Mandatory Central Clearing: Clearinghouse Failure and Systemic Risk

Cadwalader, Wickersham & Taft LLP www.cadwalader.com

Mandatory Central Clearing: Clearinghouse Failure and Systemic Risk

Presented By: Robert Zwirb ACI’s Swaps & Derivatives Transaction Conference

December 1, 2016 Introduction

• Clearing of certain OTC derivatives through central counterparties (“CCPs”) or clearinghouses is touted as a way to reduce both counterparty and systemic risk and greatly lower the likelihood of a repeat of the 2007–2009 financial crisis.

• Following the financial crisis of 2007-2009, leaders of the G-20 nations agreed that “[a]ll standardized OTC derivative contracts should be traded on exchanges or electronic trading, where appropriate, and cleared through central counterparties by end- 2012 at the latest.”

• To reduce systemic risk in the derivatives markets, the Dodd Frank Act mandated trading of certain OTC derivatives be subject to central clearing.

Cadwalader, Wickersham & Taft LLP 2 Introduction

• “The push for mandatory clearing of OTC traded derivatives is as much a result of the long history of success of exchange traded derivative markets in minimizing counterparty risk and promoting transparency as the presumed failure of certain OTC traded derivative markets to handle counterparty risk during the recent financial crisis. Simply stated, exchange traded derivative markets worked well during the crisis while some OTC derivatives markets either did not or appeared not to work well.”

• Joseph K. W. Fung; Robert I. Webb, Clearing and OTC Traded Derivatives: A Survey, Review of Futures Markets; 2012 Special Edition, Vol. 20, p. 9, July 2012.

Cadwalader, Wickersham & Taft LLP 3 Introduction

• More recently, however, concerns have been raised that CCPs themselves may be a source of systemic risk.

• For example, while acknowledging that requiring most bilateral swaps to be cleared through a CCP “minimizes counterparty risk and represents a significant step towards ensuring a safe and stable financial system,” some members of Congress have expressed concerns that such an arrangement “engenders the risk that a DCO might fail because of an increased concentration of risk at the clearinghouse, causing significant threats to the financial

system.” Letters from Sen. Elizabeth Warren, Sen. Mark Warner and Rep. Elijah E. Cummings (D-MD and Rep. Cummings to CME Group, Inc. and Ice Clear Credit LLC regarding recovery and resolution plans of those clearing organizations (July 5, 2016) .

Cadwalader, Wickersham & Taft LLP 4 Central counterparty clearing

• “Central counterparty clearing” refers to an arrangement by which a central counterparty (or CCP) is substituted as a principal to all cleared trades, becoming the buyer to all sellers and the seller to all buyers.”

Ivan Ruffini & Robert Steigerwald, OTC Derivatives — A Primer on Market Infrastructure and Regulatory Policy (Nov. 25, 2014).

Cadwalader, Wickersham & Taft LLP 5 Bilateral vs Cleared Transactions

Bilateral Central Clearing

A B 100 A B

CCP

Chart derived from presentation slides by Darrell Duffie, Failure Resolution of Central Counterparties, Banque de France-ACPR Conference, Paris (September 28, 2015).

Cadwalader, Wickersham & Taft LLP 6 Benefits of central counterparty clearing

• Clearing facilitates three important benefits: (1) multilateral netting of exposures and payments by the clearinghouse, (2) improved counterparty risk management, and (3) increased transparency for regulators and the public through increased availability of information on market activity and exposures. – Clearing also permits customers to take positions without concern for the financial integrity of persons on the other side of the trade, because it is the clearinghouse, not the customer, that deals with counterparty risk. Thus, clearing members do not need to make a credit assessment of the other clearing members or their clients. – Clearing also allows large losses to be mutualized, or spread among a CCP’s broad membership. If one member cannot honor its obligations in a trade, the member's losses are first borne by its margin. If the margin is insufficient, then the DCO can tap a default fund, which all members pay into as a condition of membership.

Cadwalader, Wickersham & Taft LLP 7 Benefits of central counterparty clearing

• Under clearing, the tangled and highly opaque picture of a purely bilateral market is replaced by a neater and simpler hub-and-spoke network in which the CCP is buyer to every seller, and seller to every buyer, allowing netting and greater transparency for participants and regulators alike, as illustrated by the chart below:

Cadwalader, Wickersham & Taft LLP 8 Benefits of central counterparty clearing

• It is also claimed that a clearinghouse is much less likely than its members to fail during a crisis.

• “When a member fails, the clearinghouse engages in netting, meaning that it uses short-term debts owed to the member to immediately repay short-term debts owed by the member.

• As a result, the surviving clearinghouse members are paid much more quickly than they would be in bankruptcy. Meanwhile, the bankrupt member's outside (non-clearinghouse) creditors are not paid any less quickly: they still are paid at the end of the bankruptcy proceeding, which the clearinghouse does nothing to prolong.

• By accelerating cash payouts to some creditors without slowing down payouts to others, the clearinghouse decreases total illiquidity risk in the financial sector.”

• Richard Squire, Clearinghouses as Liquidity Partitioning, 99 Cornell L. Rev., 857, 859 (May 2014).

Cadwalader, Wickersham & Taft LLP 9 Risks of Central Counterparty Clearing

• In general, the risks associated with clearing are: a) a default by a large clearing member or more than one clearing member, which could put at risk the financial integrity of the clearing organization; b) contagion, whereby the failure of a clearing member could cause the CCP to fail to meet its obligations to other clearing members; c) fire sales of collateral or derivatives contracts, and disorderly unwind of CCPs exacerbating broad market volatility; and d) loss of continuity of critical clearing services on which the financial system has come to depend.

Darrell Duffie, "Resolution of Failing Central Counterparties," in Making Failure Feasible: How Bankruptcy Reform Can End 'Too Big To Fail', edited by Thomas Jackson, Kenneth Scott and John E. Taylor, Hoover Institution Press, p. 88, (2015).

Cadwalader, Wickersham & Taft LLP 10 The Case For Mandatory Central Clearing

• Advocates of mandatory central clearing argue that it reduces both 1) interconnectedness that leads to financial contagion in times of stress, and 2) systemic risk.

• “Advocates have repeatedly stated that the interconnected nature of the financial system makes it vulnerable to contagion, in which the failure of one large financial institution brings down others with which it has traded. They state further that clearing ‘greatly reduces’ these interconnections. Advocates have also claimed that CCPs eliminate counterparty risk and guarantee all payments owed under derivatives contracts.” Craig Pirrong, The Inefficiency of Clearing Mandates, p. 24 (CATO Inst., Policy Analysis No. 665, 2010).

•

Cadwalader, Wickersham & Taft LLP 11 Mandatory Central Clearing—CFTC View

• “The Commission believes that a clearing requirement will reduce counterparty credit risk and provide an organized mechanism for collateralizing the risk exposures posed by swaps.”

