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A REASSESSMENT OF THE CLEARING MANDATE: HOW THE CLEARING MANDATE AFFECTS SWAP TRADING

BEHAVIOR AND THE CONSEQUENCES FOR SYSTEMIC RISK

Ilya Beylin*

Abstract

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 regulated 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 reviews, critiques and then adds a new dimension to the scholarly debate by identifying how the clearing mandate changes trading behavior and how those changes affect systemic risk. These overlooked effects have transformative potential for swaps markets as they reduce trading volume, affect swap customization, prevent bank runs, enable risk management during a crisis and create a channel for risk transfer that does not flow through large banks.

* Postdoctoral research scholar at Columbia Law School, J.D. from The University of Chicago, B.A.S. from Stanford University. I am grateful for comments to many, including John Coffee, Douglas Baird, Lisa Bernstein, Anup Malani, Brian Leiter, James Nelson, Hester Peirce, Gabriel Rauterberg, Mark Roe, Christina Skinner, Richard Squire, Alan Trammell, Ryan Williams, Maggie Wittlin, and participants at the 2015 National Business Law Scholars Conference and the 2015 Canadian Law and Economics Annual Meeting.


1144 RUTGERS UNIVERSITY LAW REVIEW [Vol. 68:1143

TABLE OF CONTENTS

INTRODUCTION ........................................................................................ 1145 PART I. SWAP TRANSACTIONS AND THE STRUCTURE OF SWAP

MARKETS .................................................................................... 1154 PART II. REDUCING LOSS FROM COUNTERPARTY DEFAULT THROUGH

NETTING, SETOFF AND MARGIN ............................................... 1173 A. Netting .................................................................................... 1173 B. Setoff ....................................................................................... 1175 C. Margin .................................................................................... 1175 D. Netting, Set-off and Margin in Bilateral and Cleared Contexts .................................................................................. 1177 E. How Netting, Setoff and Margin Contribute to Lockin in the Bilateral Context .............................................................. 1178

1. Netting, setoff and margin in the bilateral context ............. 1179 2. Netting, setoff and margin in the cleared context ............... 1183

F. Netting, Setoff and Margin in Academic Assessments of Clearinghouses ....................................................................... 1185

PART III. HOW CLEARING REALLOCATES LOSSES: MONITORING AND

MUTUALIZATION ..................................................................... 1189 A. Ex Ante Monitoring and Discipline in the Bilateral and

Cleared Contexts .................................................................... 1192 B. Ex Post Loss Allocation in the Bilateral and Cleared Contexts .................................................................................. 1196 C. Netting, Setoff and Margin in Academic Assessments of

Clearinghouses ....................................................................... 1199 PART IV. HOW CLEARING AFFECTS TRADING ACTIVITY .......................... 1203

A. The Clearing Mandate Imposes Additional Frictions on Swap Transactions ................................................................ 1203 B. The Clearing Mandate May Lead to More or Less

Standardized Transactions ................................................... 1206 C. The Clearing Mandate Affects Counterparty Behavior During a Crisis, Reducing Runs and Adding to Market

Resiliency ............................................................................... 1208 D. The Clearing Mandate Enables Disintermediation of

Derivatives Markets ............................................................... 1211 PART V. CONCLUSION .............................................................................. 1213


2016] CLEARING MANDATE 1145

INTRODUCTION

Clearinghouses have been a key element of the regulatory response to the financial crisis.1 As nations across the globe adopted mandates2 to clear standardized swap transactions, the volume of uncleared transactions decreased substantially.3 The clearing mandate represents a significant intervention into swap markets because it redirects trillions of dollars to flow through, and be guaranteed by, regulated clearinghouses. Policymakers have justified the intervention as serving to reduce systemic risk.4 Scholars have debated this claim, with the

1. The Financial Stability Board (“FSB”) serves as the global coordinator for financial reform and tracks countries’ progress towards meeting the commitments to mandatory clearing and other reform measures. As of autumn 2014, Argentina, Australia, Brazil, Canada, China, the European Union, Hong Kong, India, Indonesia, Japan, the Republic of Korea, Mexico, Russia, Saudi Arabia, Singapore, South Africa, Switzerland, Turkey and the United States have taken formal steps to implement the clearing mandate. FIN. STABILITY BD., OTC DERIVATIVES MARKET REFORMS: THE EIGHTH PROGRESS REPORT ON IMPLEMENTATION app. B at 44−49 (2014) [hereinafter FSB, OTC

DERIVATIVES]. In several of these jurisdictions, such as Japan and the United States, the clearing mandate is in effect and a variety of index credit default swaps and interest rate swaps are subject to mandatory clearing. Id.; see also Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74,284, 74,285 (Dec. 13, 2012) (to be codified at 17 C.F.R. pts. 39, 50) (“Beginning with [credit default swaps] in 2008, the [Federal Reserve Bank of New York] and other primary supervisors of OTC derivatives dealers increasingly focused on central clearing as a means of mitigating counterparty credit risk and lowering systemic risk to the markets as a whole.”). The same release also notes, “[c]learing is at the heart of the Dodd-Frank financial reform.” Id. 2. Members of the Group of 20 nations (“G-20”) have endorsed mandatory clearing as part of a multi-pronged program responding to systemic risk in over-the-counter (“OTC”) derivatives markets. FIN. STABILITY BD., OTC DERIVATIVES REFORMS PROGRESS: REPORT FROM THE FSB CHAIRMAN FOR THE G20 LEADERS’ SUMMIT 1 (2013). Other elements of the program include the reporting of OTC derivatives to trade repositories, the trading of standardized contracts on exchanges or electronic platforms, and the imposition of enhanced margin and capital requirements on uncleared derivatives. Id. 3. These trends are most pronounced in the interest-rate market, which accounts for the majority of over-the-counter derivatives activity. See BANK FOR INT’L SETTLEMENTS, STATISTICAL RELEASE: OTC DERIVATIVES STATISTICS AT END-JUNE 2014, at 3−4 (2014) [hereinafter BIS, OTC DERIVATIVES STATISTICS (2014)]; BANK FOR INT’L SETTLEMENTS, STATISTICAL RELEASE: OTC DERIVATIVES STATISTICS AT END-DECEMBER 2014, at 1 (2015) [hereinafter BIS, OTC DERIVATIVES STATISTICS (2015)] (“Central clearing, a key element in global regulators’ agenda for reforming OTC derivatives markets to reduce systemic risks, made further inroads. In credit default swap markets, the share of outstanding contracts cleared through central counterparties rose from 27% to 29% in the second half of 2014. In interest rate derivatives markets too, central clearing is becoming increasingly important.”). The same release notes: “The interest rate segment accounts for the majority of OTC derivatives activity. For single-currency interest rate derivatives at end-December 2014, the notional amount of outstanding contracts totaled $505 trillion, which represented 80% of the global OTC derivatives market.” Id. at 2. 4. Whether the intervention was in fact justified requires assessing all of the costs



great majority arguing that clearing exacerbates systemic risk.5 This

and benefits of mandatory clearing, not just whether mandatory clearing plausibly reduces systemic risk. The full analysis, however, has not been attempted and likely involves too many variables to be tractable. Instead, this article considers whether the justification proffered for the intervention is credible. If systemic risk appears to increase as a result of mandatory clearing, as some scholars suggest, then the market failure motivating the mandate is in fact exacerbated by it and the intervention is highly suspect. Of course, it may be that mandatory clearing reduces systemic risk, but the intervention is nevertheless undesirable for the costs it imposes. Crises often provoke less-than-fully-considered action. See John C. Coffee, Jr., Beyond the Shut-Eyed Sentry: Toward a Theoretical View of Corporate Misconduct and an Effective Legal Response, 63 VA. L. REV. 1099, 1100 (1977) (“[H]urried, moralistic responses to a perceived evil often prove not only ineffective, but even counterproductive.”). Systemic risk has been defined as:

the risk that (i) an economic shock such as market or institutional failure triggers (through a panic or otherwise) either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (ii) resulting in increases in the cost of capital or decreases in its availability, often evidenced by substantial financial-market price volatility.

Steven L. Schwarcz, Systemic Risk, 97 GEO. L.J. 193, 204 (2008). This definition focuses on capital markets, i.e., sources of funds for businesses to operate. In addition to capital markets, derivatives markets offer important financial services to businesses. Namely, derivatives markets allow risk shifting as discussed at further length throughout this article. See Sean J. Griffith, Governing Systemic Risk: Towards a Governance Structure for Derivatives Clearinghouses, 61 EMORY L.J. 1153, 1158 (2012) (“[A] derivative is nothing more than a contractual means by which parties allocate the risk of a fluctuation in price of an underlying reference value.”); SCHUYLER K. HENDERSON, HENDERSON ON DERIVATIVES 5 (2d ed. 2010). Accordingly, I believe a broader definition of “systemic risk” is appropriate that extends clause (ii) so it covers either increases in the cost of derivatives instruments or decreases in their liquidity, as may be evidenced by substantial, financial-market price volatility. More generally, systemic risk should be defined as “the externality imposed by distress in the financial sector on other institutions and markets within the sector as well as the broader economy.” 5. See Richard Squire, Clearinghouses as Liquidity Partitioning, 99 CORNELL L. REV. 857, 899−902 (2014); Sean J. Griffith, Substituted Compliance and Systemic Risk: How to Make a Global Market in Derivatives Regulation, 98 MINN. L. REV. 1291, 1350−56 (2014); Yesha Yadav, The Problematic Case of Clearinghouses in Complex Markets, 101 GEO. L.J. 387, 392−95 (2013); Adam J. Levitin, Response: The Tenuous Case for Derivatives Clearinghouses, 101 GEO. L.J. 445, 447−48 (2013); Mark J. Roe, Clearinghouse Overconfidence, 101 CALIF. L. REV. 1641, 1644−45 (2013); Griffith, supra note 4, at 1156-57; Julia Lees Allen, Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis, 64 STAN. L. REV. 1079, 1082 (2012); Darrell Duffie & Haoxiang Zhu, Does a Central Clearing Counterparty Reduce Counterparty Risk?, 1 REV. ASSET

PRICING STUD. 74, 74−75 (2011); Jeremy C. Kress, Credit Default Swaps, Clearinghouses, and Systemic Risk: Why Centralized Counterparties Must Have Access to Central Bank Liquidity, 48 HARV. J. ON LEGIS. 49, 51 (2011); Hal S. Scott, The Reduction of Systemic Risk in the United States Financial System, 33 HARV. J.L. & PUB. POL’Y 671, 686−705 (2010); Craig Pirrong, The Clearinghouse Cure, 31 REGULATION, Winter 2008−09, at 44, 49−50; Craig Pirrong, The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks Through a Central Counterparty 53−63 (Jan. 8, 2009) (unpublished manuscript), http://ssrn.com/



article’s primary contribution is in developing the framework for assessing whether clearing does indeed increase systemic risk.6

Prior academic work has, in some cases, assessed the mandatory clearing regime against the baseline of an ideal regime that involves no systemic risk. This approach proceeds by identifying systemic risks resulting from clearing and, finding some systemic risk, concludes that mandatory clearing was a regulatory error. Although it helpfully identifies potential for improvement, this approach cannot address the basic question of whether mandatory clearing improved on the status quo ante, which also contained systemic risk.

The first move made in this article is to identify the appropriate baseline against which the mandatory clearing intervention should be measured, namely, the world as it existed before the financial crisis in which parties could choose whether to clear their swaps. This insight puts to rest several common criticisms. Scholars have attacked clearinghouses as susceptible to adverse selection through parties choosing to clear only those swaps that clearinghouses “underprice,” i.e., collect too little collateral for. This critique misses that parties had the option to clear prior to the Dodd-Frank Act7 and that, if anything, the clearing mandate counters adverse selection through removing parties’ choice whether to clear a swap. Using an appropriate baseline also puts to rest the unqualified criticism that clearinghouses themselves pose systemic risks as thoroughfares for financial risks. While it is true that clearinghouses are a critical part of our financial infrastructure and their failure would expose a range of financial institutions and the real economy to loss, this criticism fails to account for the role clearinghouses play in buffering derivatives-market participants from losses due to counterparty default. If clearinghouses sufficiently reduce exposure to serious losses on account of counterparty default, then the net impact on systemic risk may be welcome.

Other studies have gone beyond looking at mandatory clearing in a vacuum and have compared it to the correct baseline. These studies have undertaken static analyses, comparing how a set of swap

abstract=1340660 [hereinafter Pirrong, The Economics of Clearing in Derivatives Markets]; see also Felix B. Chang, The Systemic Risk Paradox: Banks and Clearinghouses Under Regulation, 2014 COLUM. BUS. L. REV. 747, 747–48, 779–84 (discussing efficiencies of greater size among clearinghouses and the competitive concerns posed by these trends). 6. See Dan Awrey, The Dynamics of OTC Derivatives Regulation: Bridging the Public-Private Divide, 11 EUR. BUS. ORG. L. REV. 155, 165−68 (2010). 7. The “Dodd-Frank Act” or “Dodd-Frank” are used as shorthand throughout this article for the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Pub. L. No. 111-203, 124 Stat. 1376. Title VII of that Act contains legislation comprehensively reforming swaps markets.



transactions would perform on a bilateral basis (i.e., without being cleared) against how the same set would perform if all of the transactions were cleared. These analyses have come to ambiguous results, with many suggesting that the intervention may actually aggravate systemic risk. In addition to surveying and offering criticisms of these studies on their own terms, this article identifies an overlooked dimension of the clearing mandate’s significance: how the clearing mandate will affect trading behavior, and how these changes in trading behavior can increase or decrease systemic risk.8 Failure to address how the incentives created by clearing alter swap market behavior represents a significant oversight in prior scholarship. Taking these changes into account may rehabilitate the much reviled and significant intervention into multi-trillion dollar markets.

When a transaction is cleared, the transaction is extinguished and two new transactions, each identical to the initial transaction, are created. One of the new transactions is between the first party to the trade and a clearinghouse (i.e., a central counterparty), and the second transaction is between the clearinghouse and the second counterparty.9 As a result, parties to a cleared trade pay amounts due under the trade to the clearinghouse, rather than to one another.10 Irrespective of whether the clearinghouse receives payment due under a cleared trade from one counterparty, the clearinghouse must make an identical payment to the other counterparty. Thus the clearinghouse insulates counterparties to the initial trade from each other’s default risk. The example below illustrates payment flows under three swap transactions between three parties in bilateral and cleared scenarios.

8. See Robert R. Bliss & George G. Kaufman, Derivatives and Systemic Risk: Netting, Collateral, and Closeout, 2 J. FIN. STABILITY 55, 57 (2006) (“[A] complete and full economic analysis . . . requires a dynamic analysis that considers how market structures and the contracts that firms undertake are affected . . . .”). For an example of a different framework for assessing the clearing mandate, see Steven McNamara, Financial Markets Uncertainty and the Rawlsian Argument for Central Counterparty Clearing of OTC Derivatives, 28 NOTRE DAME J.L. ETHICS & PUB. POL’Y 209, 238−40 (2014). 9. For a description contrasting bilateral trades with cleared trades, see Yadav, supra note 5, at 409−13. 10. MARK JICKLING & KATHLEEN ANN RUANE, CONG. RESEARCH SERV., R41398, THE DODD-FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT: TITLE VII, DERIVATIVES 3−4 (2010).



Party A

Party B

Party C

SwapAC

SwapAB SwapBC

Figure 1 Three parties enter into three swaps bilaterally.

Figure 2

The same three parties instead enter into the three trades on a cleared basis.

As shown in Figure 2, clearing splits each trade into two identical

trades⎯one between the first counterparty and the clearinghouse, and the second between the clearinghouse and the second counterparty.

Party A

Party B

Party C

SwapAC

SwapAB SwapBC

Clearinghouse SwapAB SwapBC

SwapAC



Accordingly, it is the clearinghouse’s credit rather than the credit of the counterparty that backs a cleared trade.11 Clearinghouses are subject to extensive regulation across jurisdictions. Clearinghouses mediate trades subject to a number of operating procedures and financial backstops designed to increase the likelihood that obligations to the clearinghouse under cleared trades are satisfied. Only “members” of a clearinghouse may clear trades through it. Third parties that are not members may clear trades as customers of members. Members that clear trades on behalf of customers must register with the Commodity Futures Trading Commission (“CFTC”) and are regulated as futures commission merchants (“FCMs”).12 All members are subject to a variety of clearinghouse-imposed requirements designed to minimize risk of default, including position limits, capital requirements and requirements to post margin to secure cleared trades.13 Members also make contributions to their clearinghouse’s default fund and are subject to additional assessments to cover losses in the event that another member defaults.

Mandatory clearing can affect swap trading behavior through a number of pathways. First, the clearing mandate imposes additional frictions on swap markets. Clearing requires becoming a clearing member or establishing a customer relationship with a clearing member, and these arrangements are costly.14 This additional cost of clearing transactions should reduce overall volume. The reductions in volume may decrease the inflow of risk to the financial system. Alternatively, the increase in costs may reduce hedging by financial institutions, which may cause risk to accumulate within the financial

11. Griffith, supra note 4, at 1194−95 (“[T]he institution of clearing, if successful, effectively eliminates dealers’ counterparty credit risk and, with it, the principal advantage of keeping the vast majority of derivatives trading among a small group of (supposedly) high-credit, [sic] quality dealers.”). 12. See Commodity Exchange Act § 4d(f)(1), 7 U.S.C. § 6d(f)(1) (2012); Gabriel D. Rosenberg & Jai R. Massari, Regulation Through Substitution as Policy Tool: Swap Futurization Under Dodd-Frank, 2013 COLUM. BUS. L. REV. 667, 722 (2013). 13. CFTC regulated clearinghouses, which are called derivatives clearing organizations, must satisfy a number of core principles. Commodity Exchange Act § 5b(c)(2), 7 U.S.C. § 7(a)(1)(c)(2). These core principles include standards governing the financial resources of the derivatives clearing organization, standards governing admission and eligibility of its members, risk management standards, standards governing its own default as well as the default of its clearing members and standards specifying system safeguards. Id.; see also 17 C.F.R. § 39.1 (2015) (setting forth requirements applicable to derivatives clearing organizations); Levitin, supra note 5, at 454−56. 14. Costs are also imposed by the platform execution mandate and additional elements of the Dodd-Frank Act.



system. The net effect of the expected reduction in trades on systemic risk is, therefore, uncertain.

