A Reassessment of the Clearing Mandate: How the Clearing Mandate Affects Swap Trading Behavior and the Consequences for Systemic Risk
73 Pages Posted: 1 Jun 2015 Last revised: 21 Sep 2018
Date Written: May 18, 2015
A core part of the international response to the financial crisis has been the adoption of a requirement to clear standardized swaps. Clearing extinguishes the original transaction, creating two identical transactions between the counterparties to the original trade and a central counterparty, usually referred to as a clearinghouse. The clearing mandate represents a significant intervention into derivatives markets. The net present value of cash flows due under outstanding instruments of the types subject to the clearing mandate rivals the U.S. gross domestic product. Policymakers have justified the clearing mandate as a mitigant of systemic risk. Scholarship, however, has challenged this justification arguing that the rerouting of payment flows through clearinghouses exacerbates systemic risk. This article adds to the debate, by examining how the clearing mandate affects trading behavior and how those changes affect systemic risk. Trading behavior will be altered by the clearing mandate through four pathways:
• Greater costs of transacting under the clearing mandate reduce swap volumes. The net result of these reductions on systemic risk is uncertain. The reduction could decrease net transfers of risk into the financial system, and in particular, to major financial institutions that act as swap dealers. Alternately, the reduction could disproportionately affect hedging by the financial industry, trapping more risk within the financial system. • Attempts to evade the clearing mandate, as well as attempts to avoid being penalized under the anti-evasion provisions undergirding the mandate, will lead to less standardized documentation. As a result, documentation will become more customized and opaque, decreasing transparency and potentially increasing risk.
• The interposition of clearinghouses will reduce behavior that exacerbates systemic risk during a crisis. In particular, transactions that are cleared will not set off cascades of attempts to assign and novate obligations, thus reducing the prompts for panic. Furthermore, transactions that are cleared can be unwound during a crisis without involvement of the initial counterparty thus enabling continued risk management throughout a crisis.
• Clearing is a predicate to reducing systemic risk through disintermediating swaps markets. Clearing allows natural longs, natural shorts and other market participants to transact directly through execution platforms’ order books without using swap dealers to intermediate the flow of risk in the economy. Subject to sufficient liquidity being available in the market, clearing enables market participants to transact on dependable credit terms directly without the use of financial intermediaries.
These observations lead to a reassessment of the clearing mandate, and identify new lines of research to pursue in evaluating the desirability of the regulations that have transformed swaps markets over the last five years.
Keywords: clearing, swaps, derivatives, market structure, trading, Dodd-Frank Act
JEL Classification: K2
Suggested Citation: Suggested Citation