Financial Markets Uncertainty and the Rawlsian Argument for Central Counterparty Clearing of OTC Derivatives
79 Pages Posted: 2 Feb 2013 Last revised: 2 Jun 2014
Date Written: May 2014
One of the key measures in the Dodd-Frank Act intended to curb systemic risk in the financial system is the central counterparty (CCP) clearing mandate for over-the-counter derivatives. The mandate reflects the belief of legislators and many financial markets experts that these derivatives, particularly credit default swaps, were a key cause of the financial crisis of 2008. While derivative markets do create extensive interconnections between financial institutions, and were essential to the creation of the structured finance securities that fueled the housing bubble, in hindsight it appears that derivatives were not a proximate cause but more likely one of many ‘but for’ structural causes of the crisis. As a result, the CCP clearing mandate has come in for extensive criticism on the grounds that it carries with it significant risks for the global financial system, while providing little benefit in return.
This Article offers a critical examination of the arguments against CCP clearing and a defense of the mandate and other Dodd-Frank Title VII derivatives provisions. Beginning with the fundamental uncertainty about the true causes of the crisis that remains, including a strong probable role for a ‘behavioral’ cause of the crisis on account of the panic of financial institutions, it then examines the arguments against CCP clearing, finding that they rely on overly narrow boundaries in order to achieve a measure of precision in making a cost-benefit analysis, thereby ignoring many of the important costs that derivatives indirectly contributed to. Given that a more complete cost-benefit analysis appears to run aground on the complexity of accurately enumerating all the costs and benefits associated with modern financial markets, this Article instead proposes looking at the problem of derivatives regulation through a Rawlsian framework. Central to Rawls’s thought is the procedure of decision-making under conditions of fundamental uncertainty, or the maximin rule. I argue that application of the maximin rule is appropriate here, and that unlike the standard cost-benefit analysis grounded in utilitarianism, Rawls’s views lead to a holistic understanding of the financial markets in their larger societal context that both guides and justifies legislative action in the context of fundamental uncertainty by prioritizing the safety of the financial system. Such a holistic understanding of economic regulation is necessary as governments struggle to preserve social stability in the face of widespread economic challenges such as unemployment, income inequality, excessive debt, and continuing instability in the financial system.
Keywords: Dodd-Frank, CCP, Central Counterparty Clearing, Uncertainty, Derivatives, Credit Default Swaps, Regulation, Systemic Risk, Maximin
JEL Classification: D81, D82, G10, G15, G18, G20, K22
Suggested Citation: Suggested Citation