In addition to reducing the volume of activity, the clearing mandate can affect the types of swaps parties enter into. The clearing mandate applies only to standardized swaps. To avoid being subject to the clearing mandate, and potentially anti-evasion provisions implemented to support the mandate, parties may alter the terms on which they trade. In particular, parties may adopt more idiosyncratic and complex transaction structures to bring themselves outside of the scope of the mandate. These shifts in transactional terms may result in increased information costs to private parties and regulatory supervisors seeking to assess swap market participants’ financial positions. The resulting opacity may exacerbate systemic risk. However, the clearing requirement backed by the anti-evasion provision may also simplify swap transactions by funneling what would have otherwise been customized bilateral transactions into the standardized form that cleared transactions take. This reaction would increase transparency, reduce information costs and alleviate systemic risk.

In addition to how the clearing mandate is likely to affect trading in ordinary times, it is important to consider how clearing can affect trading during times of financial crisis. In this context, clearing will have several unambiguously salutary effects on trading activity. First, clearing preempts cascades of novations that distressed derivatives counterparties such as Bear Stearns experienced during the financial crisis.15 As market participants become concerned with a counterparty’s ability to perform under its swap contracts, they may seek to novate or assign the contracts to a new counterparty.16 This can create cascades in the market as potential transferees for the distressed counterparty’s obligations are contacted because these transferees may themselves have derivatives contracts with the distressed counterparty that they may then seek to novate or assign. During the 2007−2009 financial crisis, these dynamics singled out distressed firms that counterparties were abandoning. This herd behavior in swap markets may have

15. See THE FIN. CRISIS INQUIRY COMM’N, THE FINANCIAL CRISIS INQUIRY REPORT 287 (2011) (explaining how in its final days, Bear Stearns was increasingly substituted out of derivatives transactions through assignments and novations). 16. Id. at 386 (“The scale and nature of the over-the-counter (OTC) derivatives market created significant systemic risk throughout the financial system and helped fuel the panic in the fall of 2008 . . . . Enormous positions concentrated in the hands of systemically significant institutions that were major OTC derivatives dealers added to uncertainty in the market. The ‘bank runs’ on these institutions included runs on their derivatives operations through novations, collateral demands, and refusals to act as counterparties.”).



contributed to runs against the distressed firms in other markets, such as overnight repo, commercial paper and other short-term funding markets. Clearing obviates the reasons to seek a novation or assignment after executing a trade with a party that becomes financially distressed. Payments under a cleared trade can continue notwithstanding that a counterparty has failed because it is the clearinghouse rather than the counterparty that makes the payments due under the trade. Accordingly, clearing mutes an important pathway for spreading panic during a crisis.17

Second, clearing increases market resiliency to counterparty distress. Market dynamics observed during the deterioration of Bear Stearns demonstrate the fragility of bilateral markets when a significant swap dealer becomes distressed.18 Bilateral markets create dependencies between counterparties by requiring renegotiation to reduce or unwind existing positions.19 Central clearing removes these dependencies by enabling a dealer and its counterparties to reduce or terminate existing transactions without negotiating with one another.20 For example, termination may be accomplished through entering into a

17. Critics may argue that (a) although clearing mutes this pathway, other paths to panic remain open; and (b) novations in the bilateral context provide market discipline and serve as a useful source of information. Both arguments are valid at least in part. To the first argument, my response is that the remaining pathways themselves may be closed through separate measures, and that closing some is better than closing none (by analogy, it is not an argument against FDIC insurance for bank deposits that runs may nevertheless occur through overnight repo, commercial paper and other markets). In other words, I do not believe that each run that is begun through derivatives novations would—if novations no longer took place—nevertheless occur as soon due to some other prompt. The second argument neglects that the clearing member and clearinghouse through which the trade is cleared assume a monitoring function and can impose discipline by requiring additional collateral, limiting trading and liquidating cleared positions. 18. THE FIN. CRISIS INQUIRY COMM’N, supra note 15, at 365 (“[T]he sharp contraction in the OTC derivatives market in the fall of 2008 greatly diminished the ability of institutions to enter or unwind their contracts or to effectively hedge their business risks at a time when uncertainty in the financial system made risk management a top priority.”). 19. In the bilateral context, entering into a reverse of the original trade with a third party does not cancel the original trade because the third party may become insolvent so that there are insufficient cash flows under the reverse trade to meet payment obligations under the original trade. 20. INT’L MONETARY FUND, GLOBAL FINANCIAL STABILITY REPORT: MEETING NEW CHALLENGES TO STABILITY AND BUILDING A SAFER SYSTEM 92 (2010) (“While CCPs worldwide functioned relatively well, where such CCPs were not involved, there were difficulties in unwinding derivatives contracts.”). Here, the term CCP refers to central counterparty, a synonym for “clearinghouse” as the term is used throughout this article. Id. at 91.



reverse of the original transaction with any party rather than just the counterparty to the original transaction. This is the case because payments due to the clearinghouse under the original trade will be offset by payments owed by the clearinghouse under the reverse trade and vice versa, thus cancelling out the payments receivable and payable under the two trades. Clearing enables positions to be unwound during a crisis notwithstanding that the party to the original trade is preoccupied or otherwise unable to trade.21

Finally, alongside the G-20 mandate to execute standardized swaps through trading platforms, clearing has the potential to dis-intermediate swaps markets. Historically, swap dealers intermediated markets by responding to demand for swaps and then partially laying off the risk through offsetting transactions. Acting in this manner, swap dealers were indispensable to the functioning of the swap market as exclusive sources of liquidity for parties desiring to enter into a swap. Swap dealers were also indispensable because they were dependably creditworthy (or at least thought to be, more so than other market participants). In general, swap dealers are large banks offering their counterparties diversified balance sheets that benefit from federal oversight for safety and soundness as well as implicit government guarantees (which became explicit during the last financial crisis).22 These two characteristics—dependable liquidity and dependable credit—are being supplanted by the introduction of trading platforms and mandatory clearing under the G-20 reforms. Trading platforms convert demand for swaps into supply through aggregating demand from both sides of the market. Clearinghouses are the second key to dis-intermediation, as they allow parties desiring to go long to transact with parties desiring to go short without the involvement of a dealer and without doubting one another’s credit quality. This alternative allows risk transfer to bypass the major financial institutions that act as swap dealers, thus reducing the snarled complexity of operations among the largest financial institutions.23

21. Bliss & Kaufman, supra note 8, at 67 (explaining that in the non-cleared context, “[r]emoval of any one dealer may seriously disrupt the derivatives markets. Even if no knock-on failures occurred, a very large number of contracts would need to be replaced and new working relationships would need to be established for end users.”). 22. For some products such as energy swaps, dealers may be affiliates of firms primarily thought of as participants in physical (i.e., non-synthetic) markets. See infra note 37. 23. This consequence of the clearing mandate and platform execution requirement embedded in the G-20 reform platform points to a political economy story behind the most recent round of financial reform. Banks became the object of displeasure—both among voters and governments—following the collapse of the housing market and the extensive



The remainder of this article proceeds as follows. Part I provides a brief introduction to swap transactions and the structure of swap markets. Part II discusses three mitigants to credit risk that are used in swap transactions both in the bilateral and cleared context: netting, setoff and margin. Part II then reviews and comments on prior scholarship assessing whether netting, setoff and margin efficiencies reduce systemic risk with the introduction of mandatory clearing. Whereas Part II looks at mechanisms for avoiding loss, Part III looks at mechanisms for allocating loss in the bilateral and cleared contexts. In particular, Part III compares the bilateral and cleared context with a focus on monitoring and loss mutualization and how these impact systemic risk, again reviewing and critiquing prior scholarship. Collectively, Parts II and III identify how a set of swaps would perform in an uncleared context as opposed to a cleared context. Part IV then takes the next step by exploring how clearing affects trading behavior. Part V concludes, emphasizing the importance of reevaluating the clearing mandate in ever-evolving financial markets.

PART I. SWAP TRANSACTIONS AND THE STRUCTURE OF SWAP MARKETS

The term “swap” has ambiguous contours but some definite and frequently encountered instantiations. A practical definition of “swap” can take the following form: “a bilateral agreement to exchange future cash flows based on some agreed formula.”24 An example is a floating-for-fixed interest rate swap, which calls for (a) payments by one party based on the product of a floating interest rate and a fixed amount, called the notional, in exchange for (b) payments by the counterparty based on the product of a fixed interest rate (e.g., three percent) and the same notional amount. This example illustrates the origins of the name “swap” because the instrument allows the parties to swap payment obligations based on two interest rates—a floating rate and a fixed rate.

Swaps allow parties to achieve the economic results of transactions without entering into those transactions, which is why positions obtained through entering into a swap are sometimes referred to as “synthetic.”25 For example, the interest rate swap described above

government support extended to financial institutions. Derivatives reform may be aimed at creating a substitute for traditional bank sources of liquidity to the derivatives market through creating market structures through which the oligopolistic dealer network of banks is supplanted with a peer-to-peer derivatives market place. 24. Lawrence C. Tondel, Introduction to Derivatives, in DERIVATIVES: LEGAL PRACTICE AND STRATEGIES § 1.01[B][3], at 1-1, 1-9 (Robert D. Aicher ed., Supp. 2011). 25. Lynn A. Stout, Derivatives and the Legal Origin of the 2008 Credit Crisis, 1 HARV.



allows one party to reproduce the economic effects of borrowing the notional amount at the floating rate and lending it at the fixed rate while the counterparty achieves the inverse economics. This is done without actually borrowing and lending the notional amount, thereby saving on transaction costs and allowing the counterparties to isolate the interest rate exposure produced by the offsetting borrowing and lending transactions. In other words, a floating-for-fixed interest rate swap allows parties to take positions on the future performance of a floating rate relative to a fixed rate. Swaps can be used to provide contingent payments based on a variety of events, ranging from changes in financial indices such as inflation, currency and interest rates, to changes in prices of tangible commodities such as energy, metals and foodstuffs, to manifestations of tangible risks such as weather events and longevity trends. Another example of a swap is a natural gas swap, which may require (a) payments by one party based on the product of the market price per unit of natural gas in a particular region and a notional amount representing units of natural gas, in exchange for (b) payments by the counterparty based on the product of a fixed per unit price of natural gas and the notional amount.

The Dodd-Frank Act provides a capacious and multi-pronged definition of “swap” that includes:

any agreement, contract, or transaction . . . that provides on an executory basis for the exchange, on a fixed or contingent basis, of 1 or more payments based on the value or level of 1 or more interest or other rates, currencies, commodities, securities, instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind, or any interest therein or based on the value thereof, and that transfers, as between the parties to the transaction, in whole or in part, the financial risk associated with a future change in any such value or level without also conveying a current or future direct or indirect ownership interest in an asset (including any enterprise or investment pool) or liability that incorporates the financial risk so transferred.26

BUS. L. REV. 1, 6 (2011). 26. Commodity Exchange Act, 7 U.S.C. § 1a(47)(A)(iii) (2012). The full definition of swap is significantly more extensive and includes, among other things,

any agreement, contract, or transaction—(i) that is a put, call, cap, floor, collar, or similar option of any kind that is for the purchase or sale, or based on the value, of 1 or more interest or other rates, currencies, commodities, securities,



This statutory definition of swap is generally inclusive of the more colloquial definition of swap as a “bilateral agreement to exchange future cash flows based on some agreed formula” offered above. Notably, the quoted statutory definition is focused on synthetic transactions, i.e., those that transfer “the financial risk associated with a future change in . . . [a] value or level without also conveying a current or future direct or indirect ownership interest in an asset.”27

Having offered some definitional background on swaps, it is next helpful to discuss how swap transactions are used and the markets in which they trade.28 First consider the case of a hedging natural gas producer, Party A. Party A has financed itself with floating rate bonds. To hedge risk on its floating rate bonds, Party A has entered into a fixed-for-floating interest rate swap with a swap dealer, Party B. Given volatility in energy markets, Party A has also hedged its exposure to the price of natural gas by entering into a floating-for-fixed swap based on an index of current natural gas prices. As a result of its natural gas production, bond issuance and the two swap trades, Party A would (a) receive payments for its natural gas that floated with market rates, (b) trade those floating rate payments for fixed amounts due under the natural gas swap, (c) use fixed amounts received under the natural gas swap to satisfy its fixed payment obligations under the interest rate swap and (d) use the floating amounts received under the

instruments of indebtedness, indices, quantitative measures, or other financial or economic interests or property of any kind; (ii) that provides for any purchase, sale, payment, or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence; . . . [or] (iv) that is an agreement, contract, or transaction that is, or in the future becomes, commonly known to the trade as a swap.

Id. § 1a(47)(A). The last of these excerpted components of the definition serves to track market evolution so that future products that come to be known as swaps in the trade are captured within the legal term “swap.” An exploration of the term “swap” and the exceptions from it is beyond the scope of this article. 27. However, under other elements of the definition, transactions contemplating delivery of physical commodities rather than pure exchanges of cash qualify as swaps. Id. § 1a(47)(A)(i) (“option of any kind that is for the purchase or sale . . . of 1 or more . . . commodities”); see Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208, 48,236 (Aug. 13, 2012) (codified at 17 C.F.R. pts. 1, 230, 240, 241) (“[C]ommodity options are swaps under the statutory swap definition . . . .”). 28. See Jonathan R. Macey, Derivative Instruments: Lessons for the Regulatory State, 21 J. CORP. L. 69, 72 (1995) (“Derivatives are a means to risk management. . . . At best, the use of derivative instruments permits parties in financial transactions to shift the risks associated with such transactions to the parties that have the comparative advantage in bearing the risk.”).



interest rate swap to make interest payments due under the bonds. Through the two swap transactions, Party A has locked in steady cash flows for its employees, vendors, investors and other stakeholders. De-risking in this manner is a powerfully attractive proposition that derivatives markets are able to offer to businesses and explains a key role of derivatives in the real economy.

In addition to hedging, derivatives may be used to speculate.29 Given a view as to future market movements, derivatives may be used to express that view. For example, consider a hedge fund that expects the price of natural gas to go up. To express that view (i.e., to go long on natural gas), the hedge fund could enter into a fixed-for-floating swap under which it paid a fixed rate to receive the market price of natural gas.30 Similarly, a hedge fund that expected interest rates to go down could express that view (i.e., go short interest rates) by entering into a floating-for-fixed interest rate swap under which it paid a floating interest rate to receive a fixed rate.31

The preceding examples of the hedging natural gas producer and the speculating hedge fund give a broad stroke introduction to how swaps are used; however, the discussion leaves an important question unaddressed, namely, how do firms enter into swaps, or in other words, who supplies swaps to meet market participants’ demand for swaps? This is the question we turn to next.

The natural gas producer in the preceding example may be referred to as a natural long for natural gas and a natural short for interest rates.32 That is because, vis-à-vis prices of natural gas, the firm’s role as producer of natural gas gives it a long position in natural gas (i.e., the

29. Cf. Stout, supra note 25, at 27 (arguing that the legalization of speculative over-the-counter derivatives trading under the Commodities Futures Modernization Act of 2000 led to the financial crisis); Timothy E. Lynch, Coming Up Short: The United States’ Second-Best Strategies for Corralling Purely Speculative Derivatives, 36 CARDOZO L. REV. 545, 549 (2014) (arguing that purely speculating trades have negative externalities, destroy wealth, and are irrational). 30. Payments would be based on a notional amount, so the fixed payment made by the hedge fund would be based on the product of a fixed rate per unit of natural gas and the notional amount of natural gas. Similarly, the floating amount due to the hedge fund would be based on the market rate per unit of natural gas multiplied by the notional amount of natural gas. 31. As with the natural gas speculator, payments are based on the notional amount of the interest rate swap. The floating amount due from the hedge fund would be the product of the floating rate and the notional amount. Conversely, the fixed amount due to the hedge fund would be the product of the market rate (e.g., three-month US LIBOR) and the notional amount. 32. For a succinct overview of the structure of derivatives markets, see JICKLING & RUANE, supra note 10, at 1–5.



firm has natural gas to sell at market prices so that increases in prices redound to its benefit and decreases in prices reduce the firm’s profits). Similarly, vis-à-vis interest rates, the firm’s role as issuer of floating rate bonds gives it a short position in interest rates (i.e., the firm’s profits increase as interest rates go down and decrease as interest rates go up).33 Conversely, the hedge fund’s speculative strategies can be expressed through a short position in natural gas and a long position in interest rates. Thus the fund may be an ideal counterparty for the natural gas producer; however, in historical swap markets, the natural gas producer and the fund would rarely, if ever, transact directly. Rather, each of the parties would transact with a swap dealer. Later on in this article, it is explained how the introduction of the clearing mandate can disintermediate swap markets so that the firm and hedge fund in this example can come to transact directly.

