Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis

Abstract

This Note analyzes the effectiveness of derivatives clearinghouses in decreasing systemic risk upon a counterparty default. The analysis first explains how a derivatives clearinghouse can successfully reduce systemic risk by analyzing LCH. Clearnet’s management of the Lehman default in 2008. Next, the analysis demonstrates that if a clearinghouse could not manage a default and became insolvent, systemic risk would greatly increase. Rather than containing the impact of a counterparty default, an insolvent clearinghouse would enhance systemic risk because the two existing resolution regimes, including the Bankruptcy Code and Dodd-Frank Orderly Liquidation Authority, could not successfully unwind the institution.

The primary contribution of the Note is identifying that 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. The resulting enhanced systemic risk would necessitate government intervention. A major derivatives clearinghouse would be too big to fail.

Accordingly, this Note proposes two recommendations to ensure that derivatives clearinghouses effectively reduce systemic risk: (1) regulators should minimize the risk of clearinghouse insolvency through strict collateral, capital, and default management requirements, and (2) create an ex ante guarantee fund to serve as a government backstop and provide liquidity to an insolvent derivatives clearinghouse, thereby avoiding enhanced systemic risk.

Keywords: Bankruptcy, OTC Derivatives, Dodd-Frank, Derivatives Clearinghouses, CCP