• “‘With appropriate collateral and margin requirements, a central clearing organization can substantially reduce counterparty risk and provide an organized mechanism for clearing transactions. * * * While large losses are to be expected in derivatives trading, if those positions are fully margined there will be no loss to counterparties and the overall financial system and none of the uncertainty about potential exposures that contributed to the panic in 2008.’” • Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74284, 74285 (Dec. 13, 2012) (Final Rule), quoting Senate Report 111–176, at 32 (April 30, 2010).

Cadwalader, Wickersham & Taft LLP 12 Mandatory Central Clearing—CFTC View

• “The Commission notes that CME or its predecessors have cleared futures since 1898 and is the largest futures clearinghouse in the world. CME has not defaulted during that time.”

• “[T]he Commission believes that the central clearing of the interest rate swaps that are the subject of this determination and final rule would serve to mitigate counterparty credit risk thereby having a positive effect on reducing systemic risk.”

• “Clearinghouses have demonstrated resilience in the face of past market stress. Most recently, they remained financially sound and effectively settled positions in the midst of turbulent events in 2007–2008 that threatened the financial health and stability of many other types of entities.” Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74284, 74312, 74322 (Dec. 13, 2012).

Cadwalader, Wickersham & Taft LLP 13 Mandatory Central Clearing—Views of Critics

• Critics argue that mandatory central clearing: 1) transforms credit risk into liquidity risk, and that liquidity risk is more systemically threatening than credit risk; 2) does not make default risks disappear, but instead distributes them among the other members of the clearinghouse; and 3) does not reduce systemic risk, but rather concentrates it in the clearinghouse.

• For example, Federal Reserve Governor Jerome H. Powell points out that central clearing has its own set of risks including that of “concentrating risk in a central counterparty [that] could create a single point of failure for the entire [financial] system.” OTC Market Infrastructure Reform: Opportunities and Challenges, Speech by Federal Reserve Board Governor Jerome H. Powell at the Clearing House 2013 Annual Meeting, New York, New York (Nov. 21, 2013).

Cadwalader, Wickersham & Taft LLP 14 • “ Mandatory Central Clearing—Views of Critics

• In central clearing, “counterparty risk is aggregated in a central node, the CCP . . . this centralization of risk

can be both beneficial and a source of fragility.” Ivan Ruffini & Robert Steigerwald, OTC Derivatives — A Primer on Market Infrastructure and Regulatory Policy, p. 81 (Nov. 25, 2014).

• “There are several advantages to (clearing houses) but it’s important to know . . . that using (clearing houses) doesn’t reduce risk; indeed it concentrates

risk.” Richard Berner, Director Office of Financial Research, quoted in Douwe Medema, Clearing houses are big risk, top U.S. federal researcher says, Reuters (May 15, 2013).

Cadwalader, Wickersham & Taft LLP 15 Mandatory Central Clearing—Views of Critics

• “[T]he most potentially serious systemic effect of the mandated introduction of CCPs is that clearinghouses create concentrated nodes that interconnect financial firms—and these nodes can fail. That is, CCPs are concentrated points of potential failure that are systemically important and whose failure could cause a contagion effect—precisely what current reformers are anxious to avoid.” Craig Pirrong, The Inefficiency of Clearing Mandates, p. 27 (CATO Inst., Policy Analysis No. 665, 2010).

• Economist C.L. Culp argues that mandatory centralized clearing of standardized OTC derivatives “might well actually increase the fragility of the financial system by creating new institutions that regulators, and politicians believe are too big or too interconnected

to fail.” C.L. Culp, The Treasury Department’s Proposed Regulation of OTC Derivatives Clearing & Settlement. Chicago Booth Research Paper No. 09-30; CRSP Working Paper, July 6, 2009. Available at SSRN: http://ssrn.com/abstract=1430576.

Cadwalader, Wickersham & Taft LLP 16 Problems With the Clearinghouse Solution— CCPs Face More Risk Clearing Swaps

• “A CCP faces more risk clearing OTC derivatives, which have very high values and long maturities compared to other cleared contracts (e.g., for commodities), while the operational complexities involved in clearing OTC derivatives are also far greater.” Jo Braithwaite, Legal Perspectives on Client Clearing 9 (LSE Legal Studies Working Paper No. 14/2015, 2015), http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2629193

• “Some swaps may behave unremarkably during normal market conditions, but may be prone to unanticipated, dramatic price moves. Liquidity may fluctuate during a swap’s lifetime. Interproduct correlations are also not constant over time. • CCPs’ margin models—developed for more standardized, highly liquid derivatives—may not properly accommodate the unique features of these newly cleared products and their correlations with other cleared products.” Hester Peirce, Derivatives Clearinghouses: Clearing the Way to Failure, 64 Clev. St. L. Rev. 589, 634 (2016).

Cadwalader, Wickersham & Taft LLP 17 Problems With the Clearinghouse Solution— CCPs Face More Risk Clearing Swaps

• “OTC derivatives require more-conservative margin models because of their complexity and the greater uncertainty of the reliability of price quotes.” Hester Peirce, Derivatives Clearinghouses: Clearing the Way to Failure, 64 Clev. St. L. Rev. 589, 616 (2016).

• “As CCPs expand into new markets, . . . there is a question about how effectively SPAN [a common margin methodology] can be adapted to deal with the more complex portfolios that result.” Raymond Knott & Alastair Mills, Modelling Risk in Central Counterparty Clearing Houses: A Review, Fin. Stability Rev., p. 164 (Dec. 2002).

• “Risk management, already complex for CCPs clearing OTC derivatives, is even more difficult in large, multi-product CCPs.” Hester Peirce, Derivatives Clearinghouses: Clearing the Way to Failure, 64 Clev. St. L. Rev. 589, 622 (2016).

Cadwalader, Wickersham & Taft LLP 18 Mandatory Central Clearing and Systemic Risk

• “Central counterparty clearing can be effective in managing counterparty credit risk. Does it also mitigate systemic risk? As we have seen, it transforms counterparty relationships by interposing the clearinghouse as the common counterparty to all clearing members. As a result, clearing members (and the end-users on behalf of which they act) become completely dependent on the ability of the CCP to perform its obligations.

• In addition, central clearing concentrates risk in the CCP making it ‘... a major channel through which ... [financial] shocks are transmitted across domestic and international financial markets.’” Ivan Ruffini & Robert Steigerwald, OTC Derivatives — A Primer on Market Infrastructure and Regulatory Policy, p. 91 (Nov. 25, 2014).

