The Problematic Case of Clearinghouses in Complex Markets

58 Pages Posted: 18 Feb 2012 Last revised: 31 Jul 2016

Yesha Yadav

Vanderbilt University - Law School

Date Written: February 16, 2012

Abstract

This Article challenges the academic and policy consensus that clearinghouses adequately mitigate the risks of trading credit derivatives. The Article advances two arguments. First, scholars have devoted little attention to the risks posed by underlying assets (e.g. a mortgage loan) that the credit derivative references and the impact that these have on the clearinghouse. Credit derivatives enable the economic risk of debt to be separated from the legal rights attaching to that debt. This separation impacts the clearinghouse profoundly. As a contract party to each trade it processes, the clearinghouse can be saddled with economic risk of underlying debt without the legal rights necessary to mitigate its exposure. If a clearinghouse cannot manage its risks, the consequences are invariably systemic and enormously costly to the taxpayer. Second, the Article shows that clearinghouse members are subject to complex incentives that: (i) actually encourage risk-taking by subsidizing its cost; (ii) allow parties to shift the private costs of monitoring to the clearinghouse and themselves under-invest in due diligence; and (iii) create undue reliance on information that is impressed by the strategic motives of parties providing it.

This Article, finally, proposes a new paradigm for the clearinghouse. This model seeks to repair the consequences of the separation between economic risks and legal rights enabled by the credit derivative – as well as control the perverse incentives affecting clearinghouse members. With the clearinghouse having better powers to police its exposures, the Article proposes that reform can make the clearinghouse a more robust institution and control lax underwriting standards more broadly.

Keywords: derivatives, clearinghouses, exchanges, systematic risk, institutional design, debt governance, credit default swaps, swaps, counterparty risk, Federal Reserve Act 13(3), credit linked notes, total return swaps, regulatory reform, Title VII, Dodd-Frank Act

Suggested Citation

Yadav, Yesha, The Problematic Case of Clearinghouses in Complex Markets (February 16, 2012). Georgetown Law Journal, Vol. 101, p. 387, 2013. Available at SSRN: https://ssrn.com/abstract=2006452 or http://dx.doi.org/10.2139/ssrn.2006452

Yesha Yadav (Contact Author)

Vanderbilt University - Law School ( email )

131 21st Avenue South
Nashville, TN 37203-1181
United States

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