Clearing Credit Default Swaps: A Case Study in Global Legal Convergence

Abstract

In the wake of the global financial crisis, American and European regulators quickly converged on a reform intended to help stave off similar crises in the future: central counterparty clearinghouses for credit default swaps. On both sides of the Atlantic, regulators identified credit default swaps (CDS) as a central factor in the crisis that seized Bear Stearns, Lehman Brothers, American International Group (AIG), and ultimately global credit markets. Introducing a well-capitalized central counterparty between CDS buyers and sellers would, regulators came to believe, help contain financial failures in the future.

How and why did this convergence occur? This Article reviews the American and European responses, concluding that they converged on a similar structure largely because the financial crisis revealed the vulnerabilities of a system in which buyers and sellers entered into CDS directly, through bilateral contracts. These bilateral derivatives contracts created a web of interconnected obligations, such that the failure of one firm could bring down a chain of others. The threat of this domino effect led governments to intervene in the financial markets with massive direct and indirect support. Forced to spend public money to bail out private firms, regulators risked an unsustainable moral hazard - firms that were “Too Interconnected to Fail.” Regulators concluded that the introduction of a central counterparty (CCP) would reduce the risk that the bankruptcy of a principal in a credit default swap would precipitate a domino fall through the credit markets. Where critics argue that CCPs concentrate risk, regulators came to recognize that Bear, Lehman, and AIG had each also concentrated risk, serving as de facto central clearing counterparties, lacking the disciplines of a regulated CCP.

Keywords: Credit default swaps, credit derivatives, Bear Stearns, Lehman Brothers, global convergence, too big to fail, central counterparty clearing