Cadwalader, Wickersham & Taft LLP 19 Mandatory Central Clearing and Systemic Risk

• “Clearinghouses mitigate the credit risks that buyers and sellers would face if they dealt directly with each other. . . Yet here lies the dilemma: large clearinghouses reduce credit risk, but they heighten systemic risk since the collapse of one such entity threatens the entire financial system. • While regulators have tackled the systemic risks posed by large banks, the systemic risks of these nonbank intermediaries have received less attention. In fact, financial reform has spurred clearinghouse growth and consolidation.”

• Felix B. Chang, "The Systemic Risk Paradox: Banks and Clearinghouses Under Regulation," 2014 Colum. Bus. L. Rev. 747, 788 (2014) (emphasis added).

Cadwalader, Wickersham & Taft LLP 20 Mandatory Central Clearing and Systemic Risk

• “Clearing reduces risk; it does not eliminate it, and much of the residual risk ends up concentrated in the clearing houses themselves . . . Clearing houses are designed so that losses too big to be absorbed by their own thin slices of capital are mutualised among their members, most of which are banks. If one member is unable to meet its obligations, the others become liable. As a result, if clearing houses do falter, they may become new sources of contagion — the very problem they are meant to eliminate.

• Ultimately, instead of seeing clearing as a panacea, regulators should take a more nuanced view that recognises its limits.”

Gary Cohn, Clearing houses reduce risk, they do not eliminate it, Financial Times, June 22, 2015.

Cadwalader, Wickersham & Taft LLP 21 Mandatory Central Clearing and Systemic Risk

• The CFTC has recently begun to acknowledge the risks that central clearing may pose to the market:

• For example, in its preamble to rules requiring enhanced risk management standards for "systemically important" clearinghouses (“SIDCOs”), the CFTC acknowledges that, during times of financial stress, a clearinghouse's call for additional capital from its clearing members could start a "downward spiral which, combined with restricted credit, might lead to additional defaults of clearing members . . . and play a significant role in the destabilization of the financial markets." Enhanced Risk Management Standards for Systemically Important Derivatives Clearing Organizations, 78 Fed. Reg. 49663, 49672 (Aug. 15, 2013).

• Similarly, the agency’s Chairman recently stated: “As we make clearinghouses even more important in the global financial system, we must pay attention to the risks that they can pose.” Keynote Address of Chairman Timothy G. Massad before the Futures Industry Association Boca Conference (Mar. 11, 2015).

Cadwalader, Wickersham & Taft LLP 22 Mandatory Central Clearing and Systemic Risk

• Likewise, industry groups have come to recognize the risks entailed in mandatory clearing. For example, FIA Global, the primary industry association for "centrally cleared futures, options and swaps," issued a report in 2015 entitled "CCP Risk Position Paper" that notes that:

 clearing "entails [clearing members'] outsourcing the management of certain of . . . potentially concentrated, opaque and unquantifiable risks" to CCPs;

 clearing members "are wholly dependent on CCPs' effective management of this risk";

 in times of distress, clearing members may be "motivated to withdraw their unprotected financial resources" rather than work to ensure the continuity of the CCP; and

 in remote scenarios, "CCP default waterfall resources [might be] inadequate to absorb default-related losses.”

FIA Global, CCP Risk Position Paper (April 2015)) (emphasis added).

Cadwalader, Wickersham & Taft LLP 23 Performance of CCPs During Times of Stress: Two Schools of Thought

Two schools of thought surround the performance of clearance and settlement systems during times of financial stress.

 The first school of thought emphasizes that even in extreme conditions, the system has always come through intact; that safeguards in place for the futures markets have always worked effectively; that no customer funds have ever been lost as a result of a clearing member’s failure or default; that exchange clearing organizations have collected all margins due them from member firms; and that futures clearing mechanisms operated effectively despite record volumes, price swings, and margin flows during the 1987 and 2008 crises.

 The opposing school of thought is less sanguine about the performance of the clearing and settlement system. Members of this school point to the fact that in some of cases, the default of clearing members has been so large and precipitous as to place the segregated funds of non-defaulting customers at risk; that in such cases actual customer losses were avoided only by voluntary ad hoc actions of the clearing organization or contributions from the FCM’s principals; and that in other cases, liquidity supplied by the Fed rescued clearing firms and clearinghouses from insolvency.

Cadwalader, Wickersham & Taft LLP 24 History of CCPs During Times of Stress

• While CCPs rarely fail, clearinghouses failed in France in 1974, Kuala Lumpar in 1984, and Hong Kong in 1987, all due to margin issues. In addition, Brazil’s BM&F CCP almost failed in 1999 due to the default of two clearing members after a devaluation of Brazil’s currency. Hester Peirce, Derivatives Clearinghouses: Clearing the Way to Failure, 64 Clev. St. L. Rev. 589, 651 (2016).

• Further, the central bank acted in 1987 to buttress the Options Clearing Corporation's liquidity: “When precarious swings in the equities markets caused OCC to make margin calls that some members could not honor, the Fed used its lender-of-last-resort powers to induce and cajole the money center banks into lending to OCC.” Felix B. Chang, "The Systemic Risk Paradox: Banks and Clearinghouses Under Regulation," 2014 Colum. Bus. L. Rev. 747, 788 (2014).

Cadwalader, Wickersham & Taft LLP 25 History of CCPs During Times of Stress

• In 2008, “clearinghouses might have failed if the government hadn't rescued the commercial paper market.” Pudd'nhead Wilson in Washington, Suddenly, regulators are warning about financial clearinghouses Wall St. J. (April 23, 2011). • More recently, in mid-December 2013, HanMag Investment Securities failed to meet its option margin payment obligations to the clearinghouse of Korea Exchange (KRX). After KRX was forced to use some of the clearinghouse guaranty fund to cover the losses, clearing members were contractually obliged to make replenishment payments within a month. Some clearing members, however, failed to do so, and the replenishment payments were postponed until the end of March 2014. Darrell Duffie, "Resolution of Failing Central Counterparties," in Making Failure Feasible: How Bankruptcy Reform Can End 'Too Big To Fail', edited by Thomas Jackson, Kenneth Scott and John E. Taylor, Hoover Institution Press, p. 92 (2015).

Cadwalader, Wickersham & Taft LLP 26 History of CCPs During Times of Stress—The Financial Crisis of 2008

• “The push towards central clearing is motivated by the experience of the Great Financial Crisis. After the Lehman Brothers default in September 2008, central counterparties continued to function smoothly despite abnormally high market volatility. Within a short time frame, the positions of Lehman clients were either transferred to other, non-defaulting, CCP participants or liquidated. • Moreover, preliminary econometric evidence suggests that banks operating in systems where a larger portion of transactions were cleared by CCPs were less likely to suffer a significant deterioration of solvency when the crisis hit.”

• Dietrich Domanski, Leonardo Gambacorta and Cristina Picillo, Central clearing: trends and current issues, BIS Quarterly Review, p. 65 (Dec. 6, 2015)

Cadwalader, Wickersham & Taft LLP 27 History of CCPs During Times of Stress—The Financial Crisis of 2008

• It is often noted that CCPs made it through the recent financial crisis without direct government assistance.