Swap dealers serve as sources of liquidity to swap market participants, standing ready to meet demand from firms hedging, speculating or otherwise transacting in swaps.34 Swap dealers are subject to registration, capital, margin, internal and external business conduct and other requirements that were introduced under Title VII of the Dodd-Frank Act.35 Swap dealers are generally major financial

33. See Ellen P. Pesch, Use of Derivatives in Finance and Structured Finance Transactions, in DERIVATIVES: LEGAL PRACTICE AND STRATEGIES, supra note 24, § 8.01, at 8-5 (“For example, if a borrower wants to borrow funds from a lender, but the lender will only make a floating-rate loan, the borrower can elect to enter into a fixed-to-floating interest rate swap as a way to mitigate the interest rate risk associated with the floating-rate loan.”). 34. Commodity Exchange Act Section 1.3(ggg); see also Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” 77 Fed. Reg. 30,596, 30,598−99 (May 23, 2012) (codified at 17 C.F.R. pts. 1, 240). 35. See Capital Requirements of Swap Dealers and Major Swap Participants, 76 Fed. Reg. 27,802, 27,804 (proposed May 12, 2011) (to be codified at 17 C.F.R. pts. 1, 23, 140) (proposing capital requirements applicable to swap dealers that are not subject to prudential regulation); Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,898, 59,902 (proposed Oct. 3, 2014) (to be codified at 17 C.F.R. pts. 23, 140) (proposing margin requirements applicable to uncleared swaps for swap dealers that are not subject to prudential regulation); Margin and Capital Requirements for Covered Swap Entities, 79 Fed. Reg. 57,348, 57,353−56 (proposed Sept. 24, 2014) (to be codified at 12 C.F.R. pts. 45, 237, 349, 624, 1221) (proposing capital and margin requirements for prudentially regulated swap dealers); Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, 77 Fed. Reg. 55,904, 55,904 (Sept. 11, 2012) (codified at 17 C.F.R. pt. 23) (setting forth internal business conduct requirements including confirmation, portfolio reconciliation, portfolio compression and swap trading relationship documentation requirements applicable to swap dealers); Business Conduct Standards for Swap Dealers and Major Swap



institutions with robust balance sheets that specialize in pricing and hedging the risk transferred through swaps.36 Thus the natural gas producer would likely reach out to one or more swap dealers—directly or through a broker—with a request to provide pricing for a natural gas swap that could, in part or whole, hedge its expected production of natural gas. The swap dealer would estimate the cost it would incur to hedge that natural gas swap or maintain the risk of that swap on its balance sheet (referred to as “warehousing” the risk). Then, the dealer would respond with a price that represented its cost and a premium for profit. Assuming the transaction was executed, the swap dealer may then enter into an offsetting natural gas swap with the fund that was discussed above or another party that desired to go long on natural gas.37

Through sets of similar transactions, swap dealers serve as intermediaries of risk.38 Parties desiring to go long or short approach

Participants with Counterparties, 77 Fed. Reg. 9734, 9734 (Feb. 17, 2012) (codified at 17 C.F.R. pts. 4, 23) (setting forth external business conduct requirements that govern swap dealers in transacting with other counterparties). 36. As of the time this article was being written, there were approximately 113 registered swap dealers as reflected in the registry of swap dealers maintained by the National Futures Association. SD/MSP Registry, NAT’L FUTURES ASS’N, https://www.nfa. futures.org/NFA-swaps-information/regulatory-info-sd-and-msp/SD-MSP-registry.HTML (last visited Jan. 24, 2016). Prior literature on the clearing mandate has frequently conflated swap dealers and clearing members. These are distinct and largely non-overlapping sets of entities. Compare the list of swap dealers available above, from the SD/MSP Registry, id., with the lists of clearing members published by the CME, Clearing Firms, CME GROUP, http://www.cmegroup.com/tools-information/clearing-firms.html (last visited May 22, 2016), and ICE, Membership, ICE CLEAR U.S., https://www.theice.com/ clear-us/membership (last visited May 22, 2016). That said many of the major financial institutions have both a swap dealer and clearing member within their corporate group. 37. Tondel, supra note 24, § 1.01[B][3], at 1-10 (“Often, one party to a swap is a derivatives dealer and the other party is a so-called ‘end user.’ . . . [A] professional derivatives dealer is generally not in the business of directly speculating on interest rates (or the future prices of any other underlying assets, indices, or reference rates). Rather, in the course of conducting its business, the derivatives dealer will generally strive to maintain a balanced portfolio of derivatives positions (e.g., entering some interest rate swaps where the dealer is obligated to make payments based on a fixed rate of interest, and others where the dealer’s payments are based on a floating rate of interest).”). 38. Through regulating the intermediaries, the CFTC and SEC have obtained a purchase on swap markets. The diverse rules applicable to swap dealers (as well as security-based swap dealers) and to platforms where swaps (and security-based swaps) are traded, see discussion of swap execution facilities and designated contract markets infra, help bring order to previously unregulated swap markets. Through regulating dealers and markets for swaps, the Dodd-Frank Act also appoints formal gatekeepers with regulatory responsibilities for assuring transparency and preventing misconduct. See generally JOHN C. COFFEE JR., GATEKEEPERS: THE PROFESSIONS AND CORPORATE GOVERNANCE (2006).



swap dealers seeking to enter into swap transactions.39 Swap dealers enter into these transactions, and then find other parties to offload the risk to.40 Through the nexus of swap dealers, natural longs meet natural shorts, and speculators, such as funds, provide liquidity to other market participants.

Of course, the transactions offloading risk may be imperfect, i.e., some of the risk may remain with the dealer. This is especially true with regard to credit risk, a topic that will be revisited throughout the article. For now, it is sufficient to observe that if Party X enters into a swap with a swap dealer, and the swap dealer enters into the exact reverse of the swap with Party Y (i.e., so that cash flows due under the two swaps perfectly offset one another), the swap dealer is not perfectly hedged. This is because if either Party X or Party Y defaults to the swap dealer, the swap dealer nevertheless has to continue paying the remaining counterparty under the remaining swap. In this manner, swap dealers do not simply intermediate risk but also accumulate risk. The risk that is accumulated, putting aside transactions that they decide to warehouse, is counterparty credit risk or the risk of default. Because swap dealers are predominantly banking entities with extensive lending and other financial operations built on assessing counterparty credit risk, they have capacity to provide a strong but incomplete check on their accumulation of counterparty credit risk.

With the preceding background on the uses of swaps and market structure, we turn to the clearing mandate, and its cousin, the platform execution mandate.41 The clearing mandate has been implemented across jurisdictions, and forms an integral part of the Dodd-Frank Act.42

39. There is an active debate regarding the extent to which commercial firms actually engage in swap contracts to manage their risks. See Wayne Guay & S.P Kothari, How Much Do Firms Hedge with Derivatives?, 70 J. FIN. ECON. 423 (2003). 40. See Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant,” 77 Fed. Reg. 30,596, 30,600 (May 23, 2012) (codified at 17 C.F.R. pts. 1, 240). 41. See FSB, OTC DERIVATIVES, supra note 1, at 4, 5 (“As of November 2014, five jurisdictions report having some central clearing requirements in effect (for select interest rate, credit and FX derivatives products); this is expected to increase to 10 jurisdictions by end-2015. By that time another five expect to have some central clearing requirements adopted but not yet effective, or to be in the process of consulting on or proposing such requirements. . . . [M]ost jurisdictions have adopted the necessary legislative frameworks to support increased use of exchanges and electronic trading platforms for OTC derivatives contracts, . . . but progress in adopting specific requirements is more limited.”). 42. Initiatives to implement central clearing may be traced to a meeting of the G-20 nations in September 2009. Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74,284, 74,286 (Dec. 13, 2012) (to be codified at 17 C.F.R. pts. 39, 50). During that meeting, representatives of the twenty nations, see supra note 1, agreed



The Dodd-Frank Act added section 2(h), which requires the CFTC to review swaps and determine what should be encompassed within the clearing mandate, to the Commodity Exchange Act.43 Factors the CFTC considers in its analysis include the effect of applying the clearing mandate to a swap on the mitigation of systemic risk, competitive effects, factors relating to predictability of swap performance such as extent of outstanding notional, liquidity and pricing data and the infrastructure supporting clearing of the swap.44 Section 2(h)(1) makes it illegal to engage in a swap without submitting it to a clearinghouse if the swap is subject to the clearing mandate.45

The CFTC has been reviewing swaps and has thus far subjected a range of standardized interest rate and index credit default swaps to the clearing mandate.46 Other jurisdictions such as Australia, the European Union, Japan, Hong Kong and Singapore are also developing clearing mandates for interest rate and index credit default swaps.47

that “(1) OTC derivatives contracts should be reported to trade repositories; (2) all standardized OTC derivatives contracts should be cleared through central counterparties and traded on exchanges or electronic trading platforms . . . ; and (3) non-centrally cleared contracts should be subject to higher capital requirements.” Id. In June 2010, leaders of the G-20 reaffirmed their commitments to these derivatives market reforms. Id. The implementation of reforms has been assisted through studies and recommendations issued by the FSB. Id. Within the United States, implementation of the clearing mandate has been tasked to the CFTC, with respect to swaps, and the SEC, with respect to security-based swaps. Id. Further, “Title VII of the Dodd-Frank Act establishes a comprehensive new regulatory framework for swaps, and the requirement that swaps be cleared by [derivatives clearing organizations] is one of the cornerstones of that reform.” Id. at 74,285; see Further Definition of “Swap,” “Security-Based Swap,” and “Security-Based Swap Agreement”; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 Fed. Reg. 48,208, 48,236 (Aug. 13, 2012) (codified at 17 C.F.R. pts. 1, 230, 240, 241). 43. Commodity Exchange Act § 2(h)(2), 7 U.S.C. § 2 (2012). The SEC and non-U.S. regulatory counterparts are operating in parallel to identify swaps to subject to the clearing mandate within their jurisdiction. See Process for Submissions for Review of Security-Based Swaps for Mandatory Clearing and Notice Filing Requirements for Clearing Agencies; Technical Amendments to Rule 19b-4 and Form 19b-4 Applicable to All Self-Regulatory Organizations, 75 Fed. Reg. 82,490, 82,490 (Dec. 30, 2010) (codified at 17 C.F.R. pts. 240, 249) (proposing rules pursuant to which security-base swaps, i.e., swaps subject to SEC jurisdiction, would become subject to the clearing mandate); see also Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74,286 (discussing clearing mandate outside of the United States). 44. Commodity Exchange Act § 2(h)(2)(D), 7 U.S.C. § 2 (2012). 45. Id. § 2(h)(1)(A), 7 U.S.C. § 2. 46. 17 C.F.R. § 50.4 (2015). The CFTC has further considered clearing requirements for certain currency non-deliverable forwards. See Silla Brush, U.S. CFTC Clearing Rules Eyed for Some Currency Derivatives, BLOOMBERG (Oct. 7, 2014), http://www.bloomberg. com/news/articles/2014-10-07/u-s-clearing-rules-eyed-for-some-currency-derivative-contracts. 47. Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg.



Estimates of global interest rate swap positions top $381 trillion in notional and $13.9 trillion in gross market value.48 For index credit default swaps, the estimate tops $7.4 trillion in notional and $227 billion in gross market value.49 The value of cash flows transmitted pursuant to instruments that are, or will be, subject to the clearing mandate is in the ballpark of the gross domestic product of the United States, which was $16.8 trillion in 2013, and dwarfs the domestic production of almost all nations.50 In other words, affected product types have a significant economic presence. The clearing mandate is putting regulated entities in charge of guaranteeing and relaying massive amounts of payments on an everyday basis. It represents a deep government intervention into the network of risk allocation arrangements private parties negotiate. The justification given for this intervention has been the mitigation of systemic risk.51

Within the United States, where regulatory authority over derivatives markets is divided between the CFTC and the Securities and Exchange Commission (“SEC”), the clearing mandate has already taken hold.52 At the time the clearing mandate took effect, the majority of outstanding interest rate swap and index credit default swap transactions were not cleared.53 Since the mandate has come into effect, weekly swap reports published by the CFTC show interest rate swap transactions becoming predominantly cleared and the volumes of uncleared index credit default swaps steadily falling.54 This shows a marked change in the market towards clearing. The data reveals, however, that clearing is far from ubiquitous owing likely to a combination of the limited coverage of the clearing mandate and certain

at 74,286. 48. BIS, OTC DERIVATIVES STATISTICS (2015), supra note 3, at 15. 49. Id. 50. GDP at Market Prices (Current US$), WORLD BANK, http://data.worldbank.org/ indicator/NY.GDP.MKTP.CD (last visited Feb. 29, 2016). 51. See Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74,285−86. In addition to systemic risk, goals of transparency and prevention of market abuse have been cited by the regulatory community in adopting derivatives market reforms. See Christine Harper, G-20 Leaders Vow to ‘Raise Standards’ on Financial Regulation, BLOOMBERG (Sept. 26, 2009), http://www.bloomberg.com/news/ articles/2009-09-26/g20-leaders-vow-to-raise-standards-on-financial-regulation. 52. The clearing mandate applicable to certain interest rate swaps and index credit default swaps was phased in between March 11, 2013 and September 9, 2013. Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. at 74,320. 53. See infra Figures 1–5. 54. Archive of CFTC Swaps Report, U.S. COMMODITY FUTURES TRADING COMMISSION, http://www.cftc.gov/MarketReports/SwapsReports/Archive/index.htm (last visited Feb. 14, 2016); see also infra Figures 1–5.



exceptions therefrom.55 The clearing mandate covers standardized interest rate swaps and index credit default swaps56 that fall into defined categories (e.g., only interest rate swaps in U.S. dollars, Euros, Sterling and Yen and only those without optionality; only untranched credit default swaps that are based on certain North American and European indices of corporate debt), rather than interest rate swaps and index credit default swaps wholesale. Furthermore, certain transactions are eligible for exceptions from the clearing mandate. A prominent exception from the clearing mandate is made for a non-financial entity that is entering into a swap to hedge or mitigate commercial risk (the so called “end-user exception”).57 Additional exceptions have been promulgated for inter-affiliate swap transactions and certain swaps entered into with cooperatives.58

Because the clearing mandate applies only to certain identified sets of standardized swaps, it poses an opportunity for evasion. Parties could potentially evade the clearing requirement through structuring their trades to be outside the specified categories of swaps subject to the mandate. To prevent evasion, the Dodd-Frank Act added section 2(h)(4), which authorizes the CFTC to prescribe rules to prevent evasions of the mandatory clearing requirement, to the Commodity Exchange Act.59 The CFTC has exercised this authority to promulgate rules prohibiting the knowing or reckless evasion, or participation in or facilitation of evasion, of the clearing requirement or the mandatory platform execution requirement discussed next.60 How “evasion” may be reckless, and whether statutory authority to ban evasion of the clearing

55. See sources cited supra note 54. 56. Index credit default swaps are credit default swaps that reference an index of corporate borrowers. They are distinguished from single name credit default swaps, which reference a single borrower. See Nabila Ahmed & Sridhar Natarajan, BlackRock’s on a Mission to Save the Credit-Default Swaps Market, BLOOMBERG (May 6, 2015), http://www.bloomberg.com/news/articles/2015-05-05/blackrock-s-on-a-mission-to-save-the-credit-default-swaps-market. North American index CDS reference debtors are based in North America, whereas European index CDS reference debtors are based in Europe. Tranched CDS refers to credit default swaps that only pay the protection buyer once losses on underlying obligations exceed a certain threshold. They are distinguished from untranched CDS, which pay the protection buyer in respect of all losses on the underlying obligation. 57. Commodity Exchange Act § 2(h)(7), 7 U.S.C. § 2 (2012). 58. Clearing Exemption for Swaps Between Certain Affiliated Entities, 78 Fed. Reg. 21,750, 21,783 (Apr. 11, 2013) (codified at 17 C.F.R. pt. 50); Clearing Exemption for Certain Swaps Entered into by Cooperatives, 78 Fed. Reg. 52,286, 52,287 (Aug. 22, 2013) (codified at 17 C.F.R. pt. 50). 59. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, § 723(a)(3), 124 Stat. 1376, 1675–76. 60. 17 C.F.R. § 50.10(a) (2015).



requirement is sufficient to support a ban on evading the separate platform execution requirement is a matter left to future courts. The CFTC has also prohibited the “abuse” of any exceptions to the clearing and platform execution requirements.61

Under the Dodd-Frank Act, the clearing mandate dovetails with another element of the G-20 derivatives reform program.62 As mentioned above, in addition to clearing standardized derivatives, the reform program contemplates that standardized swaps will be traded on exchanges or electronic platforms.63 This element of the program is reflected in section 2(h)(8) of the Commodity Exchange Act. Under section 2(h)(8) of the Commodity Exchange Act, swap transactions that are subject to the clearing mandate must also be executed on a swap execution facility (“SEF”) or designated contract market (“DCM”) if a SEF or DCM has made the swap “available to trade.”64 As background, SEFs and DCMs are trading platforms that must register with the CFTC and are regulated by it.65 SEFs and DCMs have made submissions to the CFTC certifying that certain of the swaps that are subject to the clearing mandate are made available to trade by them.66

61. Id. § 50.10(b)–(c). 62. Regulatory reforms of swap markets under Title VII of the Dodd-Frank Act have been analogized to safety and soundness requirements imposed by banking regulators. See Arthur W. S. Duff & David Zaring, New Paradigms and Familiar Tools in the New Derivatives Regulation, 81 GEO. WASH. L. REV. 677 (2013). Many of the new regulations actually have counterparts under the futures regime already administered by the CFTC. Using regulated infrastructure, and in particular, derivatives clearing organizations and regulated platforms (e.g., designated contract markets) has been a core means of regulating futures markets to date and has been simply expanded to cover swaps. This expansion may have been a response to political exigency rather than motivated by dispassionate, welfare-maximizing policy analysis. Politicians may have felt the need to act and borrowed from preexisting regulatory regimes rather than designed an optimal regulatory regime for the swaps marketplace. However, even if the clearing mandate and other elements of post-crisis derivatives market reform represent arbitrary expansions of a prior regulatory regime, the expansions may—and this article argues do—have positive unintended consequences. The futures market has worked well for decades in reliance on mandatory clearing and platform execution, and while futures regulation may be in places ill-fitting to swaps (which are often intentionally idiosyncratic), it should not be terribly surprising to find at least some positive effects. 63. See sources cited supra note 2. 64. Commodity Exchange Act § 2(h)(8), 7 U.S.C. § 2(h)(8) (2012); see Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade, Swap Transaction Compliance and Implementation Schedule, and Trade Execution Requirement Under the Commodity Exchange Act, 78 Fed. Reg. 33,606, 33,606 (June 4, 2013) (codified at 17 C.F.R. pts. 37, 38). 65. See 17 C.F.R. pt. 37 (setting forth regulations governing swap execution facilities); id. pt. 38 (setting forth regulations governing designated contract markets). 66. For a list of “made available to trade” swaps that have been submitted, see Swaps Made Available to Trade Determination, U.S. COMMODITY FUTURES TRADING



These submissions were not surprising given that it is in the interests of SEFs and DCMs to require that swaps be executed on SEFs and DCMs, i.e., when approved by the CFTC, made available to trade submissions move swap execution from bilateral markets to SEFs and DCMs.67 The CFTC has been reviewing these submissions, and generally upholding certifications that submitted swaps are made available to trade and thus subject to the platform execution requirement.68 As a result, many of the swaps that must be cleared must also be executed on a regulated trading platform. Execution of swaps that have been made available to trade on SEFs and DCMs can proceed via a request for quote system or through an order book.69 A request for quote system involves the initiating party identifying three or more potential counterparties to solicit with a proposed transaction; the order of the requesting party is exposed to any contra-orders (i.e., potentially matching orders) that are sitting in the platform’s order book.70 The order book refers to platform systems maintaining sets of orders and contra-orders with price, volume and product information so as to permit automated matching of supply and demand for products traded through the platform.

