Financial Regulation, Corporate Governance, and the Hidden Costs of Clearinghouses

Abstract

Clearinghouses are systemic nodes in financial markets that handle trillions of dollars’ worth of transactions. Yet, these critical market infrastructures stand on fragile foundations. The Dodd-Frank Wall Street Reform Act of 2010, the sweeping financial reform that followed the 2008 financial crisis, embraced clearinghouses as systemic risk managers for the over-the-counter derivatives markets. While policymakers used clearinghouses to remove some counterparty risk from the markets, they ended up concentrating that risk onto them, making them systemically important.

This Article warns that while clearinghouses might have addressed some of the failures of the pre-crisis derivatives markets, they have created new issues that still remain unaddressed. The economic and governance structure set in place by the existing regulatory regime and the private rules adopted by clearinghouses in their self-regulatory capacity have important and as-yet overlooked fragilities that can undermine clearinghouses’ mission as financial stability bastions and transform them into systemic risk spreaders.

Clearinghouses operate in a framework of misaligned incentives. They face unique agency costs that spill from what this Article defines as the “member-shareholder divide” and the “separation of risk and control.” Because of their economic structure, the ultimate risk of the business is passed down to the members (i.e., users) of the clearinghouses and not borne by their shareholders, which creates moral hazard. This dynamic is further exacerbated by the tension between the public policy role bestowed on clearinghouses as systemic risk buffers and the for-profit nature of the financial conglomerates to which they belong. In addition, while clearinghouses were embraced as countercyclical mechanisms to stabilize the markets, the operation of their loss-absorption and mutualization function have procyclical features that put strong pressure on clearing members, while clearinghouses’ shareholders have a small equity at stake.

After offering a political economy explanation of the current regulatory regime for clearinghouses, this Article urges policymakers and the industry to intervene to re-align the incentives of clearinghouse shareholders to those of their members in order to ultimately enhance financial stability. Building on insights from the corporate governance and finance literature, this Article proposes reforms to address the unique agency costs that clearinghouses face, to enhance their governance and resilience, and to ensure their role as private systemic stability infrastructures. Clearinghouses should have more skin in the game in their business and their capital structure should be complemented with hybrid convertible financial instruments to more effectively allocate losses, recapitalize the business, and better align the economic incentives of clearinghouses’ stakeholders. A multi-stakeholder board should be established to enhance the participative governance of these firms and support the legitimacy and accountability of their operations. Finally, a new approach to the recovery and resolution of troubled clearinghouses that could result in their remutualization should be implemented in order to provide certainty in times of distress, as well as an ultimate realignment of members’ and shareholders’ incentives.

Keywords: Dodd-Frank, clearinghouse, central counterparty, risk-sharing, default waterfall, CFTC, title VII, title VIII, CCP, central clearing, risk management, Federal Reserve, resolution, systemic risk, financial crisis, derivatives

JEL Classification: G20, G21, G23, G10, G18, K20, L50, G28, G32, G38, G15, K00, K12, K2, K22, K23, K20