The experience of LCH.Clearnet, Ltd. (LCH) during the Lehman Brothers bankruptcy proceedings provides a recent example of how a clearinghouse can successfully manage a member default:

 In managing the Lehman default, LCH did not need to access the default fund; LCH's success can be attributed to effective margining requirements and the clearinghouse's ability to determine the amount of collateral necessary to cover future potential losses upon a member default.

 But while CCPs made it through the recent financial crisis without direct government assistance, many of their major clearing members, as Federal Reserve Board Governor Jerome H. Powell has noted, did receive such assistance.

Cadwalader, Wickersham & Taft LLP 28 Lessons From the 1987 Stock Market Crash

• During the 1987 stock market crash, former Fed Chairman Ben Bernanke noted that “concerns about solvency impeded the operation of the payments and clearing systems, contributing to financial gridlock. . . [and] fear[s] that major brokers, FCMs, or clearinghouses might default created uncertainty about the contract performance guarantee. Both aspects reduced market liquidity and disrupted trading. Conceivably these problems could have forced a market shutdown.”

• To deal with this crisis, the Fed intervened in its capacity as lender-of-last- resort: “The principal effect of the loans was to transfer some trader default risk from the clearinghouses and their members to money-center banks . . . This allowed the payments process to begin to normalize; it also restored confidence in the clearinghouse’s guarantee of futures contract performance . . . the Fed [thus]redistributed risks in the system in a socially beneficial way . . . [by] provid[ing] ex post insurance to the clearinghouse against a shock that it seemed possible would exhaust the insurance capability of the clearinghouse itself.”

• Ben Bernanke, “Clearing and Settlement during the Crash” Review of Financial Studies vol. 3, no. 1, at p. 149 (1990) (emphasis added).

Cadwalader, Wickersham & Taft LLP 29 Lessons From the 1987 Stock Market Crash

• “[L]ate settlement payments associated with derivatives markets were one of the root causes of near payments gridlock during the 1987 market crash.” John W. McPartland, Clearing and Settlement of Exchange Traded Derivatives, Chi. Fed Letter, No. 267, Oct. 2009, at 3.

• Former Fed Chairman Ben Bernanke noted that during the 1987 stock market crash, “clearinghouses . . . absorbed significant amounts of intraday liquidity from the markets by collecting, but not always paying out . . . variation margin—payments that investors were required to make as the values of their holdings plunged . . . although the clearinghouse system avoided defaults, investor uncertainties about the viability of the clearinghouses, as well as about the ability of major broker-dealers to meet their obligations, intensified market fluctuations and panic.” Speech of Chairman Ben S. Bernanke , Clearinghouses, Financial Stability, and Financial Reform, 2011 Financial Markets Conference, Stone Mountain, Georgia (Apr. 4, 2011) (emphasis added).

Cadwalader, Wickersham & Taft LLP 30 Lessons From the 1987 Stock Market Crash

• “[B]ecause of the large moves in stock prices on October 19, 1987, the magnitude of margin calls were far larger than on typical days. Moreover, there were serious doubts about the solvency of several members of major clearinghouses . . . In these circumstances, normal clearing and payment mechanisms were on the verge of breakdown.” Craig Pirrong, The Inefficiency of Clearing Mandates p. 26 (CATO Inst., Policy Analysis No. 665, 2010).

• “An example of the risks posed by CCPs’ dependence on time- critical liquidity flows intermediated by settlement banks occurred in October 1987 when global equity markets plunged and clearing members were required to meet large intraday and end-of-day margin calls. Settlement banks became ‘less willing to advance credit to clearing members’ and the Federal Reserve had to take action to ensure adequacy of aggregate liquidity in the financial system.” Ivan Ruffini & Robert Steigerwald, OTC Derivatives — A Primer on Market Infrastructure and Regulatory Policy, p. 91 (Nov. 25, 2014) (citations omitted).

Cadwalader, Wickersham & Taft LLP 31 Summary of Important Customer Protections

• The futures and swaps industry relies upon: 1) a system of financial safeguards to prevent a default by a clearing member from occurring in the first place; 2) the interpositioning of clearing corporations between FCMs to insulate FCMs from each others’ failures; and 3) modified bankruptcy rules that are designed to minimize losses to customers if an FCM does fail by elevating the status of customers’ claims over that of other FCM creditors. 4) Failure resolution procedures if a CCP fails.

Cadwalader, Wickersham & Taft LLP 32 Financial Integrity of the FCM

• To protect an FCMs’ solvency and to safeguard customer assets in an FCM: (i) customers are required to post risk-based initial margin, and mark-to- market (variation) margin, (ii) customer funds held by FCMs are subject to segregation, and (iii) FCMs are subject to capital and risk management requirements.

• In addition to these specific safeguards, the structure and organization of the commodity futures industry also serves to protect customer funds. In particular, clearing organizations serve as the central counterparty to all trades and thus act as guarantors of the net obligations of member firms to each other.

• If an FCM becomes insolvent, notwithstanding these protections, then the rights of the various parties are governed by a special bankruptcy regime under the Bankruptcy Code and CFTC rules that prescribes how customer claims are calculated and gives some priority to the claims of public customers over other general creditors.

Cadwalader, Wickersham & Taft LLP 33 Financial Integrity of the CCP

• Similar, but not identical protections are applied to clearinghouses:  To guarantee the performance of all clearing members, a CCP collateralizes, or margins, the financial performance exposure that the CCP has to each of its clearing members (called clearing margin).  Initial Margin is generally set to cover one day’s probable market movement with a 95% to 99% confidence limit, and is designed to cover the worst-case close out costs in the event a member defaults. For swaps, CFTC rules require that margin cover a five-day liquidation period at a 99% confidence level.  Collection of variation margin daily by the CCP removes daily market risk from the clearing system and therefore prevents losses from accumulating above the levels collateralized by the collection of initial margin.

Cadwalader, Wickersham & Taft LLP 34 Financial Integrity of the CCP

 By setting the margin requirements at levels that anticipate a likely one- day market price movement, a CCP should have any potential liquidation risks reasonably well collateralized before the fact.

 A defaulting member’s initial margin, therefore, should cover CCP losses during the default management process. If it does not, the CCP proceeds down a so-called “default waterfall” to absorb any remaining losses.

 A default waterfall hierarchy typically first uses the defaulting member’s resources to absorb losses, including the defaulter’s initial margin and contributions to a guaranty fund, then capital of the CCP itself if losses are still not covered, then non-defaulting members’ contributions to the guaranty fund.

 If losses outstrip these resources, however, the CCP moves to the unfunded part of the waterfall by imposing additional losses on non- defaulting members through assessments for additional contributions or haircuts on non-defaulters’ margin.