Many SEFs had been operating as platforms for executing trades between swap dealers prior to registering as SEFs and, as such, becoming subject to open access requirements.71 The conversion of inter-dealer markets into regulated platforms that are open to all qualified traders represents a move towards greater egalitarianism in swaps markets, a theme that will be revisited later in this article.72

Figure 3 tracks outstanding notional for interest rate swaps in the United States.73 The first three gray lines in the chart represent dates

COMMISSION, http://sirt.cftc.gov/sirt/sirt.aspx?Topic=SwapsMadeAvailableToTradeDeter mination (last visited May 27, 2016). 67. Prior to certification and CFTC approval, parties can execute swaps bilaterally or through a platform. Following certification and approval, covered trades can only be executed through a platform (absent an applicable exception). 68. See sources cited supra notes 64, 66. 69. 17 C.F.R. § 37.9. 70. Core Principles and Other Requirements for Swap Execution Facilities, 78 Fed. Reg. 33,476, 33,494–501 (June 4, 2013) (codified at 17 C.F.R. pt. 37). 71. See 17 C.F.R. § 37.202(a). 72. Cf. Matthew Leising, Swaps Revolution Falling Flat as Brokers Keep Grip on New Market, BLOOMBERG BUS. (Mar. 4, 2014), http://www.bloomberg.com/news/articles/2014-03-05/swaps-revolution-falling-flat-as-brokers-keep-grip-on-new-market. 73. The Figures present outstanding notional amounts of cleared transactions based on CFTC swap reports. See Weekly Swaps Report, U.S. COMMODITY FUTURES TRADING COMMISSION, http://www.cftc.gov/MarketReports/SwapsReports/Archive/index.htm (last visited Feb. 14, 2016). Figures 3–7 show average outstanding notional amounts over a



on which the clearing mandate was phased in within the U.S. The initial compliance deadline, which occurred on March 11, 2013, applied primarily to swap dealers, large hedge funds and proprietary trading shops.74 The second compliance deadline occurred on June 10, 2013 and applied to a range of financial entities that were not covered by the first compliance deadline.75 The third compliance deadline occurred on September 9, 2013 and applied to the balance of swap market participants.76 The fourth gray line represents the onset of the platform execution mandate on February 15, 2014.77 The chart shows a significant decline in the notional amount of outstanding uncleared transactions following the onset of the clearing mandate.78

Figure 4 disaggregates the data in Figure 3 to show trends by the type of market participant. The four lines show, respectively, total outstanding notional for cleared trades involving swap dealers, uncleared trades involving swap dealers, cleared trades involving other market participants and uncleared trades involving other market participants.79 Figure 4 shows that most of the decline in outstanding notional is due to reduction in swap dealer transactions. End-users

one-month running window. 74. Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74,284, 74,320 (Dec. 13, 2012) (codified at 17 C.F.R. pts. 39, 50). 75. Id. 76. Id. 77. On February 26 Market Participants Must Begin Trading Additional Interest Rate Swaps and Index Credit Default Swaps on a Regulated Platform, SIDLEY AUSTIN LLP (Feb. 4, 2014), http://www.sidley.com/news/2-4-14derivativesupdate. 78. Based on correspondence with the CFTC, the sharpness of the decline in between the last onset of the clearing mandate and the onset of the platform execution mandate may be the result of a cessation of voluntary over-reporting of non-U.S. swaps by swap market participants. The sharp decline coincides with a change in the presentation of CFTC data that began with the report for the week of November 8, 2013. Prior to November 8, 2013, data was compiled from voluntary submissions and other sources. On and after November 8, 2013, data was compiled from swaps data mandatorily reported to swap data repositories. However, even ignoring this sharp decline, the graph shows an ongoing decrease in outstanding uncleared swap notional and supports the conclusion that markets have shifted from predominantly uncleared to predominantly cleared swaps. 79. The data for swap dealers also includes data for “major swap participants.” However, there are presently only two major swap participants, so it is assumed that most of the notional volume is attributable to swap dealers. See SD/MSP Registry, supra note 36 (providing registration information for swap dealers and major swap participants). Major swap participants are firms required to register on account of very large swap exposures that do not qualify as swap dealers. In other words, whereas swap dealers are required to register on account of their activities and role in the swap markets as liquidity providers, major swap participants are required to register on account of the size of their positions in swap markets. For the remainder of this article, references to CFTC data on swap dealers will include data on major swap participants.



have not exited the market at the same rate; in fact, data shows end-users use of interest rate swaps has slightly increased over this period. If we assume reasons for hedging have remained constant throughout this period, the trends in volumes support that regulation has not hampered the use of interest rate swaps by end-users.

Figures 5, 6 and 7 provide similar data for index credit default swaps (“CDS”). Figure 5 shows the overall decline in the volume of uncleared European and North American index CDS. Volumes of cleared index CDS have remained relatively stable, although the volume of cleared European CDS has declined since the initial period. Figure 6 breaks out the decline of European CDS by market participant; although both swap dealers’ and other market participants’ volumes have declined, the former declines dominate particularly in the uncleared category. Figure 7 breaks out volume trends for North American index CDS by market participant. It shows that most of the decline in uncleared volume is due to decreases in swap dealer transactions, and that cleared volumes for both swap dealers and other market participants have remained stable. These declines are generally consistent with transactions that were entered into on an uncleared basis prior to the clearing mandate now either being foregone or entered into on a cleared basis; however, declines in cleared transactions suggest that other forces are also at work, such as potentially reduced hedging and other risk management activity. Because these Figures are based on swap transaction data made public by the CFTC, a U.S. regulator, several grains of salt should accompany their consumption. First, the data only covers swap transactions; accordingly, to the extent that there is substitution to other instruments (e.g., futures), a decline in swap transactions does not correspond to a decline in economic activity. Second, the data only covers transactions reportable to the CFTC, and thus would exclude transactions that occur outside of the United States between non-U.S. persons; accordingly, to the extent non-U.S. persons are moving their transactions outside of the United States in response to clearing and other regulatory responsibilities, the declines overstate global decreases in swaps activity. It is unlikely that many non-financial end-users are able to effectively transfer the locus of their swap transactions abroad. However, what is clear is that since the implementation of the clearing and platform execution mandates in the United States, the extent of swap activity within the United States by swap dealers has declined substantially. Whether this is the result of responses to regulatory burdens or other factors is uncertain.



Figure 3 Outstanding notional for cleared and uncleared interest rate swap

transactions.



Figure 4 Outstanding notional for cleared and uncleared interest rate swap

transactions by market participant.



Figure 5 Outstanding notional for cleared and uncleared European and North

American index CDS transactions.



Figure 6 Outstanding notional for cleared and uncleared European index CDS

transactions by market participant.



Figure 7 Outstanding notional for cleared and uncleared North American index

CDS transactions by market participant



PART II. REDUCING LOSS FROM COUNTERPARTY DEFAULT THROUGH

NETTING, SETOFF AND MARGIN

The risk of non-performance, even giving effect to legal remedies, inheres in all agreements. Netting, setoff and margin are important credit risk mitigation techniques used to reduce exposure to counterparty default in the context of swap transactions.80 This Part explains these credit risk mitigation techniques, comparing their use in the bilateral and cleared contexts. After explaining these risk mitigation techniques and how they differ in the two contexts, this Part reviews how netting, setoff and margin have been viewed within the clearinghouse systemic risk debate and offers a new perspective on how these techniques have affected trading behavior.

A. Netting

When two parties enter into derivatives transactions, they can choose to integrate some of those transactions so that they are governed by the same master agreement.81 Integrated transactions become part of a single contract, a characteristic that becomes important when resolving the transactions in the case of insolvency.82 Restructuring under the Bankruptcy Code permits parties to “accept” or “reject”

80. Tondel, supra note 24, § 1.01[C][4] (“One of the ways of ensuring a counterparty’s performance is for the counterparty to provide collateral (usually in the form of marketable securities).”). 81. INT’L SWAP DEALERS ASS’N, INC., 1992 ISDA MASTER AGREEMENT (MULTICURRENCY—CROSS BORDER) § 1(c) (1992) [hereinafter 1992 ISDA MASTER AGREEMENT] (“All [t]ransactions are entered into in reliance on the fact that this Master Agreement and all Confirmations[, i.e., records of individual transactions] form a single agreement between the parties (collectively referred to as this ‘Agreement’), and the parties would not otherwise enter into any [t]ransactions.”); INT’L SWAPS & DERIVATIVES ASS’N, INC., 2002 ISDA MASTER AGREEMENT § 1(c) (2002), [hereinafter 2002 ISDA MASTER AGREEMENT] (same). 82. 1992 ISDA MASTER AGREEMENT, supra note 81, § 1(c); 2002 ISDA MASTER AGREEMENT, supra note 81, § 1(c); see DAVID MENGLE, INT’L SWAP & DERIVATIVES ASS’N, ISDA RESEARCH NOTES: THE IMPORTANCE OF CLOSE-OUT NETTING 2 (2010), http://www2.isda.org/attachment/MTY4MQ==/Netting-ISDAResearchNotes-1-2010.pdf (“Netting takes two forms in the ISDA Master Agreement. Payment netting takes place during the normal business of a solvent firm, and involves combining offsetting cash flow obligations between two parties on a given day in a given currency into a single net payable or receivable . . . . The other form of netting is close-out netting, which applies to transactions between a defaulting firm and a non-defaulting firm. Close-out netting refers to a process involving termination of obligations under a contract with a defaulting party and subsequent combining of positive and negative replacement values into a single net payable or receivable.”).



executory agreements.83 Generally speaking, executory agreements are those where material performance is required on both sides.84 Unmatured swap transactions frequently meet the definition of an executory contract because they provide for reciprocal payment obligations based on one or more underlier, which may require either party to make a payment to the other.85 As such, both parties frequently have performance obligations potentially outstanding under swap transactions. Being able to accept or reject an executory contract means that the debtor may choose to maintain the contract in force (i.e., accept the contract) or terminate the contract, as of immediately before the bankruptcy date, and receive or pay the amount due in connection with such termination.86

If each derivatives transaction between two parties was treated as an independent contract, a debtor could cherry-pick transactions to terminate.87 For instance, a debtor could reject all transactions under which it was in-the-money while accepting all transactions under which it was out-of-the-money.88 This would result in the counterparty having to pay an immediate amount to the debtor that equaled the counterparty’s gross losses under the transactions, while the debtor could delay payment of amounts due under the remaining transactions (and expose the counterparty to the risk that the debtor would have insufficient funds to satisfy those payments as they came due). In addition to serving as a transfer from the counterparty to the debtor’s other creditors and potentially the debtor, this treatment could result in the unwinding of key transactions such as hedges and speculative positions that the counterparty’s business strategy relied on. Having to

83. See Jesse M. Fried, Executory Contracts and Performance Decisions in Bankruptcy, 46 DUKE L.J. 517, 519 (1996). 84. BARRY E. ADLER, DOUGLAS G. BAIRD & THOMAS H. JACKSON, CASES, PROBLEMS, AND MATERIALS ON BANKRUPTCY 225 (4th ed. 2007). 85. Transcript of Record at 109, In re Lehman Bros. Holdings Inc., 416 B.R. 392 (Bankr. S.D.N.Y. 2009) (No. 08-13555) (describing an ISDA Master Agreement as “a garden variety executory contract, one for which there remains something still to be done on both sides”). 86. 11 U.S.C. § 365 (2012). 87. See Douglas G. Baird & Edward R. Morrison, Dodd-Frank for Bankruptcy Lawyers, 19 AM. BANKR. INST. L. REV. 287, 289 (2011) (explaining that the safe harbor from the automatic stay granted to swaps and other financial contracts was motivated, in part, by foreclosing to debtors “a long window in which to make the assume-or-reject decision [which] creates an opportunity for cherry-picking”). 88. A party is in-the-money if the liquidation value of a transaction is positive, i.e., if the party would be paid upon a hypothetical acceleration of the transaction. A party is out-of-the-money if the liquidation value of the transaction is negative, i.e., if the party would have to pay its counterparty upon a hypothetical acceleration of the transaction.



put these transactions back into place with third parties would require additional time and expense, straining the counterparty at a time when it prematurely had to settle the contracts under which the debtor was in-the-money.

To avoid this outcome, parties may integrate multiple transactions so they form one and the same contract, evocatively referred to as a “master agreement.”89 As a result, should one party become insolvent, there is no opportunity to cherry-pick individual transactions. Rather, the bankrupt party would have to decide whether to accept or reject the master agreement and all of the transactions that had been integrated into it. Acceptance of the master agreement would result in acceptance of all of the transactions entered into under that agreement.90 Conversely, rejection of the master agreement would result in rejection of all of the transactions entered into under that agreement, the calculation of the net payment owed based on the termination of all of those transactions and the payment of that amount to the party that was net in-the-money.

B. Setoff

Setoff is conceptually related to netting, but distinct in that it applies to legally separate agreements between two counterparties.91 An obligation under one agreement that is owed to a party is effectively an asset of that party. Setoff permits an obligation owed by a party to be offset against such assets, so that a net payment is due instead of two reciprocal payments being due between the counterparties. This avoids the possibility that the debtor is paid one hundred cents on the dollar to satisfy payments owed to the debtor while the creditor is paid at a discount reflecting the debtor’s insolvency.92

C. Margin

Collateral securing obligations under derivatives transactions is referred to as “margin.”93 Margin comes in two forms: variation margin

89. See 1992 ISDA MASTER AGREEMENT, supra note 81; 2002 ISDA MASTER AGREEMENT, supra note 81. 90. See sources cited supra note 81. 91. ADLER, BAIRD & JACKSON, supra note 84, at 391. 92. See 1992 ISDA MASTER AGREEMENT, supra note 81, § 6(e) (providing that amounts payable upon an early termination are subject to setoff); 2002 ISDA MASTER AGREEMENT, supra note 81, § 6(e). 93. INT’L SWAPS & DERIVATIVES ASS’N, INC., 1994 CREDIT SUPPORT ANNEX ¶ 4 (1994),



and initial margin. Derivatives trades are generally valued on a daily basis. Based on that valuation, or “mark,” variation margin is collected to secure the estimated exposure of the in-the-money counterparty to the out-of-the-money counterparty, i.e., variation margin is posted by the out-of-the-money counterparty based on the estimated value of its obligations.94 Unlike variation margin, which is collected on a retrospective basis over the course of the trade, initial margin is collected at the outset of the trade and is intended to cover the risk that a party defaults and does not post variation margin during some period after default while the trade is being closed out.95 In other words, initial margin is intended to cover exposure that is not secured by variation margin that may build up following default.96 In the over-the-counter (“OTC”) swaps market, dealers frequently require counterparties to post initial margin but do not post initial margin themselves. This practice is expected to partly change based on rules that have been proposed under the Dodd-Frank Act.97 Under those rules, dealers must post initial margin to other dealers and to counterparties with significant financial exposure.98

As collateral securing swaps trade, margin functions to separate the likelihood that the posting counterparty will satisfy its obligations from the more complex analysis of the posting counterparty’s overall financial health.99 This is because so long as the value of collateral is sufficient to satisfy the counterparty’s obligations under the trade, a first priority security interest in the collateral guarantees payment of the obligations in full.100 Collateral has a fundamental role in managing

http://assets.isda.org/media/e0f39375/c35598aa-pdf/ [hereinafter 1994 CREDIT SUPPORT ANNEX]. 94. Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,898, 59,901 (proposed Oct. 3, 2014) (to be codified at 17 C.F.R. pts. 23, 140) (explaining the role of initial margin in serving as a performance bond). 95. Id. (explaining the role of variation margin in serving as a mechanism for periodically recognizing changes in the value of open positions and reducing unrealized losses to zero). 96. See Commodity Exchange Act, 7 U.S.C. § 7a-1(c)(2)(D)(iv) (2012). 97. See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,920. 98. Id. 99. In addition to being a source of collateral for obligations ex post, the obligation to post margin provides an ex ante constraint on a party’s ability to take risky positions. See id. at 59,901 (“Well-designed margin systems protect both parties to a trade as well as the overall financial system. They serve both as a check on risk-taking that might exceed a party’s financial capacity and as a resource that can limit losses when there is a failure by a party to meet its obligations.”). 100. See generally LINDA J. RUSCH & STEPHEN L. SEPINUCK, PROBLEMS AND MATERIALS



credit risk in swap transactions.101

D. Netting, Set-off and Margin in Bilateral and Cleared Contexts

Netting, set-off and margin are used to manage credit risk in both the bilateral and cleared contexts. In the bilateral context, netting reduces the aggregate amount owing between two counterparties under a master agreement to the sum of amounts owing under the individual transactions entered into under that master agreement. In calculating the sum, negative amounts are subtracted (i.e., amounts owed to a counterparty reduce amounts owed by that counterparty). In the cleared context, netting reduces the aggregate amount owed by a customer to its clearing member to the sum of amounts owed by the customer to the clearing member (again, reducing the gross amount owed by the customer to the clearing member by the gross amount owed by the clearing member to the customer). In the cleared context, netting also reduces the aggregate amount owed by a clearing member on behalf of its customers (and separately, in its proprietary capacity) to the clearinghouse.

