap Transaction Compliance and Implementation Schedule, and Trade Execution Requirement Under the Commodity Exchange Act, 78 Fed. Reg. 33,606 (June 4, 2013) (to be codified at C.F.R. pts. 37 and 38); Provisions Common to Registered Entities, 76 Fed. Reg 44,776, 44,793-96 (July 27, 2011) (to be codified at C.F.R. pt. 40); Silla Brush, Javelin Files to Trade Interest-Rate Swaps, Spurring Sef Shift, Bloomberg (October 19, 2013), http://www.bloomberg.com/news/2013-10-19/javelin-files-to-trade-interest-rate-swaps-spurring-sef-shift.html.

[20] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. 45,292, 45,331–40 (July 26, 2013) (to be codified at 17 C.F.R. § 1).

[21] See id. at 45,335–36.

[22] See id. at 45,336.

[23] See id. at 45,335–36.

[24] See id. at 45,369 apps. D & E.

[25] The CFTC’s cross-border guidance defines a U.S. Person “generally to include, but not be limited to: (i) Any natural person who is a resident of the United States; (ii) any estate of a decedent who was a resident of the United States at the time of death; (iii) any corporation, partnership, limited liability company, business or other trust, association, joint-stock company, fund or any form of enterprise similar to any of the foregoing (other than an entity described in prongs (iv) or (v), below) (a ‘legal entity’), in each case that is organized or incorporated under the laws of a state or other jurisdiction in the United States or having its principal place of business in the United States; (iv) any pension plan for the employees, officers or principals of a legal entity described in prong (iii), unless the pension plan is primarily for foreign employees of such entity; (v) any trust governed by the laws of a state or other jurisdiction in the United States, if a court within the United States is able to exercise primary supervision over the administration of the trust; (vi) any commodity pool, pooled account, investment fund, or other collective investment vehicle that is not described in prong (iii) and that is majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v), except any commodity pool, pooled account, investment fund, or other collective investment vehicle that is publicly offered only to non-U.S. persons and not offered to U.S. persons; (vii) any legal entity (other than a limited liability company, limited liability partnership or similar entity where all of the owners of the entity have limited liability) that is directly or indirectly majority-owned by one or more persons described in prong (i), (ii), (iii), (iv), or (v) and in which such person(s) bears unlimited responsibility for the obligations and liabilities of the legal entity; and (viii) any individual account or joint account (discretionary or not) where the beneficial owner (or one of the beneficial owners in the case of a joint account) is a person described in prong (i), (ii), (iii), (iv), (v), (vi), or (vii).” Id. at 45,316–17.

[26] See id. at 45,369 apps. D & E.

[27] See id. at 45,350 n.513.

[28] See id. at 45,369 apps. D & E.

[29] A “guaranteed affiliate” is a “non-U.S. person that is an affiliate of a U.S. person and that is guaranteed by a U.S. person.” Id. at 45,318.

[30] See id. at 45,369 apps. D & E. The CFTC has not precisely defined “affiliate conduit” but has stated that certain factors are relevant to the consideration of whether a non-U.S. Person constitutes an affiliate conduit. See id. at 45,369 app. D n.1. Such factors include “whether (i) the non-U.S. person is majority-owned, directly or indirectly, by a U.S. person; (ii) the non-U.S. person controls, is controlled by, or is under common control with the U.S. person; (iii) the non-U.S. person, in the regular course of business, engages in swaps with non-U.S. third party(ies) for the purpose of hedging or mitigating risks faced by, or to take positions on behalf of, its U.S. affiliate(s), and enters into offsetting swaps or other arrangements with such U.S. affiliate(s) in order to transfer the risks and benefits of such swaps with third-party(ies) to its U.S. affiliates; and (iv) the financial results of the non-U.S. person are included in the consolidated financial statements of the U.S. person.” Id.

[31] See id. at 45,369 app. D. Substituted compliance does not apply with respect to the external business conduct rules that constitute the Category B Transaction-Level Requirements. See id. at 45,369 app. E. This may be partly because such rules, which require dealers in certain transactions to provide pre-trade and daily mid-market marks, and, upon request, scenario analyses, are not expected to have analogs in many non-U.S. jurisdictions. See Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties, 77 Fed. Reg. 9,734 (February 17, 2012) (to be codified at 17 C.F.R. pts. 4 and 23).

[32] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations,78 Fed. Reg. at 45,368.

[33] Even with regard to the EU, one of the only foreign regulators with which the CFTC has appeared to have tangibly productive discussions, see infra n.51–53 and accompanying text, the lack of a detailed agreement between regulators is reportedly harming the negotiation of a U.S.-EU free trade agreement. Luke Baker & Stephen Adler, Derivatives Dispute Harming EU-U.S. Free-Trade Talks, Reuters (October 29, 2013), http://uk.reuters.com/article/2013/10/29/uk-eu-us-regulation-idUKBRE99S0G220131029.

[34] See Edward F. Greene & Ilona Potiha, Issues in the Extraterritorial Application of Dodd-Frank’s Derivatives and Clearing Rules, the Impact on Global Markets and the Inevitability of Cross-Border and US Domestic Coordination, 8 Cap. Mkts. L.J. 338, 353 (2013).

[35] See id.

[36] See id. at 386.

[37] See Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 Fed. Reg. at 45,344.

[38] Id. at 45,342.

[39] Id. at 45,342–43. “In evaluating whether a particular category of foreign regulatory requirement(s) is comparable and comprehensive to the applicable requirement(s) under the [Commodity Exchange Act] and Commission regulations, the Commission will take into consideration all relevant factors, including but not limited to, the comprehensiveness of those requirement(s), the scope and objectives of the relevant regulatory requirement(s), the comprehensiveness of the foreign regulator’s supervisory compliance program, as well as the home jurisdiction’s authority to support and enforce its oversight of the registrant.” Id. at 45,343.

[40] Id. at 45,344.

[41] Id. at 45,343.

[42] See id.

[43] Id. at 45,343–44.

[44] Id. at 45,343.

[45] Id. at 45,344.

[46] See id. at 45,343.

[47] Id. at 45,343–44.

[48] Id. at 45,342.

[49] See Ellig & Shadab, supra note 14, at 282 (“Outcomes are the actual benefits created, or harms avoided, for citizens. . . . [R]egulations issued are outputs that may affect outcomes, but they are not outcomes.”).

[50] Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, 78 Fed. Reg. 30,968, 30,975 (proposed May 23, 2013) (to be codified at 17 C.F.R. pts. 240, 242, and 249).

[51] See Press Release, U.S. Commodity Future Trading Commission, The European Commission and the CFTC Reach a Common Path Forward on Derivatives (July 11, 2013), available at http://www.cftc.gov/PressRoom/PressReleases/pr6640-13.

[52] Id.

[53] Id.

[54] Id.

[55] Id.

[56] See Greene & Potiha, supra note 34, at 385–92.

By

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/.

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).

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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.