Cadwalader, Wickersham & Taft LLP 35 Financial Integrity of the CCP—Default Waterfall Hierarchy

• A typical CCP Default Management Waterfall consists of:

Initial margin of the defaulting clearing member ↓ Default fund contribution of defaulting clearing member ↓ Contribution of CCP capital ↓ Default fund contributions of non-defaulting members ↓ Additional CCP capital ↓ Default fund contributions of non-defaulting members ↓ Exercise of CCP powers of assessment on non-defaulting members ↓ Recovery regime ↓ Resolution regime

Cadwalader, Wickersham & Taft LLP 36 Financial Integrity of the CCP

Principle 4 of the Principles for Financial Market Infrastructures, which the CFTC follows, addresses the risk that a counterparty to the CCP will be unable to fully meet its financial obligations when due.

 Specifically, Principle 4 states that a ‘‘CCP should cover its current and potential future exposures to each participant fully with a high degree of confidence using margin and other prefunded financial resources.’’

 Principle 4 as codified in CFTC Rule 39.29 requires a CCP that is “systemically important” or that is involved in activities with a more complex risk profile to maintain financial resources sufficient to cover a wide range of potential stress scenarios, including, but not limited to, the default of the two participants and their affiliates that would potentially cause the largest aggregate credit exposure to the CCP in extreme but plausible market conditions.

Cadwalader, Wickersham & Taft LLP 37 Types of CCP Default

• Clearing member default: A default by one or more large clearing members may put at risk the financial integrity of the clearing organization, which is required to pay variation margin to clearing members with profitable positions notwithstanding its inability to collect such margin owed to it from the defaulting members.

• In addition, insolvency of a CCP can result from:

• (i) operational risk (or the risk that an CCP improperly handles segregated funds and due to fraud, incompetence, or other mishap creates a shortfall), and

• (ii) investment risk (the risk that an CCP experiences losses on its investment of customer collateral or its own capital, which it cannot cover using its capital).

Cadwalader, Wickersham & Taft LLP 38 The Clearinghouse Solution—Challenges In Managing a Default

• Dodd-Frank intends to minimize the impact of counterparty default by increasing the number of derivatives trades cleared. Dodd-Frank also seeks to make clearinghouses more secure through enhanced risk management requirements.

• However, in light of the increasing reliance upon mandatory clearing in today’s financial markets, understanding what would happen if a clearinghouse could not successfully manage a default is critical to evaluating the impact that mandatory clearing has on systemic risk.

Cadwalader, Wickersham & Taft LLP 39 The Clearinghouse Solution—Challenges In Managing a Default

Efforts to preserve the financial integrity of a CCP during a time of financial market stress face a number of challenges including the following:

1) Failure of Recovery Plans to Take a System-Wide Approach

2) Recovery and Resolution Requirements Are Too General and Too Discretionary

3) Margin Calls During a Downturn May Exacerbate a Liquidity Crisis

4) Mandated Clearing May Make a Financial Network More Vulnerable to Precipitous Failure

5) Recovery Tools and CCP Resources May Not Be Adequate in Times of Stress

6) In a Distressed Scenario, Clearing Members May Be Unable or Unwilling to Rescue the CCP

7) Clearinghouses May Be Unable to Handle Multiple Clearing Member Defaults

8) Resolution of Clearinghouses Following Default May Not Be Possible

Cadwalader, Wickersham & Taft LLP 40 Failure to Take a System-Wide Approach

• “The typical CCP recovery strategy does not take a system-wide perspective and is premised on imposing losses on, or drawing liquidity from, CCP members during what may be a period of systemic stress. Many of these members are themselves systemically important firms, which will likely be suffering losses and facing liquidity demands of their own in anything but an idiosyncratic stress scenario at a CCP.” Speech by Fed Governor Daniel K. Tarullo at the Office of Financial Research and Financial Stability Oversight Council's 4th Annual Conference on Evaluating Macroprudential Tools: Complementarities and Conflicts, Arlington, Virginia (Jan. 30, 2015).

• “[R]egulators and legislators have failed to look at the problem holistically, instead focusing on derivatives in isolation without seriously questioning how the changes in derivatives rules will primarily shift risk rather than reduce it, whether it is a good thing or not has escaped attention completely.” Craig Pirrong, When the Levee Breaks, Streetwise Professor (June 8, 2011).

Cadwalader, Wickersham & Taft LLP 41 Failure to Take a System-Wide Approach

• “CCP managers focus on CCP survival, not on the survival of the entire system, and this is quite dangerous when as is almost certainly the case, their decisions have external effects.” Craig Pirrong, Some of Cassandra’s (AKA SWP’s) Warnings on Clearing Begin to Take Hold, Streetwise Professor (November 27, 2013).

• “[E]fforts to make CCPs more resilient can increase pressures elsewhere in the financial system (the “levee effect.”). Relatedly, regulators have not fully come to grips with the redistributive aspects of clearing–including in particular how netting . . . can just relocate systemic risks.” Craig Pirrong, The Fifth Year of The Frankendodd Life Sentence, Streetwise Professor (July 21, 2015).

• “Just as making the levee higher at one point does not reduce flooding risk throughout a river system, but redistributes it, strengthening a CCP can redistribute shocks elsewhere in the system in a highly destabilizing way.” Craig Pirrong, Some of Cassandra’s (AKA SWP’s) Warnings on Clearing Begin to Take Hold, Streetwise Professor (November 27, 2013).

Cadwalader, Wickersham & Taft LLP 42 Regulatory Guidelines Lack Specificity

• Guidance issued by regulators for recovery or resolution of troubled CCPs often lack specificity. Here are a few examples:

 Financial Stability Board: “There is no single strategy that is suitable for all scenarios. In practice, a combination of approaches might be deemed necessary depending on the scenario. Resolution authorities may undertake planning regarding loss allocation, but without giving any ex ante public indications about what those plans and preferred tools might be and how losses would be allocated across direct and indirect participants.”

 ISDA: “It follows that if the contributions to guarantee the default performance of CMs, made by all CMs, is to be a limited amount – and it must be, as the amount of default tail losses are beyond the control of surviving CMs – the tail losses exceeding the large but nevertheless limited resources provided (the “residual losses”) must be born somehow by somebody in some way.”

Cadwalader, Wickersham & Taft LLP 43 Regulatory Guidelines Lack Specificity

• Committee on Payments and Market Infrastructures:

 “Notwithstanding the different regimes and tools for allocating credit losses, liquidity shortfalls, and other losses, if a loss or shortfall occurs, that amount will ultimately be allocated in some manner to owners, participants and, potentially, other creditors.”

