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Clearinghouses as Liquidity Partitioning


Richard Squire


Fordham University School of Law

May 15, 2014

99 Cornell Law Review 857 (2014)

Abstract:     
To reduce the risk of another financial crisis, the Dodd-Frank Act requires that trading in certain derivatives be backed by clearinghouses. Critics mount two main objections: a clearinghouse shifts risk instead of reducing it; and a clearinghouse could fail, requiring a bailout. This Article’s observation that clearinghouses engage in liquidity partitioning answers both. Liquidity partitioning means that when one of its member firms becomes bankrupt, a clearinghouse keeps a portion of the firm’s most liquid assets, and a matching portion of its short-term debt, out of the bankruptcy estate. The clearinghouse then applies the first toward immediate repayment of the second. Economic value is created because creditors within the clearinghouse are paid much more quickly, and other creditors are paid no less quickly, than they would be otherwise. The rapid cash payouts for clearinghouse members reduce illiquidity and uncertainty in the financial sector, the main causes of contagion in a crisis. And because the clearinghouse holds only liquid assets, it avoids the maturity mismatch between short-term liabilities and long-term assets that characterizes the balance sheets of many financial institutions. A clearinghouse therefore is much less likely than its members to fail during a crisis. To ensure that clearinghouses remain stable and systemically valuable, rulemakers should require clearing of a wide variety of derivatives contracts, but should limit clearinghouse membership to dealer firms.

Number of Pages in PDF File: 68

Keywords: clearinghouse, bankruptcy, systemic risk, liquidity, orderly liquidation authority, asset partitioning, netting, setoff, Dodd-Frank

JEL Classification: G21, G28, G33, G38, K20

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Date posted: December 5, 2012 ; Last revised: May 28, 2014

Suggested Citation

Squire, Richard, Clearinghouses as Liquidity Partitioning (May 15, 2014). 99 Cornell Law Review 857 (2014). Available at SSRN: http://ssrn.com/abstract=2185064 or http://dx.doi.org/10.2139/ssrn.2185064

Contact Information

Richard C. Squire (Contact Author)
Fordham University School of Law ( email )
140 West 62nd Street
New York, NY 10023
United States
212-964-1584 (Phone)
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