Set-off also works in both the bilateral context and the cleared context. Like netting, set-off reduces the amount payable between two parties in the bilateral context from two reciprocal gross amounts to a single net amount. Similarly, to the extent that there are multiple sources of obligations between a customer and its clearing member or a clearing member and the clearinghouse, set-off reduces gross amounts payable by these counterparties to one another to a single net amount payable in the event that either party becomes insolvent.

Finally, margin is used in both the bilateral context and the cleared context to reduce credit risk.102 In the bilateral context, margin is posted under a credit support annex or another ancillary agreement to the master agreement.103 In the cleared context, margin is posted pursuant to rules governing the clearing member and the clearinghouse, although additional margin requirements may be imposed by both. In adopting clearing requirements, regulators identified the under-collection of margin in the bilateral context as a

ON SECURED TRANSACTIONS 59–64 (3d ed. 2014). 101. Norman Menachem Feder, Deconstructing Over-the-Counter Derivatives, 2002 COLUM. BUS. L. REV. 677, 723–24. 102. See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. at 59,901. 103. See 1994 CREDIT SUPPORT ANNEX, supra note 93, ¶ 4.



justification;104 based on studies of the financial crisis, although the bilateral context allows for margin requirements, margin was under-employed prior to the financial crisis leading to a sharp increase in collateral use in 2008.105 AIG became a case study in the dangers of under-collecting variation margin when a downgrade in its credit rating led to a liquidity crunch due to springing obligations to post fourteen billion dollars in high quality collateral to support its swap obligations.106

As explored next, netting, setoff and margin within the bilateral context create significant incentives for end users to transact with a single dealer. This is a form of lockin that central clearing overcomes, increasing liquidity.

E. How Netting, Setoff and Margin Contribute to Lockin in the Bilateral Context

In the bilateral context, netting, setoff and margin create a propensity to trade with the same dealer as opposed to new counterparties. The reasons to favor an incumbent based on these contractual technologies are developed below, but in general they may be summarized as due to the complementarity of preexisting transactions to new transactions. When a new transaction is added to a portfolio of transactions, so long as the new transaction is not perfectly correlated with the portfolio, being able to net, offset and use previously posted margin will produce credit risk mitigating efficiencies. Accordingly, netting, setoff and margin can produce a lock-in effect that increases the costs of trading with a new dealer. This in turn helps dealers maintain separate stables of clients and can contribute to cartel behavior.107

104. See Levitin, supra note 5, at 454–55 (explaining that relative to clearinghouses, bilateral markets provide for discontinuous margin collection). 105. See Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74,284, 74,285 (Dec. 13, 2012) (codified at 17 C.F.R. pts. 39, 50) (“The [President’s Working Group] identified the need for an improved integrated operational structure supporting OTC derivatives, specifically highlighting the need for an enhanced ability to manage counterparty risk through ‘netting and collateral agreements by promoting portfolio reconciliation and accurate valuation of trades.’ These issues were exposed in part by the surge in collateral required between counterparties during 2008 . . . indicating not only the increase in risk, but also circumstances in which positions may not have been collateralized.” (footnote omitted)). 106. Shah Gilani, The Inside Story of the Collapse of AIG, MONEY MORNING (Sept. 23, 2008), http://moneymorning.com/2008/09/23/credit-default-swaps-3/. 107. For a list of examples of derivatives dealers acting collusively to dominate markets, see Griffith, supra note 4, at 1198–200.



Besides the benefits of complementarity with preexisting transactions through netting, setoff and margin, which are discussed below, repeat transactions with a counterparty carry the cost of foregone diversification as well as the benefit of reduced information asymmetries. Transacting with additional counterparties poses the benefit of diversification, reducing exposure to a single counterparty’s default risk. However, transacting with the same counterparty allows the use of information gathered over the course of previous transactions and justifies greater investment in information regarding the counterparty’s credit standing. Because of these offsetting considerations, the net effect of choosing to transact with the same counterparty is not clear. Even when adding the benefits of transacting with the same counterparty arising from netting, setoff and margin discussed below, it is ambiguous whether a party will be better off by returning to a preexisting counterparty or seeking diversification by finding a new counterparty in the market. However, it is clear that ceteris paribus, netting, setoff and margin weigh in favor of transacting with the same counterparty in the bilateral context.

1. Netting, setoff and margin in the bilateral context

To understand the incentives created by the risk mitigation techniques of netting, setoff and margin, an example is studied in the bilateral context. Recall the natural gas producer that issued floating rate bonds in Part I. For ease of exposition, let us refer to the natural gas producer as Party A. Party A enters into a fixed-for-floating interest rate swap with a swap dealer, which we will call Party B. Now Party A would like to enter into a floating-for-fixed natural gas swap, and it may do so either with its preexisting counterparty, Party B, or with a new swap dealer, Party C. Which will it do assuming that Party B and Party C are able to offer Party A the same terms, competing only on price? As this example will show, the benefits of netting will enable Party B to charge a lower net price to Party A than Party C can, thus leading Party A to continue transacting with Party B following the initial transaction.

This dynamic results because netting permits the reduction of any amount due from Party A under the interest rate swap with any amount due to Party A under the natural gas swap. In other words, netting allows less credit to be extended to Party A if both swaps are entered into with Party B. Because less credit is extended, exposure from Party A’s default (and the amount of compensation that has to be charged for that risk) is reduced. To illustrate with concrete numbers,



consider Table 1 below.

Table 1: Illustrating the Effects of Netting

Amount due to (from)

Party A under

Interest Rate Swap


Party A under

Natural Gas

Swap

Party A has entered into both swaps with

Party B

Party A has entered into natural gas swap

with Party C

Amount due to

Party B

Amount due to

Party C

Amount due to

Party B

Amount due to

Party C

$100 $50 N/A N/A N/A N/A

-$100 -$50 $150 N/A $100 $50

$100 -$50 N/A N/A N/A $50 -$100 $50 $50 N/A $100 N/A

Total amount payable by Party A

$200 $300

Table 1 compares the amounts that would be payable by Party A to

Parties B and C in the scenario that Party A entered into both swap transactions with Party B (middle two columns) and the scenario that Party A entered into the natural gas swap with Party C (rightmost two columns). The table shows the effects of these two transactions on Party A’s payment obligations that cover the four potential permutations of relative obligations under the interest rate swap and the natural gas swap: (1) there are amounts owing to Party A under both swaps; (2) Party A owes amounts under both swaps; (3) Party A is owed an amount under the interest rate swap but owes an amount under the natural gas swap; and (4) Party A owes an amount under the interest rate swap, but is owed an amount under the natural gas swap. The results shown in the table illustrate that netting (i.e., where both swaps are entered into with Party B) reduces the aggregate amounts owed by Party A. The key to observe is that the total amount that may be due from Party A in the first scenario is always less than or equal to the amount that may be due from Party A in the second scenario. The supporting intuition is simple. In the scenario where the new swap is entered into with the same counterparty as prior swaps have been entered into, any amount that is owed to Party A under one of the two transactions reduces dollar for dollar any amount that Party A owes under the other transaction. This means that the net amount owed by



Party A to its counterparty will always be less than or equal to the gross amounts owed by Party A under the separate swaps.108

If instead of two derivatives transactions that are subject to netting we consider the case of two transactions under separate agreements that are eligible for offset, we see that the same logic (and illustration) explains why setoff predisposes a counterparty to trade with the same dealer. Again, the aggregate gross amounts owed under each of the agreements will be greater than or equal to the net amount owed by Party A under the agreements. Accordingly, where setoff is available against outstanding transactions, the payee under those transactions will receive greater credit protection and thus be able to charge a lower price than a new counterparty.

Like netting and setoff, in the bilateral context, margin encourages a party to trade with the same dealer. To understand why, again consider two transactions—the interest rate swap and the natural gas swap from the above example. If both swaps are subject to variation margin, Party A will have to post high quality collateral based on how far out-of-the-money it is under the swap. Using the four cases from Table 1 above, Table 2 identifies how much margin Party A would have to post under its two swap transactions in the two scenarios that (a) Party A entered into both trades with the same dealer, Party B; and (b) Party A entered into the interest rate swap with Party B and the natural gas swap with Party C.

108. It should also be noted that labeling the first transaction an interest rate swap is of course arbitrary, and instead, the interest rate swap could represent a portfolio of transactions to which the natural gas swap was being added. In this manner, the example above captures the addition of a marginal trade where there is a preexisting portfolio with one counterparty.



Table 2: Illustrating the Effects of Variation Margin


Party A under

Interest Rate Swap


Party A under

Natural Gas

Swap

Party A has entered into both swaps with

Party B

Party A has entered into natural gas swap

with Party C

Variation margin due to

Party B


Party C


Party B


Party C

$100 $50 N/A N/A N/A N/A

-$100 -$50 $150 N/A $100 $50

$100 -$50 N/A N/A N/A $50 -$100 $50 $50 N/A $100 N/A Total amount of variation margin

that Party A must post

$200 $300

As Table 2 shows, irrespective of the relative performance of the two

swaps, Party A has to post less margin if it chooses to transact with Party B both times than if it chooses to transact with a new dealer for the second swap.109 The intuition here is the same as for netting and offset above. When Party A transacts with the same counterparty, it reduces the amount of its obligations under any one swap by the amount it is owed under the other swap thereby reducing the obligation that has to be collateralized with margin. Because securities and other collateral that may be posted as margin are costly to obtain,110 being able to post less margin will lead Party A to transact with the same

109. This conclusion does not hold if variation margin received from one counterparty may then be posted to the other counterparty. In practice, instances where variation margin is both received by the end-user and can then be posted as margin to another dealer will be somewhat rare. In many cases, the trading relationship with the dealer will provide for unilateral margin so that the dealer does not have to post margin to the end-user, subject the dealer’s posting of margin to significant thresholds or other conditions, permit the dealer to post low quality margin or prohibit rehypothecation by the end-user. It does not appear based on the Proposed Uncleared Margin Regulation that a serious inhibition will be placed on this practice through regulatory reform. 110. Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants, 79 Fed. Reg. 59,898, 59,901 (proposed Oct. 3, 2014) (to be codified at 17 C.F.R. pts. 23, 140) (expressing concern “that the imposition of margin requirements on uncleared swaps will be very costly for [swap dealers]”).



counterparty.

2. Netting, setoff and margin in the cleared context

As illustrated above, netting, setoff and clearing technologies in the bilateral context encourage parties to return to the same dealer for subsequent transactions. The same is not true in the cleared context. In the cleared context, netting, setoff and margin efficiencies are realized through clearing the trade through the same clearing member and clearinghouse. Because clearing breaks the trade into two—one between the first counterparty and the clearinghouse, and one between the clearinghouse and the second counterparty—the identity of the counterparty becomes irrelevant after the trade is cleared. Assuming that the natural gas swap and the interest rate swap are cleared through the same clearing member and clearinghouse, Table 3 illustrates that the obligations of the natural gas producer to its clearing member (and the clearing member’s obligations to the clearinghouse) are not affected based on whether the second swap is entered into with the same counterparty as the first swap.

Table 3: Obligations in Cleared Context


Party A under

Interest Rate Swap


Party A under

Natural Gas

Swap

Amount due to clear-ing member and

clearinghouse (Party A has entered into both swaps with

Party B and cleared them through the

same clearing mem-ber and clearing-

house).

Amount due to clearing member and clearinghouse (Party A has entered into the first swap with

Party B and into the second swap with Party C, clearing

them both through the same clearing

member and clearinghouse).

$100 $50 N/A N/A

-$100 -$50 $150 $150 $100 -$50 N/A N/A -$100 $50 $50 $50 Total amount due

from Party A across all cases

$200 $200



Because in the cleared context, the portfolio of swap trades builds up as between the counterparty and its clearing member / clearinghouse rather than as between two counterparties, there is no incentive to execute trades with the same dealer.

Recent surveys by the Bank for International Settlements find that for interest rate swaps, concentration of derivatives activity at dealers is falling substantially.111 Interest rate swaps account for the majority of over-the-counter derivatives activity and are subject to clearing mandates in a number of jurisdictions. The drop in concentration may be due to the transition of this important segment of derivatives activity to the cleared context, where for the reasons discussed above, there may be fewer incentives to engage in swap transactions with the same counterparty. It should be noted, however, that there are other considerations that inform the decision whether to enter into a swap with the same counterparty. These include diversification and reduction of informational asymmetries.112 Mandatory clearing moots considerations of diversification that may drive a swap user to transact with multiple counterparties.113 As a result, the clearing mandate may override an important consideration that had previously driven parties to transact with diverse counterparties. On the other hand, clearing also moots practices of selecting through diligence a swap counterparty to transact with on a repeated basis, i.e., clearing makes investment in learning a counterparty’s credit standing unimportant.114

Moving beyond incentives that may drive counterparties, it is also worth considering the institutional context within which their employees undertake trading. This context is likely shaped by swap dealers’ role as key intermediaries within swap markets.115 Not only do those desiring to enter into a swap turn to swap dealers, but those

111. BIS, OTC DERIVATIVES STATISTICS (2014), supra note 3, at 4; BIS, OTC DERIVATIVES STATISTICS (2015), supra note 3, at 1. 112. See supra Part II. 113. Diversification may take place across counterparties as well as across legal regimes governing the contracts. See Kelli A. Alces, Legal Diversification, 113 COLUM. L. REV. 1977, 1984–85 (2013). 114. See Yadav, supra note 5, at 410 (“When contracting with the CCP, a party assumes much lower costs of due diligence because a party need only assure the creditworthiness of the CCP, rather than individual counterparties in the market.”). Yesha Yadav argues that clearinghouses provide information on aggregate exposures to certain industries, sectors, or parties in the market as well as information on the vulnerabilities of counterparties. Id. at 411. Arguments favoring clearinghouses for the information they provide on market participants and market practices are weakened by the existence of alternative sources for this information, and in particular, the reporting of all swaps (both cleared and uncleared) to swap data repositories. 115. See Kathryn Judge, Intermediary Influence, 82 U. CHI. L. REV. 573, 610–11 (2015).



embarking on a career in trading often begin by working at a dealer bank (i.e., on the “sell-side”) before moving to hedge funds or other “buy-side” firms where they put skills learned on the sell-side to work. Generally, few institutions other than dealers enter into the volume of swaps needed to sustain a team of traders so there are few other environments where aspiring traders can learn. It is thus at dealer firms that norms and expectations by which traders operate become defined and personal relationships are forged with other traders. It would not be surprising given the career trajectories of many traders that those on the buy-side will turn to one or a few institutions when looking to enter into a trade (i.e., concentration in swaps markets may be explained by buy-side traders simply going back to the sell-side dealers where they learned to trade). Shared culture and personal relationships can and do bias individuals to limit their gamut of counterparties. This institutional feature is likely to be somewhat disrupted by the mandate, described above, to move trading in standardized products to SEFs and DCMs.

A priori, the net effect of the clearing mandate and the related trade execution mandate for the diversity of counterparties is not clear. Diversification may have been a strong force pushing parties to trade with a broad range of counterparties. That force has no purchase on cleared trades, and it may outweigh the many countervailing reasons why in the bilateral environment trading may be more concentrated. On net, mandatory clearing may increase or decrease market concentration (although, again, recent trends are consistent with mandatory clearing reducing market concentration).

