Central Clearing for Credit Default Swaps - Efforts in the EU and the US to Combat Systemic Risk Through Regulation

Abstract

Credit default swaps (CDS) are financial derivatives that allow for the transfer of credit risk. Although initially praised for their ability to disperse risks, events during the financial crisis significantly altered the views regarding these instruments. Regulators were concerned that a default by a large CDS counterparty could lead to cascading defaults, which could ultimately bring down the entire financial system. This fear for systemic risk encouraged government bailouts of troubled financial institutions. As a result, the mild regulatory regime for CDS came under severe scrutiny. This led both US and EU regulators to launch a variety of reform initiatives, intended to reduce counterparty risk in the CDS market.

One of the legislative initiatives concerns the introduction of central clearing for CDS. A central clearing institution would step in between the parties after the CDS transaction to assume all counterparty risk. The main focus of this thesis is on the central clearing regulations. First, credit default swaps and their market are reviewed. Next, the answer to a first research question is sought: “Are the concerns of regulators with regard to CDS justified and, if so, does central clearing offer an effective solution to the concerns?”. To answer this question, the concepts of counterparty risk and systemic risk are first discussed. Thereafter, the effects of central clearing on these risks are examined, by contrasting them to the effectiveness of already existing bilateral clearing techniques, i.e. netting and collateralization. Finally, the answer to a second research question is sought: “How have regulators translated the idea of central clearing into law?”. For this purpose, a meticulous legal research is carried out. First, the pre-crisis regulatory regime for CDS is reviewed, from a securities law angle as well as from a comparative Euro-American perspective. Next, the regulatory processes leading to the adoption of the central clearing regulations are discussed. Thereafter, a material comparative analysis is made of the provisions related to central clearing in the EU and US regulatory initiatives. Finally, the thesis is concluded with an evaluation of both legislations in the light of all previous analyses.

The research first shows that central clearing regulations rely on a series of presumptions, both concerning the gravity of counterparty risk threats and the necessity of central clearing. Additionally, the EU and US clearing regulations are similar with regard to the broad innovations they introduce, i.e. the mandatory central clearing of a variety of over-the-counter derivatives and counterparty risk management requirements for central clearing institutions and for non-cleared swaps. However, the specific content of the provisions often differs. Furthermore, both legislations are limited to enouncing broad principles. This is also the case for the crucial provisions related to counterparty risk management. Therefore, these provisions in se do not guarantee the proper regulation of counterparty risk management practices. Consequently, much is to be expected from the implementing measures adopted by regulatory institutions. Finally, the central clearing regulations demonstrate a shift from private to public regulation with regard to CDS and influence the pre-crisis approaches to securities regulations in the US and in Europe.

Keywords: Credit Default Swaps, Central Clearing