Credit Default Swap Clearinghouses and Systemic Risk: Why Centralized Counterparties Must Have Access to Central Bank Liquidity

Abstract:     
Credit default swaps ("CDSs") were widely blamed as a primary cause of the recent financial crisis; CDSs fomented panic as the price of credit protection spiked and contributed to the Federal Reserve's decision to bail out American International Group. To reduce the likelihood that credit derivatives will lead to future financial distress, the Dodd-Frank Wall Street Reform and Consumer Protection Act mandates that many CDSs be traded through a centralized counterparty, a clearinghouse that acts as a seller to every buyer and a buyer to every seller. Proponents of central clearing argue that this reform minimizes risks to the financial system by reducing interconnections and dispersing losses. While the systemic benefits of central clearing are manifest, the downsides are less obvious; clearinghouses concentrate risk and pose enormous threats to financial stability should they fail. Ignoring such drawbacks, several members of Congress involved in the Dodd-Frank negotiations, disturbed by the Federal Reserve's unprecedented market interventions, sought to revoke the central bank's authority to lend to clearinghouses. This Article argues that these imprudent efforts, though ultimately unsuccessful, could have prevented the Federal Reserve from staving off a catastrophic clearinghouse collapse. This Article asserts that clearinghouse access to central bank credit is crucial, particularly when central clearing of volatile CDSs is required.

Number of Pages in PDF File: 46

Keywords: Credit Default Swap, Clearinghouse, Systemic Risk, Regulatory Reform, Federal Reserve, 13(3), Counterparty Risk, Jump-To-Default Risk, Credit Default Swaps

JEL Classification: G00, G20, G21, G29, F40

Accepted Paper Series