 “A presumptive decision point [that would trigger resolution of a CCP] provides more predictability for participants that may have a positive, stabilising effect in an environment of market uncertainty and provide greater incentives for participants and owners to take meaningful recovery action to avoid resolution. On the other hand, the presumptive approach might also undermine the CCP’s ability to effectively implement its recovery plan.”

 “Once a loss materializes, if it is not allocated to one entity it will necessarily be allocated to another entity, and if it is not allocated by one method it will necessarily be allocated by another method.

 “If a [CCP’s] rules do not provide a comprehensive description of how all uncovered losses are allocated, the FMI may be forced to struggle through the crisis in a disorderly manner when all pre-arranged tools are exhausted, which may destabilize the financial markets as a whole and put public funds at risk.”

Cadwalader, Wickersham & Taft LLP 44 Margin Calls During Times of Stress May Create a Liquidity Crisis

• During a crisis, CCPs could face significant liquidity strains.  CCPs function by making and receiving payments according to a strict timeline. Adherence to a strict timeline of payments is important to keep the system working.  “[T]he rigid variation margining mechanism inherent in central clearing creates a tight coupling that can lead to catastrophic failure. Operational or financial delays that prevent timely payment of variation margin can force the CCP into default, or force it or its members to take extraordinary measures to access liquidity during times when liquidity is tight.

 Everything in a cleared system has to perform like clockwork, or an entire CCP can fail. Even slight delays in receiving payments during periods of market stress (when large variation margin flows occur) can bring down a CCP.” Craig Pirrong, A Pitch Perfect Illustration of Blockchain Hype, Streetwise Professor (October 12, 2016).

Cadwalader, Wickersham & Taft LLP 45 Margin Calls During Times of Stress May Create a Liquidity Crisis

• “The central concern with respect to CCP liquidity risk is that a failure of one or more clearing members to meet variation margin calls on time could cause the CCP itself to be unable to meet its own payment obligations as and when expected. Such a failure could jeopardize the ability of [the CCP’s] nondefaulting clearing members to meet their payment obligations when expected and thus is a potential vector for financial contagion.” Patrick M. Parkinson, Speech to Federal Reserve Bank of Chicago Annual Over the Counter Derivatives Symposium: CCP Liquidity Risk Management and Related Failure Management Issues (Apr. 11, 2014).

• Former Fed Chairman Ben Bernanke noted that clearinghouses’ margin calls during the 1987 stock market crash “were widely criticized in postmortems for ‘draining liquidity from the system,’” and that when called upon to provide such funds, banks initially were reluctant to comply. Ben S. Bernanke, Clearing and Settlement During the Crash, 3 Rev. Fin. Stud. 133, 147 (1990).

Cadwalader, Wickersham & Taft LLP 46 Margin Calls During Times of Stress May Create a Liquidity Crisis

• A CCP may destabilize the financial system by making protective margin calls that cause members “to sell assets in a second market, driving down prices there.” If margin payments are delayed, “the CCP may redistribute part of its risk to liquidity providers such as banks.” Raymond Knott & Alastair Mills, Modelling Risk in Central Counterparty Clearing Houses: A Review, Fin. Stability Rev., p. 164 (Dec. 2002).

• “The main source of systemic risk from the clearing mandate derives from the huge liquidity strains that clearing (notably variation margin on a rigid time schedule) will create when the market is stressed. There has been some attention to ensuring CCPs have access to liquidity in the event of a default, but that’s not the real issue either. The real issue is funding large margin calls during a crisis.” Craig Pirrong, The Fifth Year of The Frankendodd Life Sentence, Streetwise Professor (July 21, 2015) (emphasis added).

Cadwalader, Wickersham & Taft LLP 47 Mandated Clearing May Make a Financial Network More Vulnerable to Precipitous Failure

• Two problems associated with CCP default waterfalls are: i) moral hazard and ii) wrong-way risk. • Moral Hazard: A default waterfall may discourage better quality end users from becoming clearing members since their funds can be used to restore losses of weaker members. • Wrong-Way Risk: A CCP faces elevated risks when a clearing firm‘s probability of default is elevated precisely when it owes the CCP substantial amounts on its cleared positions. In such a scenario, the financial condition of the CCP is weakest at the time its financial obligations are greatest.

Cadwalader, Wickersham & Taft LLP 48 Mandated Clearing May Make a Financial Network More Vulnerable to Precipitous Failure

“In the case of a clearinghouse’s insolvency, the clearing members’ incentives create a collective action problem whereby not only would the clearinghouse fail, but many clearing members would likely experience significant losses.

Clearinghouse rules permit clearing members to elect to terminate and liquidate their portfolios upon the insolvency of the clearinghouse. As a result, most clearing members, if not all, would want to exit, creating a run on the clearinghouse. The resulting run on the clearinghouse’s assets would ultimately accelerate its failure.”

Julia Lees Allen, Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis. 64 Stan. L. Rev. 1079, 1094 (Apr. 2012).

Cadwalader, Wickersham & Taft LLP 49 Mandated Clearing May Make a Financial Network More Vulnerable to Precipitous Failure

• “Extreme but plausible events, such as the failure of clearing members or a rapid change in the value of instruments traded by a CCP, could expose it to financial distress. If the CCP has insufficient resources to deal with such stress, it may look to its clearing members to provide support. • But if the problems arise during a period of generalized financial stress, the clearing members may themselves already have been weakened or, even if they remain sound, the diversion of their available liquidity to the CCP may prevent customers of the clearing members from accessing needed funding.”

• Speech by Fed Governor Daniel K. Tarullo at the Office of Financial Research and Financial Stability Oversight Council's 4th Annual Conference on Evaluating Macroprudential Tools: Complementarities and Conflicts, Arlington, Virginia (Jan. 30, 2015)

Cadwalader, Wickersham & Taft LLP 50 Mandated Clearing May Make a Financial Network More Vulnerable to Precipitous Failure

• “A centralised structure of trading exposures may also affect the likelihood and nature of endogenous shocks in the form of forced deleveraging, fire sales and runs. The critical issue in this regard is the interaction between CCPs' risk management practices and those of clearing participants. • On the one hand, if stringent risk management by a CCP replaces lax counterparty risk management in bilateral markets, central clearing would tend to reduce the risk of such procyclical behaviour. • On the other hand, an unexpected tightening of CCP risk management could still lead to liquidity pressures on participants that could ultimately trigger fire sales and a self-reinforcing

deleveraging.” Dietrich Domanski, Leonardo Gambacorta and Cristina Picillo, Central clearing: trends and current issues, BIS Quarterly Review, p. 69 (Dec. 6, 2015).