F. Netting, Setoff and Margin in Academic Assessments of Clearinghouses

The preceding exploration of how netting, setoff and margin can contribute to lockin serves as one example of how the same demand for swap transactions may play out differently in the bilateral and the cleared context. It is not an example that has been explored in the literature, and may explain decreasing concentration levels seen among major swap dealers. However, along other dimensions, differences between netting, setoff and margin in the bilateral and cleared contexts have been studied in prior scholarly literature. These analyses are turned to next.

Three major scholarly works undertake to assess how netting, setoff or margin perform in the bilateral setting vis-à-vis the cleared setting. An important initial treatment was produced by Darrell Duffie and



Haoxiang Zhu.116 Duffie and Zhu address the essential question of whether the efficiencies in reducing unsecured credit through netting are greater in the bilateral or the cleared context. A key conclusion of their work is that clearing does not unambiguously lead to greater netting than transacting bilaterally.117 This conclusion is based on the insight that there may be a tension between netting across counterparties and netting across asset-classes.118 As demonstrated above, transacting through a clearinghouse allows netting across counterparties as each cleared swap is split into two parts, the first of which is entered into through the clearing member with the clearinghouse. This first half nets against the first half of any other swap cleared through the same clearing member and clearinghouse irrespective of who the counterparties to the swaps are. Duffie and Zhu observe that the clearinghouse model may lead to decreased netting if different clearinghouses are used for clearing different asset classes.119 In contrast, swaps of various asset classes may be entered into with the same counterparty. Accordingly, netting across product types may be relatively greater in the bilateral context while netting across counterparties may be relatively greater in the cleared context. This conclusion is based on a model, and the results acknowledge that if a clearinghouse offers clearing services to a sufficiently diverse menu of products that clearing results in greater margin efficiencies. In particular, the paper shows that “a single [clearinghouse] that clears both credit derivatives and interest-rate swaps is likely to offer significant reductions in expected counterparty exposures, even for a relatively small number of clearing participants.”120 Several clearinghouses currently offer clearing in credit derivatives, interest rate swaps and other swap products; for example, the CME offers clearing services for index credit default swaps, interest rate swaps and various currency swap products.121 We can tentatively conclude that

116. See Duffie & Zhu, supra note 5. 117. Id. at 90 (“We show that the separate central clearing of one class of derivatives, such as credit default swaps, could reduce netting efficiency, leading to higher expected counterparty exposures and collateral demands.”). 118. Id. at 76. 119. Cf. M. Todd Henderson, Credit Derivatives Are Not “Insurance,” 16 CONN. INS. L.J. 1, 57 (2009) (although the paper conflates clearinghouses, where transactions are cleared, with exchanges, where transactions are executed, it provides a useful example of how clearinghouse netting may decrease outstanding liabilities in derivatives markets—Duffie and Zhu provide models and examples that show clearinghouses may reduce overall netting). 120. Duffie & Zhu, supra note 5, at 76. 121. See CME GROUP, http://www.cmegroup.com/trading/otc/ (last visited May 31, 2016) (identifying swaps cleared by the CME).



clearinghouses are in a position to reduce counterparty exposures under swaps through netting. On first pass, this commends clearinghouses as a means to reducing interconnectedness and credit risk—two variables that may contribute to systemic risk and the production of financial crises.122

Duffie and Zhu began the debate, but their analysis has since been qualified. In particular, Mark Roe wrote an important paper drawing attention to a tradeoff between greater netting among derivatives counterparties and a decreased amount of assets remaining available to satisfy non-derivatives claims.123 In his paper, Roe extends a fundamental insight from bankruptcy literature that observes that “recognizing the right [of netting, setoff or security in collateral] in bankruptcy often means that the creditor holding the right will . . . recover a greater percentage of his or her claim as compared to other creditors who have no similar entitlement.”124 In other words, protecting the rights of cleared swap counterparties through netting and other efficiencies as theorized by Duffie and Zhu has adverse consequences for other creditors of the swap market participant. Roe’s analysis shows how netting, setoff and margin may erode credit protection backing non-swap transactions, thereby shifting the flow of systemic risk from the swaps network to another set of credit relationships. Roe demonstrates that this possibility is very real by identifying how repo markets, money markets and other markets with systemic significance rely on major swap market participants’ capacity to repay their obligations.125 Credit enhancements achieved through clearing or other reforms should be approached with skepticism as they may be parts of a zero-sum game in which some systemic creditors win and others lose.126 The corollary of this insight is that to the extent

122. See Duffie & Zhu, supra note 5, at 78 (“Risk of loss from counterparty default is a first-order consideration for systemic risk analysis.”). 123. See Roe, supra note 5, at 1663–69. 124. COLLIER ON BANKRUPTCY ¶ 553.02 (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2016); accord CHARLES JORDAN TABB, THE LAW OF BANKRUPTCY 166 (3d ed. 2014); DAVID L. BUCHBINDER, A PRACTICAL GUIDE TO BANKRUPTCY 190 (1990). 125. Roe, supra note 5, at 1682. It should be noted, however, that to the extent these transactions such as overnight repos are themselves separately collateralized, the loss to obligors due to swap netting, setoff and collateral is minimized. Furthermore, there have been proposals to institute the clearing of repo transactions, which could be a first step to common netting and collateralization of swap and repo transactions. See Liz McCormick, Financial Firms Move Closer to Central Clearing in Repo Market, BLOOMBERG BUS. (Apr. 13, 2015), http://www.bloomberg.com/news/articles/2015-04-13/financial-firms-move-closer-to-central-clearing-in-repo-market. 126. This zero-sum game has also been noted by Craig Pirrong. See Pirrong, The Economics of Clearing in Derivatives Markets, supra note 5, at 27 (“It should be noted that



clearing fails to achieve heightened protections for swap counterparties, that deficiency may benefit other important creditors. Although raised as a criticism of the clearing mandate, this logic implies that clearing may not matter one way or the other.

A further take on this debate came from Richard Squire. Squire shows that although the gains to swap counterparties from greater netting, setoff and collateral may represent costs to non-swap counterparties, the results are not zero sum.127 There is a key insight presented in these arguments: netting and other credit enhancements may increase the speed with which claims from swap counterparties are resolved, leaving swap markets with less uncertainty and—most importantly—less shortage of liquidity due to protracted bankruptcy processes that must precede the satisfaction of ordinary claims. In this manner, credit enhancements accomplished through clearing result in faster payouts or “liquidity partitioning.”128 If this argumentation is correct, clearinghouses help reduce systemic risk through changing the interplay of netting, setoff and margin. The argument that clearing alleviates liquidity shortages assumes that mandatory clearing increases netting, which is called into some question by the discussion of Duffie and Zhu above.129 This argument also rests on the assumption that netting in the cleared context results in faster resolution of swap claims in the bilateral context. This assumption is likely correct, but merits some exploration. In particular, both in the bilateral and cleared contexts, swaps are exempt from the automatic stay that generally slows down the resolution of claims against a bankrupt company.130

this ‘benefit’ from netting is in fact a transfer, rather than a true cost savings. . . . [T]he total loss suffered by creditors [as a result of netting] does not change, although the allocation of the loss between derivatives counterparties and other creditors changes.”). 127. See Squire, supra note 5, at 891–906. 128. A related observation is made by Craig Pirrong, who has identified the potential for greater netting efficiency through clearing as allowing for more efficient replacement of transactions following a default. See Pirrong, The Economics of Clearing in Derivatives Markets, supra note 5, at 25–30. If swap contracts are used for ongoing financial activity such as hedging or speculation, a party will want to maintain the swap contract notwithstanding its counterparty’s default. In order to maintain transactions following a default, a counterparty will want to enter into replacement transactions (potentially using damages collected on account of the default to enter into those replacement transactions). To the extent that netting reduces the number of replacement transactions that a party needs to enter into following default, netting reduces the transaction costs associated with counterparty default and resumption of swap positions. Id. 129. See supra notes 116−22 and accompanying text. 130. Franklin R. Edwards & Edward R. Morrison, Derivatives and the Bankruptcy Code: Why the Special Treatment?, 22 YALE J. ON REG. 91, 94 (2005) (“Thanks to an exemption from the [Bankruptcy] Code’s automatic stay—which bars all other creditors from terminating contracts with or seizing assets from a firm in bankruptcy—



Accordingly, in the bilateral context, the wait to recover amounts due under a swap will generally be quite short. However, there has been a move afoot to extend the waiting period before bilateral swaps may be closed out as a number of major financial institutions have entered into agreements that waive the rights to prompt close-out.131 Accordingly, through private ordering, the waiting period for resolving bilateral swap trades in bankruptcy may become significant.132 To the extent a gap in timing develops between settlement of amounts due under bilateral swaps and amounts due under cleared swaps, clearing may have the benefits that Squire identifies.

Netting, collateral and setoff differences are not, however, the only distinctions between the uncleared and cleared scenarios. As the next two Parts will develop, there are additional considerations informing the debate over clearinghouses.

PART III. HOW CLEARING REALLOCATES LOSSES: MONITORING AND

MUTUALIZATION

Netting, setoff and margin serve to reduce losses resulting from swap defaults. The preceding Part compares how these loss mitigation technologies function in the bilateral and the cleared context. This Part compares how losses that are incurred when default occurs would be allocated in the two contexts. Ex ante, the allocation of loss impacts whether and how market participants monitor and discipline one another. Ex post, the allocation of losses impacts parties’ balance sheets, potentially destabilizing swap market participants financially or sending teetering participants into default.

In the bilateral context, a party’s inability to satisfy amounts owed under a swap contract directly translates into losses by its counterparty. It is common for swap contracts to include an event of default for when a counterparty fails to pay an amount owing, repudiates the contract or declares bankruptcy.133 In these

counterparties to these derivatives contracts are free to terminate the contracts and then seize collateral to the extent that they are owed money.”). 131. See Stephanie Massman, ISDA Resolution Stay Protocol: A Brief Overview, HARV. L. SCH. BANKR. ROUNDTABLE (Feb. 10, 2015), http://blogs.law.harvard.edu/bankruptcy roundtable/2015/02/10/isda-protocol-a-brief-overview/. 132. For a view of the role of private regulation of swap markets, see Gabriel V. Rauterberg & Andrew Verstein, Assessing Transnational Private Regulation of the OTC Derivatives Market: ISDA, the BBA, and the Future of Financial Reform, 54 VA. J. INT’L L. 9 (2013). 133. See Mark I. Greenberg, The ISDA Master Agreement, in DERIVATIVES: LEGAL PRACTICE AND STRATEGIES, supra note 24, § 4.04[D][1] (discussing common events of



circumstances (as well as other events of default and termination events), the counterparty may require the payment of liquidated damages to resolve one or more transactions under the master agreement. The master agreement sets forth the method for calculating an amount due in these events of premature termination.134 Following the early termination of transactions under a master agreement, a payment will be owed by the out-of-the-money party to settle the terminated transactions. The method of calculating the payment varies across derivatives master agreements. Typical approaches involve estimating how much it would cost to replace the prematurely terminated transactions so as to put the non-defaulting party into the same position as it would have been in but for the early termination whether through estimates based on market quotations or other means.135

An important characteristic of loss allocation in the bilateral context is that every dollar due but not paid under a swap transaction is a dollar lost by the non-defaulting counterparty.136 In other words, for any given trade, losses are fully internalized by a single counterparty. The same is not necessarily true across multiple trades. Diversification or other reasons (such as differences in prices offered) may lead a party to trade with multiple counterparties in the bilateral context. Where a swap market participant fails in the bilateral context, it will default on a portfolio of trades that may have been entered into with a range of counterparties. For example, when a dealer defaults in the bilateral context, losses from its portfolio will be spread across its end-user counterparties. Thus although losses from each bilateral transaction are concentrated on the counterparty to that transaction, losses from the portfolio are spread out across counterparties.137

In the cleared context, losses are spread among the clearinghouse

default). 134. 1992 ISDA MASTER AGREEMENT, supra note 81, § 6(e) (setting forth method for calculating close-out amount upon events of default and termination events); 2002 ISDA MASTER AGREEMENT, supra note 81, § 6(e) (same). 135. See Greenberg, supra note 133, § 4.04 (discussing Market Quotation and Loss methods for calculating the termination payment under the 1992 ISDA Master Agreement and the Close-out Amount method for calculating the termination payment under the 2002 ISDA Master Agreement). 136. For these purposes, losses should be measured net of any guarantees or other contribution arrangements that supplement cash flows from the primary obligor under the transaction with cash flows from other third parties. 137. See Pirrong, The Economics of Clearing in Derivatives Markets, supra note 5, at 14 (“In bilateral markets, default costs are borne exclusively by the defaulter’s counterparties.”).



and its clearing members.138 Losses may stem from a customer’s failure to pay a clearing member or, with respect to proprietary trades by a clearing member, the clearing member’s failure to pay. All trades entered into by a customer are guaranteed by the member clearing the trade on behalf of the customer. Accordingly, to result in losses for the clearinghouse, a customer’s default must coincide with a default by its clearing member.139 In the event that a clearing member fails to meet obligations to the clearinghouse incurred in a proprietary capacity or on behalf of a customer, a default management process takes place at the clearinghouse. That process funds the shortfall from the defaulting clearing member first from clearing fund contributions made by other members.140 If prior contributions from clearing members are insufficient to cover the losses, a tranche of clearinghouse capital is used to cover losses.141 After that tranche is exhausted, finite assessments may be made by the clearinghouse on its members.142 Finally, the remainder of clearinghouse capital is available to absorb losses. Because a clearinghouse acts as an intermediary for payment obligations, transactions to replace the defaulted transactions are likely to be put into place to maintain the same net in- and out-flows from the clearinghouse.143 The “losses” discussed in this paragraph are expected to be the costs of entering into those replacement transactions, such as through moving a book of defaulted transactions from the defaulting clearing member to a healthy clearing member. Initial margin plays a key role in funding these replacement payments.

Because of the described loss sharing between the clearinghouse and its members, every dollar that is not paid by a party, in expectation,144 represents only a fraction of a dollar lost from the

138. JOHN W. LABUSZEWSKI, JOHN E. NYHOFF, RICHARD CO & PAUL E. PETERSON, THE CME GROUP RISK MANAGEMENT HANDBOOK: PRODUCTS AND APPLICATIONS 91−95 (2010). 139. See Clearing Membership, CME GROUP, http://www.cmegroup.com/clearing/ cme-clearing-overview/clearing-membership.html (last visited May 31, 2016) (explaining criteria for becoming and role of CME clearing members). 140. See, e.g., CME Rulebook: Chapter 802 CDX Index Untranched CDS Contracts: Part A 80202A.D., 80202.B.D. (2014), http://www.cmegroup.com/rulebook/CME/VII/802/802. pdf. 141. Id. 142. Cf. Griffith, supra note 4, at 1184 (arguing that rights to contribution from clearing members beyond the pre-funded contributions are likely to be of less value in times of financial stress). 143. See Commodity Exchange Act § 5b(c)(2)(G) (requiring CFTC regulated clearinghouses, i.e., derivatives clearing organizations, to take timely action to continue meeting each obligation of the derivatives clearing organization). 144. The assumption here is that losses are great enough to reach clearinghouse capital, and thus become shared between the clearinghouse and its members. Even if



perspective of the clearinghouse or its members.145 In other words, no single party bears all of the losses from any given trade. However, losses from a cleared portfolio are shared by the clearinghouse and its clearing members and these losses grow with the size of the cleared portfolio. This is the reverse of how loss sharing works in the bilateral context where all the losses from a trade are borne by the counterparty but counterparties are not adversely affected by additional transactions being added to the portfolio so long as they are not the counterparties to those transactions. Table 4 illustrates the divergent dynamics in the bilateral and cleared contexts.

Table 4: Loss Allocation in Bilateral and Cleared Contexts

Bilateral Cleared

Swap Transaction

Losses from a bilateral transaction are wholly

internalized by the counterparty to that

transaction

Losses from a cleared transaction are shared by the clearinghouse

and the clearing mem-bers

Swap Portfolio

Losses from a portfolio of bilateral transac-

tions are spread across the counterparties to

those transactions

Losses from a portfolio of cleared transactions

are shared by the clearinghouse and the clearing members irre-

spective of the coun-terparties to those

transactions The differences in loss allocation between the bilateral and cleared

contexts result in distinct ex ante incentives and ex post consequences from swap market participant default. These are explored next.

A. Ex Ante Monitoring and Discipline in the Bilateral and Cleared Contexts

The differences in loss allocation between the bilateral and the cleared context lead to differences in counterparty monitoring and

losses do not reach clearinghouse capital, however, they are still shared in the sense that they are spread over the clearing members’ contributions to the default fund. 145. Pirrong, The Economics of Clearing in Derivatives Markets, supra note 5, at 15 (explaining that “a CCP ‘mutualizes’ default risk”).



interaction across the two contexts. In the bilateral context, as the sole bearer of losses, the counterparty is incentivized to include terms in its trading relationship documentation that mitigate credit risk. Examples include requirements to exchange financial information and provide notice upon the occurrence of an event of default, additional collateral requirements in the event of credit downgrades, and rights to terminate transactions under a master agreement in the event of a cross-default.146 Over the course of a transaction, a party to a swap regularly receives information regarding the quality of its counterparty’s credit standing and may use that information to identify if any covenants within the swap documentation have been breached. As in other credit arrangements, covenants in master agreements grant counterparties control rights to protect their economic rights under the transactions, i.e., the triggering of covenants by a counterparty allows not only acceleration of the payment obligations but also renegotiation of the deal to fit new circumstances.147 Swap agreements are executory not only in potentially requiring payments from both counterparties over their term, but also in imposing governance terms supporting those payment obligations. For example, as we saw above and will explore below, deteriorating credit quality may lead counterparties to exercise their rights to novate or assign a swap.

