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Mandatory Central Clearing: Clearinghouse Failure and Systemic Risk

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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
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