Cadwalader, Wickersham & Taft LLP 51 Mandated Clearing May Make a Financial Network More Vulnerable to Precipitous Failure

• “[The] failure of a CCP to meet its payment obligations when due could undermine confidence in the CCP’s safety, soundness, and reliability. This in turn could significantly impair the liquidity of the financial markets to which it provides clearing services, thereby increasing market risk and counterparty credit risk to all participants in those markets. As a practical matter, many financial markets offer anonymous trading, which is workable only if the market is served by a CCP whose creditworthiness is taken for granted by market participants. If confidence in a CCP is shattered and, as is often the case, no other CCP serves the market, the market would cease functioning.”

• Patrick M. Parkinson, Speech to Federal Reserve Bank of Chicago Annual Over the Counter Derivatives Symposium: CCP Liquidity Risk Management and Related Failure Management Issues (Apr. 11, 2014).

Cadwalader, Wickersham & Taft LLP 52 Mandated Clearing May Make a Financial Network More Vulnerable to Precipitous Failure

• “[I]f a CCP were for some reason unable to perform on the defaulting member's payment obligations in a timely manner and in the expected currency, its surviving members would face liquidity shortfalls that would quickly trigger a cascade of failures on their obligations to their counterparties beyond the CCP, transmitting liquidity risk more broadly to a wider set of market participants.” Statement of Susan McLaughlin, Fed. Reserve Bank of N.Y., CFTC Market Risk Advisory Committee Meeting, Apr. 2, 2015.

• “The contagion risk entailed by central clearing should not be understated, and the risk of multiple defaults across [central counterparties] should not be underestimated.” ISDA, Risk Sensitive Capital Treatment for Clearing Member Exposure to Central Counterparty Default Funds, p. 7 (2013).

Cadwalader, Wickersham & Taft LLP 53 Mandated Clearing May Make a Financial Network More Vulnerable to Precipitous Failure—CFTC View

• “Assessment powers are more likely to be exercised during periods of financial market stress. “

• “If during such a period, a clearing member defaults and the loss to the SIDCO is sufficiently large to deplete (1) the collateral posted by the defaulting entity, (2) the defaulting entity’s default fund contribution, and (3) the remaining pre-funded default fund contributions, a SIDCO’s exercise of assessment powers over the nondefaulting clearing members may exacerbate a presumably already weakened financial market.

• The demand by a SIDCO for more capital from its clearing members could force one or more additional clearing members into default because they cannot meet the assessment. The inability to meet the assessment could lead clearing members and/or their customers to de-leverage (i.e., sell off their positions) in falling asset markets, which further drives down asset prices and may result in clearing members and/or their customers defaulting on their obligations to each other and/or to the SIDCO. In such extreme circumstances, assessments could trigger a downward spiral and lead to the destabilization of the financial markets.” Enhanced Risk Management Standards for Systemically Important Derivatives Clearing Organizations, 78 Fed. Reg. 49663, 49672 (Aug. 15, 2013).

Cadwalader, Wickersham & Taft LLP 54 Mandated Clearing May Make a Financial Network More Vulnerable to Precipitous Failure—CFTC View

• “During periods of market stress, when CCP margin requirements increase, and when availability of bank capital may decline, portability will be more difficult as less capital is available to accept the cleared derivative portfolios from other clearing members. Without the ability to transfer client positions in an orderly manner, a CCP would be forced to liquidate the positions of clients of a failed or distressed clearing member, creating a strain on the market, market losses for clients, and losses of clients' hedge positions, which would increase risk in the real economy.”

• Report of the CCP Risk Management Subcommittee of the CFTC Market Risk Advisory Committee (November 2016).

Cadwalader, Wickersham & Taft LLP 55 Recovery Tools May Not Be Adequate In Times of Stress—CCP Guaranty Funds Provide Only Limited Protection Against Default

• Each clearing organization maintains one or more guaranty funds that it can draw upon in addition to the margin deposited with it by the clearing member in the event the clearing member defaults on a margin call.

• The fund, which is usually supplemented by the ability of a clearing organization to impose additional capital calls on its clearing members, comes into play if a clearing member is unable to pay up.

• The protection provided by the clearing organization guarantee, however, is limited in scope—it applies only to losses resulting from the substitution of the Clearing House upon contracts between clearing members. The guarantee does not protect customers from the risk of default on the part of their own FCM or the clearinghouse.

Cadwalader, Wickersham & Taft LLP 56 Recovery Tools May Not Be Adequate In Times of Stress—CCP Resources Are Modest Compared to Potential Losses

• “[C]apital of CCPs tends to be quite modest compared with their other prefunded resources, their gross exposures and the scale of their potential losses. • The size of this capital cushion within the waterfall is typically a percentage of the total capital and is uncorrelated with the risks incurred by the CCP should one or more participants fail to meet their trading obligations. A recent study . . . indicates that the capital held by the five biggest CCPs in swaps is equivalent to just 2.6% of the sum of margin requirements and the default fund.”

• Dietrich Domanski, Leonardo Gambacorta and Cristina Picillo, Central clearing: trends and current issues, BIS Quarterly Review, pp. 71-72 (Dec. 6, 2015)

Cadwalader, Wickersham & Taft LLP 57 Recovery Tools May Not Be Adequate In Times of Stress—CCP Guaranty Funds Provide Only Limited Protection Against Default

• More important, the financial level of such funds are typically modest compared with the primary safeguard, which is collateral supporting open positions.

For example, at mid-year 2016, one major clearinghouse held $139 billion in margin as compared with $300 million in corporate contributions, $6.8 billion in security deposits from clearing members representing its guaranty fund, and another $11 billion in assessment powers as part of a financial safeguard system that encompasses futures, credit default and interest rate swaps.

 However, the CFTC emphasizes that no mutualized guaranty

fund resources have ever been used to cover a default. CFTC Staff Report: "Supervisory Stress Test of Clearinghouses,” (November 2016), p. 9.

Cadwalader, Wickersham & Taft LLP 58 Recovery Tools and CCP Resources May Not Be Adequate In Times of Stress

• “Whether, and under what conditions, central clearing absorbs or spreads losses depends on the size of the shock and on CCPs’ financial resources.”

 “As long as the negative shocks are sufficiently small, a more densely connected financial network enhances financial stability: a properly resourced CCP would act as shock absorber. Ideally, losses would be fully covered with the defaulter’s own prefunded resources, leaving other clearing members unaffected.

 However, once losses exceed the CCP’s prefunded resources, the same features that make a financial system more resilient may become sources of instability. As a consequence, financial networks may be ‘robust-yet-fragile.’”

 “Ultimately, if the (exogenous) shock is so big that losses exceed the CCP’s prefunded and callable resources, a CCP could be forced into resolution and fail. Such a failure may have system-wide effects: clearing participants might find it difficult to manage positions if a CCP fails; and all clearing participants would have to find alternative ways of closing trades, at a time when there might be heightened uncertainty about the value of the underlying exposures and the associated market and counterparty risk.”

• Dietrich Domanski, Leonardo Gambacorta and Cristina Picillo, Central clearing: trends and current issues, BIS Quarterly Review , p. 68 (Dec. 6, 2015) (emphasis added).