In addition to control rights achieved through the terms of trading relationship documentation, the bilateral context offers diversification as a means for reducing the risk from counterparty default. Through transacting with multiple swap counterparties, a swap market participant reduces the loss from any one counterparty’s default. As such, diversification is a substitute for credit risk mitigation through the terms of ISDA Master Agreements and other trading relationship documentation.

Diversification, however, can lead to under-monitoring due to a form of the free riding problem.148 Market participants may engage in indirect monitoring through relying on a party’s other counterparties to detect credit deterioration. For example, counterparties may come to

146. See Pesch, supra note 33, § 8.03(D) (discussing provisions requiring additional posting of collateral upon credit downgrades); Greenberg, supra note 133, § 4.04[D][1][f] (discussing event of default that occurs upon a cross-default). 147. See generally Douglas G. Baird & Robert K. Rasmussen, Private Debt and the Missing Lever of Corporate Governance, 154 U. PA. L. REV. 1209, 1212–13 (2006); see also Ilya Beylin, Tax Authority as Regulator and Equity Holder: How Shareholders’ Control Rights Could Be Adapted to Serve the Tax Authority, 84 ST. JOHN’S L. REV. 851, 860–61 (2011). 148. See Jerry Green, Elon Kohlberg & Jean-Jacques Laffont, Partial Equilibrium Approach to the Free-Rider Problem, 6 J. PUB. ECON. 375 (1976).



rely on market chatter (at the extremes, calls for novations and assignments) as well as cross-defaults for identifying circumstances warranting an intervention. These indirect forms of monitoring may be particularly unreliable due to adverse selection.149 Counterparties that identify credit weakness may opt out of dealing with a party, leaving only less attentive market participants to serve as monitors. Parties choosing to transact with a counterparty may jointly suffer from a form of winner’s curse.150

Setting aside free riding and adverse selection problems, diversification may reduce investment in monitoring and disciplinary activity. To see this, it is instructive to compare the monitoring activities of a party all of whose transactions are with the same counterparty with the monitoring activities of a party that diversified its transactions across counterparties. The diversified swap market participant may rationally monitor and discipline its counterparties less as the costs of doing so increases with the number of counterparties. Accordingly, the extent of monitoring and resulting discipline in the bilateral context depends on the extent of diversification.151 Relying on private monitoring and discipline in the bilateral context may fail if parties choose to control risks through diversification and indirect monitoring rather than through zealous negotiation and enforcement of covenants.

In the cleared context, the credit risk of the original counterparty becomes irrelevant upon clearing of the swap. Accordingly, the monitoring that takes place in the bilateral context as between counterparties is no longer a source of information and discipline. Instead, that role is transferred to the clearing member that clears the swap, where the swap is entered into by a customer and the clearinghouse, for both proprietary and customer swaps. Because a clearing member must guarantee all of its customers’ swaps, clearing members are incentivized to reduce the risk of customer default. Some of the ways in which clearing members reduce the risk of customer default include position limits (that impose limits on customer exposure to asset classes or other sources of risk), margin requirements (in

149. For a discussion of adverse selection in contemporary trading markets, see Merritt B. Fox, Lawrence R. Glosten & Gabriel V. Rauterberg, The New Stock Market: Sense and Nonsense, 65 DUKE L.J. 191, 217−21 (2015). 150. John H. Kagel & Dan Levin, The Winner’s Curse and Public Information in Common Value Auctions, 76 AM. ECON. REV. 894, 894 (1986). 151. Viral V. Acharya, Iftekhar Hasan & Anthony Saunders, Should Banks Be Diversified? Evidence from Individual Bank Loan Portfolios, 79 J. BUS. 1355, 1356–57 (2006).



addition to margin requirements imposed by the clearinghouse) and other terms within clearing agreements. Additionally, in the cleared context, all clearing members have incentives to monitor the efficacy of the clearinghouse’s risk management practices as they would all be subject to losses in the event that one clearing member defaults.152

The sharing of losses among the same set of players in the cleared context has important ramifications. A clearing member’s incentives to monitor a customer’s trading behavior grow with that customer’s cleared portfolio. That is because the clearing member guarantees the customer’s inability to pay amounts due on that portfolio on a dollar for dollar basis. Similarly, the incentives of the clearinghouse and the other clearing members to monitor the clearing activity of a member grow with the size of that member’s customer and proprietary portfolios. That is because the clearinghouse and other clearing members share any losses from a member’s inability to pay.

The consequences of scaling a portfolio are thus dramatically different in the bilateral and cleared context. In the bilateral context, diversification may mean that losses from additional trades fall on new parties so that a portfolio can grow without any preexisting party being exposed to additional risk. The same is not true in the cleared context where the same parties bear losses for the marginal trade as for the initial trade, namely, the clearinghouse and its clearing members.153 In other words, in the bilateral context, the incentive a party has to monitor its counterparty does not necessarily increase as the counterparty’s portfolio grows whereas in the cleared context, the incentives clearing members and the clearinghouse have to monitor increase as a customer’s or clearing member’s portfolio grows. Accordingly, in the cleared context, the incentive to monitor grows with portfolio size. As a result, as a customer’s or clearing member’s portfolio grows and becomes more systemic, it is likelier to become subject to monitoring and credit risk mitigation techniques.154

Thus far, the discussion focused on how monitoring would take place in the two contexts. It is important to note that the current regulatory regime is heterogeneous, providing for the clearing of some transactions and the bilateral execution of others.155 Within this

152. See Yadav, supra note 5, at 411–12 (explaining why loss-mutualization may lead to policing of risky conduct among clearing members). 153. Use of multiple clearinghouses or multiple clearing members may counteract the effect pursuant to the analysis developed by Duffie and Zhu. Duffie & Zhu, supra note 5. 154. This justification has not previously been offered to explain the clearing mandate. 155. As discussed above, under section 2(h) of the Commodity Exchange Act, a non-financial entity using a swap to hedge or mitigate commercial risk may elect to enter into



heterogeneous context, useful comparison can take place between the pricing and risk management of cleared transactions and transactions executed bilaterally. For example, margin required to support a bilateral interest rate swap may be compared to the margin required to support a similar swap that has been cleared. This may be done not only by market actors such as swap dealers that participate in both markets, but also by regulators. The CFTC, for example, will have periodic valuation data on both cleared and bilateral swaps. Data on cleared swaps comes from clearinghouses and swap dealers, with both parties having to report valuations for cleared swaps;156 with respect to uncleared swaps, one of the counterparties to the swap must report valuation data on either a daily or quarterly basis, depending on whether it is a swap dealer.157 In this manner, deterioration in the valuation or margining of swaps may be detected. Moreover, to the extent that market participants provide favorable valuations or under-collect margin, these practices—whether the result of adverse selection or purposeful risk taking—may be identified through benchmarking against cleared and uncleared transactions of the same type. The CFTC and SEC should take advantage of the opportunities for benchmarking and identifying outliers by reviewing reported data and requesting additional data such as collateralization levels. In this manner, risk taking in the bilateral and cleared contexts may be identified before excessive levels of systemic risk accumulate.

B. Ex Post Loss Allocation in the Bilateral and Cleared Contexts

As discussed above, the means used in bilateral markets to address counterparty credit risk may differ, leaning towards the contractual

that swap on an uncleared basis notwithstanding that the swap is subject to the clearing mandate. Furthermore, only some products are subject to the clearing mandate. Accordingly, a bilateral market is expected to continue; and furthermore, certain products are expected to trade on both a bilateral and a cleared basis as only a subset of transactions will qualify for the end user exception. 156. 17 C.F.R. § 45.4(b)(2) (2015) (providing that for cleared swaps, valuation data must be reported daily by both the derivatives clearing organization and, if the reporting counterparty is a swap dealer (or major swap participant), by the reporting counterparty). There is a counterproductive proposal to eliminate valuation reporting by swap dealers where the transaction is cleared. See Amendments to Swap Data Recordkeeping and Reporting Requirements for Cleared Swaps, 80 Fed. Reg. 52,544, 52,546−51 (proposed Aug. 31, 2015) (to be codified at 17 C.F.R. pt. 45). If adopted, this proposal would remove the check on clearinghouse valuation errors that is supplied through independent valuation data generated by swap dealers (and major swap participants). 157. Daily reporting is also required of major swap participants. 17 C.F.R. § 45.4(c)(2). End-users generally have to report on a quarterly basis. Id.



terms and enforcement model for some asset classes or among some counterparties, and leaning towards diversification for other asset classes and counterparties. Whichever approach is taken, losses from a party’s inability to pay amounts owing under swap contracts fall on its counterparty. If few counterparties are represented in a party’s portfolio of swaps, the party’s default may have very concentrated effects on those few counterparties. Concentrated losses may result in domino-like effects where the failure of a swap market participant results in the failure of one or more of its counterparties.158 If a portfolio consists of trades with a diversified range of counterparties, losses to any one counterparty resulting from default will be reduced. As discussed above, however, diversification may result in great aggregate costs for the market while each counterparty bears only limited losses.

To the extent diversification is the chosen method for reducing counterparty credit risk in bilateral markets, it is susceptible to failure during crisis conditions. Systemic risk manifests itself as correlated losses across financial institutions.159 Spreading swap relationships across a range of counterparties does not effectively diversify systemic risk. That is because when multiple swap market participants fail, losses due to their default may accumulate with the same counterparties. In other words, diversification only works to reduce losses where the losses are not correlated; during a financial crisis, market participants incur correlated losses exposing their counterparties to risk of correlated default. This is a source of weakness in the bilateral system, where diversification may lead institutions to march unaware into a storm that engulfs them all.

Default of a clearing member during ordinary market functioning will result in losses being shared by the other clearing members and the clearinghouse. Clearinghouses, particularly systemically important clearinghouses which almost all operating clearinghouses in the United States are, are designed to withstand clearing member failure.160

158. See Roe, supra note 5, at 1652 (“A key institution fails and cannot pay its debts to other financial institutions, which in turn fail. The failures cascade through the interconnected financial sector.”). As Mark Roe observes, however, the fear of domino-like failures is inconsistent with experience. Rather than one counterparty’s failure setting off another counterparty’s failure, what we have seen is the correlated weakening of counterparties that are holding similar assets or engaged in similar activities. As those shared assets deteriorate or business activities seize up, market participants experience distress that stems from a common cause. 159. See id. at 1677 (“[I]n a systemic crisis, the causes of one firm’s failure can simultaneously bring down other firms, whose aggregate failure can in turn collapse the interconnected system.”). 160. See Griffith, supra note 4, at 1186 (“The CFTC requires sufficient capital to enable



Although clearinghouse members will suffer losses as their contributions to the clearinghouse are depleted and new contributions become due, systemic consequences are likely to be contained if at the time of default there is no ongoing market turmoil, i.e., the other clearing members are not experiencing losses at the same time as the defaulting clearing member defaults. This was the case when MF Global, a large clearing member of the CME, failed and declared bankruptcy.161 Although initially the clearing member’s failure was accompanied by a “misplacement” of customer funds, subsequent resolution procedures identified the missing funds.162 More importantly, MF Global’s failure did not prompt deep market volatility or other failures; rather, the MF Global’s failure was contained and resolved in an orderly fashion.

During a crisis, the mutualization of risk through the clearinghouse may spread financial distress. As explained above, during a crisis, financial institutions are likely to experience deteriorating balance sheets in a correlated manner. For example, assets commonly held within segments of the financial industry (e.g., mortgages) may lose value; or operations relied on for profit may be interrupted (e.g., securitization). Correlated losses would be aggravated through loss sharing during a time of crisis. If one clearing member fails, other clearing members would suffer through losses of their contributions as well as potential assessments.163 In other words, mutualization would require clearing members to bear losses at a time of general market distress making knock-on failures more likely.

Whether the bilateral or the cleared context creates a less systemically pernicious allocation of losses cannot be determined a

the clearinghouse to withstand the default of its single largest member unless the clearinghouse is deemed systemically important, in which case it must have sufficient capital to withstand the default of its two largest members. The SEC, by contrast, would require clearinghouses to ‘maintain sufficient financial resources to withstand, at a minimum, a default by the two participants to which it has the largest exposures in extreme but plausible market conditions,’ unless the clearinghouse does not clear credit default swaps, in which case it needs to be able to withstand the default only of its single largest member.” (footnote omitted)). 161. See Testimony of Terrence A. Duffy Executive Chairman CME Group Inc. Before the S. Comm. on Banking, 112th Cong. 1 (2012) (statement of Terrance A. Duffy, Executive Chairman, CME Group, Inc.). 162. Ben Protess, MF Global Customers to Be Paid Back in Full, N.Y. TIMES (Apr. 3, 2014), http://dealbook.nytimes.com/2014/04/03/mf-global-customers-to-be-paid-back-in-full/. 163. Moreover, the clearinghouse could lose its own capital in absorbing losses from a failed clearing member.



priori.164 Loss sharing from a diversified bilateral portfolio may impact a range of systemically important counterparties just as clearinghouse mutualization may transfer losses to a range of systemically important clearing members.165 Potentially, clearing members may be better or worse at absorbing losses than major swap market participants. Clearing members that clear on behalf of customers, i.e., futures commission merchants, are subject to capital requirements; however, following the Dodd-Frank Act, so are swap dealers. Whether regulated futures commission merchants or swap dealers will be better at absorbing losses during a crisis is an empirical question that is difficult to answer. Furthermore, as discussed above, not all portfolios should be expected to be diversified. Some bilateral traders may have highly concentrated portfolios, which may result in significant losses for their counterparties in the event of default. Again, it is difficult to predict given the potential permutations in market structure and networks of obligations, whether failure in the bilateral or the cleared context poses less systemic risk.

C. Netting, Setoff and Margin in Academic Assessments of Clearinghouses

The preceding exploration of loss allocation in the bilateral and cleared contexts exposes how incentives to monitor risk and the results of risk manifestation may differ across the two contexts. Some of these results have been explored in prior scholarship, which is turned to next. In discussing existing literature, this article supplements and critiques.

Craig Pirrong produces a complex, multidimensional comparison of the relative costs and benefits of clearing.166 His argument notes that in some circumstances, clearing will have net benefits, while in others, clearing will have net costs.167 He begins with a simplified model that has no information asymmetries. Within that model, he identifies that clearing can improve outcomes for hedgers as—relative to the bilateral scenario—they are more protected from defaults, particularly defaults correlated with the manifestation of the risk being hedged.168 Based on

164. See Pirrong, The Economics of Clearing in Derivatives Markets, supra note 5, at 58 (“[S]ince holding positions constant the only effect of the formation of a CCP is to redistribute default losses, it is not obvious a priori that clearing reduces systemic risks.”). 165. See id. at 31–33. 166. See id. 167. Id. at 63–66. 168. Id. at 22.



these observations, Pirrong predicts that clearing will change trading dynamics, and in particular, that trading volumes will rise as hedgers realize greater utility from hedging transactions in the cleared context.169 The article then continues by developing the model to include asymmetric information of two forms: asymmetric information in pricing an instrument and asymmetric information in estimating likelihood of default (i.e., balance sheet risk).170 Pirrong explains why swap dealers may have access to and be incentivized to use a richer set of information regarding pricing and creditworthiness than clearing houses.171 Assuming the informational advantage possessed by swap dealers, Pirrong identifies how adverse selection dynamics may evolve from asymmetric information within the cleared context.172 In particular, Pirrong identifies that there is likely to be over-clearing of instruments where the clearinghouse is under-collecting margin whether because it is improperly pricing the swap position or improperly estimating the likelihood of default.173 The over-clearing will impose risk on all clearinghouse members through mutualization.174

The article’s analysis of information asymmetries between dealers and a clearinghouse does not account for the potential comparison of pricing and collateral practices across the two contexts. As discussed above, the CFTC has created reporting obligations that elicit valuation information from clearinghouses and dealers and allow comparison of the two. In its supervisory role, the CFTC will be able to identify and seek the correction of mispricing. It is to be hoped that the CFTC will

169. Id. at 24–25. It remains an open question why hedgers that are better off with clearing would not have opted into clearing prior to the imposition of the clearing mandate. Clearing—whether mandated or not—does have benefits for counterparties such as through standardizing the creditworthiness on transactions to the creditworthiness of the relevant clearinghouse. While clearing has costs and benefits for private parties, the central question addressed by this article is whether clearing reduces social costs (and in particular, systemic risk). If clearing does not reduce social costs, it is hard to support an argument for mandating clearing across the market. 170. Id. at 33–43. 171. See also Yadav, supra note 5, at 420–35 (arguing that clearinghouses suffer from informational asymmetries and that member firms can use information advantages to undertake private rent seeking at the expense of the clearinghouse). 172. Pirrong, The Economics of Clearing in Derivatives Markets, supra note 5, at 51 (“[A] comparative analysis suggests that sharing default risks as is done on bilateral OTC markets offers certain efficiency advantages over centralized default risk sharing through a CCP for (a) complex products traded on relatively illiquid markets, that (b) are traded by opaque firms specializing in information-intensive intermediation.”). 173. Id. at 42–43; cf. Yadav, supra note 5, at 411 (“[T]he mutualization of losses fosters firm-level self-restraint.”). 174. See Pirrong, The Economics of Clearing in Derivatives Markets, supra note 5, at 60–61.



use the information it receives from market participants to help them avoid underpricing of risk. Yesha Yadav also argued the case that information asymmetries may undermine clearinghouses’ risk management.175 A second response to the concern that information asymmetries will undermine clearinghouses is that the clearing mandate actually corrects rather than exacerbates these asymmetries. Prior to the clearing mandate, parties could select which contracts to clear—opting to clear those that were relatively less expensive in terms of margin and other clearing costs. Following the mandate, all contracts falling within the scope of the clearing mandate have to be cleared, and thus there is no latitude for parties to submit only the contracts for which clearing services are underpriced. 176

Adam Levitin has argued that the policy success of the clearinghouse intervention depends on clearinghouses’ ability to withstand rather than prevent losses.177 This perspective stresses clearinghouse capital and access to member contributions as systemic risk mitigants over monitoring as a loss prevention method.178 Levitin compares the resources available to clearinghouses and swap dealers for judging risks and finds the two are not materially different.179 He notes that both clearinghouses and dealers are subject to competitive pressures to underprice risk. This observation should be supplemented with a note on adverse selection, which in the bilateral context will lead to better prices being offered by swap dealers that are underestimating the risk of warehousing the transaction. A key contribution from Levitin is the recognition that if collateral securing the trade (and other forms of loss absorption) are sufficient, then systemic damage can be contained.

