Financial Regulation, Corporate Governance, and the Hidden Costs of Clearinghouses
1 Pages Posted: 14 Apr 2021 Last revised: 30 Jun 2021
Date Written: October 18, 2018
Clearinghouses are at the heart of the modern financial system, and they are responsible for the handling of trillions of dollars’ worth of financial transactions. The Dodd-Frank Wall Street Reform Act of 2010, the sweeping financial reform that followed the 2008 financial crisis, embraced them as systemic risk managers for the over-the-counter derivatives markets. While policymakers used clearinghouses to remove some financial risk from the markets, they ended up concentrating it onto them, making them systemically important. Yet, these critical market infrastructures stand on fragile foundations.
This Article warns that while clearinghouses might have solved some of the problems of the pre-crisis derivatives markets, they have created new ones. 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 flaws that undermine clearinghouses’ mission as financial stability bastions and can transform them into systemic risk spreaders.
Clearinghouses operate in a framework of misaligned incentives. On one side they face unique agency costs that spill from owners-members divide and the separation of ownership and risk of losses. Because of their economic structure, the ultimate risk of the business is pass-down onto the members (i.e. users) of the clearinghouses, and not borne by their owners, and this creates moral hazard. This dynamic is further exacerbated by the tension between the public policy function bestowed on clearinghouses and the for-profit nature of financial conglomerates 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’ owners have limited equity at stake.
This Article urges policymakers and the industry to intervene to align the incentives of clearinghouses owners to those of their main stakeholders and to their public policy function. After offering a political economy explanation of the current structure and regime, this Article suggests reforms to mitigate these problems, to enhance clearinghouses’ governance and resilience and to ensure clearinghouses role as private systemic stability infrastructures. Hybrid financial instruments should complement the capital structure of clearinghouses to better align the economic interests of clearinghouses’ stakeholders, a multi-stakeholder board should be established to enhance the accountability of these firm, and a new approach to the resolution of troubled clearinghouse that could result in the remutualization of the firm should be implemented to provide certainty in time of distress.
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
Suggested Citation: Suggested Citation