Cadwalader, Wickersham & Taft LLP 59 In a Distressed Scenario, Unfunded Contributions May Fail to Materialize

• “A CCP resolution precipitated by member defaults is likely to take place in an environment of financial instability with the failed resolution of a number of significant clearing participants leading to their default in multiple CCPs.

• Contingent commitments in the CCP’s own rules may be vulnerable to the risk that participants are unwilling or unable to meet obligations in a stressed environment (‘performance risk’) or that drawing on these resources

further adds to financial instability.” Financial Stability Board, Essential Aspects of CCP Resolution Planning—Discussion Note (Aug. 16, 2016).

Cadwalader, Wickersham & Taft LLP 60 In a Distressed Scenario, Unfunded Contributions May Fail to Materialize

• “Current CCP waterfall designs allow for an assessment on Default Fund contributions, which is either uncapped or can go up to the existing Default Fund contribution of each member. Such assessments run the risk of not being provisioned when required, due to members lacking the liquidity resources in a stress scenario. Thus, the unfunded portion of the Default Fund may not materialize as expected in a stress scenario and is subject to wrong-way risk.”

• Rama Cont, The End of the Waterfall: Default Resources of Central Counterparties, Norges Bank Working Paper 16/2015 (November 30, 2015).

Cadwalader, Wickersham & Taft LLP 61 CCPs May Be Unable to Handle Multiple Clearing Member Defaults

• In times of market stress, defaults by more than one clearing member could inflict a liquidity shortage on a CCP.  “If one or more clearing members fail to meet their clearing obligations, the CCP itself must provide liquidity in order to make timely payments to the original trading counterparties. The CCP’s own liquid assets and backup liquidity lines made available by banks may provide effective insurance against liquidity shocks resulting from the difficulties of one or a few clearing members.  But they can hardly provide protection in the event of a systemic shock, when a large number of clearing participants – potentially including the providers of liquidity lines – become liquidity-constrained, thereby triggering domino effects.” Dietrich Domanski, Leonardo Gambacorta and Cristina Picillo, Central clearing: trends and current issues, BIS Quarterly Review (Dec. 6, 2015)

Cadwalader, Wickersham & Taft LLP 62 CCPs May Be Unable to Handle Multiple Clearing Member Defaults

• CCPs may not be well-suited to handle crises in which multiple firms ran into trouble simultaneously:

 “[A] . . . mechanism through which a clearinghouse could become insolvent is through multiple-member defaults. With a larger volume of trades cleared, it is likely that most major financial institutions will be counterparties to a derivatives clearinghouse. As a result, in an unanticipated time of distress in the financial markets such as occurred in 2008, several major financial institutions could simultaneously face liquidity problems that force them to default on their derivatives positions.

 If multiple clearing members defaulted concurrently, it is unclear whether even the most effective default management procedures would enable a derivatives clearinghouse to effectively manage the defaults and avoid insolvency.” Julia Lees Allen, Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis. 64 Stan. L. Rev. 1079, 1093 (Apr. 2012).

Cadwalader, Wickersham & Taft LLP 63 Resolution of CCP Following Default May Not Be Possible

• In the event of a failure involving a systemically important CCP, a key policy question is whether to interrupt the contractually based CCP default management process with an overriding failure resolution process and when to do so. • Another issue is whether and when to override the resolution process with a government intervention. • Title II of Dodd Frank assigns administration of failure resolution process of systematically important CCPs to the Federal Deposit Insurance Corporation. • Options include various forms of margin gains haircutting, reorganization of the CCP, transfer to another CCP, or winding down. However, all such options face serious challenges.

Cadwalader, Wickersham & Taft LLP 64 Resolution of CCP Following Default May Not Be Possible

“An insolvent derivatives clearinghouse creates an unsolvable problem with respect to resolution: untangling the derivatives trades will inevitably take more than a day, but if sorting out the portfolios takes even a few days, clearing members will start a run on the clearinghouse and accelerate its failure. The resulting enhanced systemic risk would necessitate government intervention. A major derivatives clearinghouse would be too big to fail.”

• “If a derivatives clearinghouse were to become insolvent, the clearinghouse would not prevent increased systemic risk upon the default of a clearing member as per the stated purpose of Dodd-Frank, but rather would greatly increase systemic risk. Because successful management through either Chapter 11 proceedings or the Dodd-Frank Orderly Liquidation Authority is unlikely, the government would be forced to intervene to provide liquidity and cabin systemic risk.” Julia Lees Allen, Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis. 64 Stan. L. Rev. 1079 , 1079 & 1099 (Apr. 2012).

Cadwalader, Wickersham & Taft LLP 65 Resolution of CCP Following Default May Not Be Possible

 Upon the insolvency of a derivatives clearinghouse, the likelihood that another clearinghouse would have the capacity to absorb the insolvent clearinghouse's portfolios is low, particularly given the tendency for derivatives clearinghouses to specialize in particular financial products.

 The Secretary of Treasury could take action to subject the clearinghouse to the newly established liquidation authority procedures created by Dodd-Frank to resolve systemically important financial institutions.

 However, the liquidation authority could not successfully unwind the clearinghouse because of logistical complexities in transferring the trades to a bridge financial institution and auctioning off the insolvent clearinghouse's trades.

Julia Lees Allen, Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis. 64 Stan. L. Rev. 1079, 1098-99 (Apr. 2012).

Cadwalader, Wickersham & Taft LLP 66 Conclusion

• Speaking at an industry conference last year, CFTC Chairman Timothy Massad stated that “[t]he absence of regulation allowed the build-up of excessive risk in the over-the-counter swaps market. . . [and] [t]hat risk intensified the crisis and the damage it caused.” Keynote Address of Chairman Timothy G. Massad before the Futures Industry Association Boca Conference (Mar. 11, 2015).

• One of the key ingredients for reducing risk in the aftermath of the financial crisis is the mandate for central clearing. Notwithstanding results of a recently released stress test by the CFTC showing that CCPs had ample resources to meet or exceeded required resilience standards under extremely stressful market scenarios, a key policy question is whether this post-crisis regulatory prescription will instead allow the build-up of excessive risk in a handful of clearinghouses, which will intensify a future financial crisis.

• The problem that may confront financial regulators during the next financial crisis may not be what to do when one or two prominent members of a clearinghouse choose to default, but what to do when more than two members suffer a liquidity drain. That risk is akin to the one faced by the financial sector in 2008 in the OTC swaps market, and it is a risk that needs to be focused on with the onset of a mandated system of clearing. Indeed, CFTC Chairman Massad's statement that, "[a]s we make clearinghouses even more important in the global financial system, we must pay attention to the risks that they can pose" only underscores the problem.

Cadwalader, Wickersham & Taft LLP 67