Harmonizing European Union Bank Resolution: Central Clearing of OTC Derivative Contracts Maintaining the Status Quo of Safe Harbors

Abstract

The unlimited access to over-the-counter (“OTC”) credit derivatives may have been one of the main reasons for the financial crisis. Prior to the crisis, credit derivatives were mainly used for speculation purposes rather than as true risk-management tools. This speculation in turn resulted in the excessive accumulation of leverage followed by the failure of many financial and non-financial institutions. Institutions such as Lehman Brothers or AIG were unable to post additional collateral and experienced runs by their OTC derivative contract counterparties. The existing safe harbor protection of derivative contracts in bankruptcy prevented reorganization or bankruptcy protection triggering massive public bailouts. In 2009, the G20 addressed this issue and agreed to a broad reform of the global OTC credit derivative markets. This article focuses on one aspect of these reforms, the improvement of market infrastructures and the requirement of central clearing through central counterparties (“CCPs”) in Europe. Soundly run and properly regulated CCPs may indeed reduce systemic risk in financial markets. However, CCPs also concentrate counterparty risk and create an entirely new level of systemic risk for global financial markets. It is argued in this article that the European Union approach to central clearing of OTC derivative contracts is in fact allowing central counterparties to remove themselves from the middle of trades by expanding safe harbor protections and creating a complicated network of exemptions. This may reduce any incentive for CCPs to effectively monitor risk and increase the overall systemic risk associated with credit derivative clearing. The European Union approach to central clearing may thus have the opposite effect of reform by creating an even larger and less controllable risk for global financial markets. This article argues that safe harbors for clearinghouses should not be expanded, but should be repealed instead. The threat of bankruptcy may function as an important incentive for CCPs to properly assess the risk associated with their credit derivative positions.