Charting a Course in Clearing

Abstract

Memorable tales of financial collapse, such as that of Lehman Brothers (Lehman), Bear Stearns, and American Financial Group (AIG), frequently drive narratives of financial market crises and future preventative regulatory solutions. Much U.S. financial regulation, such as the monumental and historic “Dodd-Frank Wall Street Reform and Consumer Protection Act,” (Dodd-Frank) can be understood from this perspective. Aspects of such responses, however, are sometimes puzzling. An example is the reforms surrounding certain financial market utilities in Dodd-Frank’s Title VIII, “Payment, Clearing, and Settlement Supervision Act of 2010” (Title VIII). Financial market utilities often play a vital role in a process known as “payment, clearing and settlement,” which occurs after a financial trade is made. Title VIII authorizes the Federal Reserve Board (Fed), in consultation with the Treasury Department, to extend “discount and borrowing privileges only in unusual or exigent circumstances” to financial market utilities designated by Dodd-Frank’s new Financial Stability Oversight Council as “systemically important” or of “systemic importance.” That is, to provide an emergency funding backstop to such financial utilities. The Fed’s new emergency authority is additional to and separate from its “13(3)” emergency powers reformed by Dodd-Frank.

What little attention has so far focused on Title VIII analyzes the Fed’s new authority in relation to over-the-counter (OTC) derivatives, especially credit default swaps (CDS). The actual scope of financial contracts for which this new authority is relevant, however, is quite vast: it includes any financial transactions using designated financial utilities. Therefore, Title VIII’s financial utility reforms are relevant not only to OTC derivatives, but also potentially to repurchase agreements (repos), and any other “financial transactions” that use designated financial utilities now or in the future. On the one hand, these reforms purport to be a critical component in “solving” the AIG problem, but this conclusion is uncertain. On the other hand, these reforms lay the groundwork for alleviating the problem of Lehman and Bear Stearns, but fall short of achieving a potential solution. For these reasons, I suggest that Title VIII’s financial utility reforms both go too far in theory in addressing the “AIG problem,” but not far enough in practice in addressing the “Bear Stearns and Lehman problem.”

Keywords: Clearing, Financial Collapse, U.S. Financial Regulation, Title VIII, AIG, Bear Stearns, Lehman, Dodd-Frank, Central, Counterparty, Clearinghouse

JEL Classification: E50, G20, K2