Ultimately, Levitin presents the case for clearinghouses as ambiguous. He acknowledges the argument made by Mark Roe, discussed in the preceding Part. Levitin also identifies that clearinghouses may embark on a race to the bottom, seeking market share through implementing laxer collateral and other risk management policies. This race may result in clearinghouses taking on excessive amounts of risk to benefit shareholders at creditor expense, or simply as a reflection of short-term competitive goals trumping longer-term risk management goals. The latter conduct would be consistent

175. See Yadav, supra note 5. 176. See Levitin, supra note 5. 177. See id. at 448 (“Even if clearinghouses are more likely to incur losses than dealer banks, what matters is their resilience to the losses.”). 178. Id. 179. Id.



with myopia, an observed behavioral bias.180 It would also be consistent with employees carrying out corporate policies with an expectation to leave the organization after reaping the rewards of increased market share and prior to the manifestation of risk.

Finally, Levitin acknowledges that even if the failure of a clearinghouse may be less probable than the failure of a swap dealer due to risk mutualization and other loss absorbency techniques available to clearinghouses, the failure of a clearinghouse may impose greater systemic risk than the failure of a swap dealer. As discussed above, in a diversified bilateral setting, swap dealer default may impose losses on a wide range of counterparties; similarly, clearinghouse default through mutualization would impose loss on a wide range of clearing members as their contributions were forfeit and assessments were levied against them. Which of the two scenarios would impose greater systemwide losses is an open question; however, Levitin’s point that “the failure of a clearinghouse would have systemic consequences that would be far worse than a dealer bank’s failure” is intuitively more than plausible.181

In another important article, Sean Griffith looks under the hood of clearinghouses and identifies a number of decisions made by clearinghouses that affect whether systemic risk is appropriately addressed by them.182 Clearinghouses set criteria for membership, impose margin and contribution requirements on members, and propose which instruments should be subject to the clearing mandate.183 How these key questions are decided will affect the amount of systemic risk imposed by clearinghouses. Dealer members and other clearinghouse stakeholders may have interests that steer these decisions away from reducing systemic risk.184 For example, although subject to loss in the event of a clearing member’s default, other clearing members may not be wholly motivated to reduce excessive risk-taking due to agency costs and behavioral biases. More generally, Griffith identifies that the reduction of systemic risk is a public good and thus would be

180. See David Souder & Philip Bromiley, Explaining Temporal Orientation: Evidence from the Durability of Firms’ Capital Investments, 33 STRATEGIC MGMT. J. 550, 550–51 (2012). 181. Levitin, supra note 5, at 463. 182. Griffith, supra note 4; see also Kristin N. Johnson, Clearinghouse Governance: Moving Beyond Cosmetic Reform, 77 BROOK. L. REV. 681 (2012). 183. Griffith, supra note 4, at 1189. 184. Id. at 1201 (“The waterfall of losses inside the clearinghouse hits [clearing members] first, and the failure of the clearinghouse to contain counterparty credit risk is a threat, primarily, to those [clearing members] that most often transact through it.”).



underprovided through private markets.185 This is undoubtedly true, however, the relevant baseline for judging clearinghouse performance in reducing systemic risk is the bilateral context in which the public good should also be underprovided through the markets. Furthermore, as developed above, there is a plausible explanation for why inadequate attention may be given to counterparty credit quality in bilateral markets. Namely, diversification may lead to free riding as each party believes another will monitor and discipline a counterparty.

PART IV. HOW CLEARING AFFECTS TRADING ACTIVITY

The preceding two Parts discussed how loss reduction and loss allocation differ across the bilateral and cleared trading contexts. This Part provides an original exploration of how trading behavior may differ across the two contexts, with a focus on how these changes may affect systemic risk and other considerations that justify an intervention. As identified in this Part, the effects of the clearing mandate on trading behavior are likely to be significant for a number of reasons.

A. The Clearing Mandate Imposes Additional Frictions on Swap Transactions

The clearing mandate increases transaction costs. Clearing requires becoming a clearing member or establishing a customer relationship with a clearing member. For purposes of a rough estimate of the magnitude of the costs imposed by the clearing mandate, consider that transaction fees for clearing customers’ interest rate swaps at one of the major clearinghouses range from $1 to $24 per $1 million notional, with a $2 annual maintenance fee.186 Applying these fees to the estimated

185. Id. at 1210. 186. Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg. 74,284, 74,325 (Dec. 13, 2012) (to be codified at 17 C.F.R. pts. 39, 50). The quoted fees are for clearing at the CME. The other major clearinghouse for interest rate swaps, LCH, charges comparable fees that consist of $1–20 of transactional fees per $1 million notional and maintenance fees of $5–20 per swap per month. Id. For credit default swaps, the ICE Clear Credit charges an initial transaction fee of $6 per million notional amount and does not charge transaction fees. Id. Proprietary (as opposed to customer) positions are also subject to clearing fees. For example, for interest rate swaps cleared through the CME, clearing members are charged a transaction fee that ranges from $0.75 to $18.00 per million notional, depending on the transaction’s maturity. For credit default swaps, the ICE Clear Credit charges its clearing members $5–6 per transaction per million notional. Neither the CME nor the ICE charges its clearing members clearing proprietary trades a maintenance fee.



$381.00 trillion of outstanding interest rate swap notional, one time transaction fees on the outstanding notional would total between $381 million and $9144 million and annual maintenance costs would be about $762 million.187 These are significant costs, which are of course only a ballpark approximation given that several factors suggest that less than all interest rate swaps will move to clearing (a) a significant proportion of interest rate swaps were cleared prior to the clearing mandate coming into effect, (b) a significant proportion of interest rate swaps remain uncleared, even in the United States where the clearing mandate has gone into effect.188 However, the numbers provide a qualitative sense of the materiality of the regulatory costs. Added to these costs imposed by the clearinghouse would be the costs of obtaining clearing services from a clearing member, as well as indirect costs such as those of obtaining collateral to post as margin. Furthermore, putting these clearing arrangements into place and maintaining them requires time from legal, compliance and other personnel.189 The effect of these significant additional costs should be to reduce the volume of swaps.190 This effect should be concentrated among swaps that, but for the clearing mandate, would not have been cleared. Figures 1−5 provided in Part I above corroborate these theoretical predictions, as the Figures show declines in the notional weighted volumes of uncleared transactions that are not offset by increases in the weighted volumes of cleared transactions. In other words, while some swaps that would have been executed on a bilateral basis prior to the clearing mandate are now being cleared, other swaps that would have been executed on a bilateral basis prior to the clearing mandate are now foregone.191

187. BIS, OTC DERIVATIVES STATISTICS (2015), supra note 3, at 15. 188. Recall that the scope of the clearing mandate even for interest rate swaps and credit default swaps in the United States is subject to limitations and that the end-user exception and other exceptions can take transactions outside of the scope of the clearing mandate. 189. Clearing, however, substitutes for managing the trade bilaterally so there could be offsetting time savings. 190. Some of the costs of clearing would be compensated through the receipt of valuable risk management services, including the daily margining and clearinghouse guarantee. However, the level of risk management offered by the clearinghouse may exceed the level that would be chosen by participants in an efficient market; and this over-spending on risk management would not be compensated. Furthermore, the compensation would be incomplete because some of the costs would represent clearinghouse profit and, to the extent clearinghouse operations reduced systemic risk, some of the costs would support the reduction of externalities. In fact, the more clearinghouses reduced systemic risk through their operations, the less of the benefit from clearing would be internalized by those paying fees to clear. The discussion in this footnote was motivated by an eye-opening conversation with Richard Squire. 191. The volume of uncleared swaps is likely to further decrease when regulations



The effect of the clearing mandate in reducing swap volume may impact the systemic risk of swap markets.192 Whether greater volume or lower volume reduces systemic risk is an open question. As discussed at the outset, swap transactions have the effect of shifting risk. The level of systemic risk may depend not on how much risk there is, but rather on which market participants are exposed to the risk. On net, swaps likely have the effect of shifting risk from the commercial sector to the financial sector because (a) dealers do not offload all risk that they incur when transacting with natural longs and natural shorts, and (b) some of the risk that dealers offload is transferred to hedge funds and other members of the financial sector. Enabling risk shifting through swap transactions may lead to risk being transferred to entities better able to bear it, or the opposite. For instance, non-financial market participants may be safer repositories for risk as they may be less interconnected or have lower risk of short-term funding flight than financial entities. However, non-financial market participants may be closer to the “real economy” and thus transform financial distress into household distress more readily, for instance, through disruption of the supply of goods and services used by businesses and individuals or disruption of employment relationships. It should be remembered that the Treasury took an interest in the restructuring of General Motors and Chrysler, rather than focusing solely on banks.193 With that said,

requiring margin when trading with swap dealers in the bilateral context are implemented. See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants; Proposed Rule, 79 Fed. Reg. 59,898 901 (proposed Oct. 3, 2014) (to be codified at 17 C.F.R. pts. 23, 140). Those regulations propose to increase the costs of trading on a bilateral (as opposed to cleared) basis, so as to incentivize parties to clear their trades. Through increasing costs of swap trading, the uncleared margin rules would further depress the volume of swaps. As discussed infra the reduction would have an ambiguous effect on systemic risk. To the extent that overall swap volumes declined, the effect may be favorable as it could decrease the amount of risk flowing into the financial system; however, if the reduction affected hedging by swap dealers, it could actually increase the amount of systemic risk. 192. This article does not reach a conclusion as to whether increased swaps volume mitigates or exacerbates systemic risk. The effects are likely to be mixed. For example, increased swap activity may exacerbate systemic risk through increasing leverage, interconnectedness or other variables that correlate positively with systemic risk. However, congressional inquiry into the crisis also identified lack of liquidity as a source of significant stress:

[I]n the absence of a liquid derivatives market and efficient price discovery, every firm’s risk management became more expensive and difficult. The usual hedging mechanisms were impaired. An investor that wanted to trade at a loss to get out of a losing position might not find a buyer, and those that needed hedges would find them more expensive and or unavailable.

THE FIN. CRISIS INQUIRY COMM’N, supra note 15, at 364. 193. Carl Gutierrez, GM and Chrysler Covered by TARP, FORBES (Dec. 20, 2008),



most discussions of systemic risk see it residing in the financial sector and I tend to agree.194 Accordingly, decreased swap volumes should result in decreased systemic risk so long as the decreases occur in transactions that would otherwise shift risk to swap dealers; if on the other hand, the decreased volume is due to more warehousing of risk by swap dealers (i.e., decreased laying off of risk by swap dealers), decreased volumes may correspond to increases of systemic risk.195

Even assuming that the decrease in swap transactions reduces the net flow of risk into the financial sector, it is questionable whether increasing frictions in this manner is an optimal means for reducing systemic risk. Instead of imposing additional costs through the clearing mandate, the government could reduce swap transaction volumes through a tax.196 This would not only increase the real price of swap transactions, reducing their incidence, but raise revenues for the government. It is an open question whether it is better to increase transaction costs through increasing revenues for private parties such as clearinghouses and their members or through increasing tax revenues.

B. The Clearing Mandate May Lead to More or Less Standardized Transactions

In addition to changing the volume of swap transactions, the clearing mandate may change the terms of transactions that are entered into. These changes can affect information costs as well as legal risk. Information costs arise because, simply put, swap documentation is one more thing to look at when assessing the financial health of a party. To understand an entity’s risks, it is important to look beyond its operations to its derivatives activities through which the entity may transfer its existing risks in whole or in part or incur new risks. Swaps are a feature of an entity’s risk profile that requires study to understand. In addition to affecting information costs, changes in documentation can affect legal risk where the new documentation

http://www.forbes.com/2008/12/20/auto-bailout-update-markets-equity-cx_cg_1219 markets29.html. 194. Anthony J. Casey & Eric A. Posner, A Framework for Bailout Regulation 48–49 (Coase-Sandor Inst. for Law & Econ., Working Paper No. 724, 2015), http://papers.ssrn. com/sol3/papers.cfm?abstract_id=2564259. 195. See supra note 192. 196. See Lawrence H. Summers & Victoria P. Summers, When Financial Markets Work Too Well: A Cautious Case for a Securities Transactions Tax, 3 J. FIN. SERVS. RES. 261 (1989).



includes provisions of more (or less) ambiguous interpretation or enforceability.

Evasion of the clearing mandate and Dodd-Frank provisions prohibiting evasion may prompt market participants to alter the terms on which they transact whether to evade the clearing mandate or to avoid penalties for evading the mandate. Thus the clearing mandate may cause a shift not only (a) from uncleared transactions to cleared transactions and/or foregone transactions, but also (b) between standardized and customized transactions. The shift from standardized transactions may increase legal risk as well as information costs. Conversely, a shift from customized transactions would decrease legal risk and information costs.

As noted in Part I’s discussion of the legal regime, there is a concern that the clearing mandate may be evaded through transacting on terms that bring a swap outside of the class of contracts subject to the mandate. For instance, rather than entering into a U.S. dollar denominated interest rate swap, parties could enter into an interest rate swap in some other currency and pair it with a currency conversion swap thus bringing the transaction outside of the clearing mandate while effecting the same economic trade. To avoid this type of evasive activity, the CFTC has adopted anti-evasion rules.197 The rules are broad, and make it unlawful to “knowingly or recklessly evade or participate in or facilitate an evasion of [the clearing or platform execution mandates]” as well as to abuse any exceptions or exemptions therefrom. Interests in evading the clearing mandate and avoiding being penalized for evasive activity may lead parties to change the terms of their swap agreements. Any such changes in the customized direction would likely be quite substantive as they would need to result not only in the criteria for inclusion in the scope of the clearing mandate not being met, but also in substantiating a strong argument to withstand a challenge under the anti-evasion provision.198 Any such moves by counterparties may increase the complexity of transactions, and add to legal risk—including legal risk of being subject to a proceeding for evasion. Through prompting evasion (and applying an ambiguous anti-evasion standard), the clearing mandate may decrease standardization, increasing the costs of parsing transactions and also

197. 17 C.F.R. § 50.10 (2016). 198. Once developed, heightened margin and capital requirements that apply to uncleared swap transactions may counteract incentives to avoid the clearing mandate as these additional regulatory regimes may make it more expensive to transact on an uncleared (as opposed to cleared) basis.



increasing legal risk.199 On the other hand, the clearing requirement and anti-evasion

provision may encourage standardization. Only standardized trades are susceptible to clearing because the models that undergird valuation, collateral and other risk management practices rely on statistical inference that cannot proceed based on experience with one-off and idiosyncratic trades. The anti-evasion provision has the effect of funneling trades into standardized, clearable form. Parties entering into a trade that resembles a standardized trade subject to the clearing mandate may well choose to reduce some of the customization and clear the trade rather than run the risk of being penalized under the anti-evasion provision. The result is trades that are less customized but also further from the parties’ first-best commercial arrangements. The simplification of terms may result in cruder, less tailored risk-transfer. However, simplification would also reduce information costs and reduce the legal uncertainties created by idiosyncratic terms.200 As a result, the net effect may lead to more or less customization, more or less transparency and more or less legal risk. A key factor in determining the direction that the market takes will be the cost of clearing (as opposed to leaving the trade uncleared). The higher the relative cost of clearing, the more of an incentive parties will have to customize their swaps to avoid the clearing mandate. Heightened margin and capital requirements imposed on uncleared trades can create pressures in the other direction, and thereby standardize the trades.

Increases in transparency and standardization may mitigate systemic risk. Conversely, increases in opacity of documentation and further customization may increase systemic risk. However, the strength of the relationship between customization and systemic risk is unknown. Increases in legal risk may also increase systemic risk, although to date there has not been a single financial crisis that has been traced to a buildup of legal risk.

C. The Clearing Mandate Affects Counterparty Behavior During a Crisis, Reducing Runs and Adding to Market Resiliency

Although generally the effects of the clearing mandate on the level of systemic risk are uncertain, during a crisis, clearing will have several

199. Legal risk refers to the possibility that a contractual provision is not enforceable, or not enforced as the parties intended. 200. Commercial arrangements that choose customized over standard terms eschew the benefit of precedent and other interpretive guidance that forms around standardized provisions.



unambiguously salutary effects. First, clearing preempts cascades of novations that distressed derivatives counterparties such as Bear Stearns experienced during the financial crisis.201 As market participants become concerned with a counterparty’s ability to perform under a swap contract, they may seek to novate or assign the contract to a new counterparty.202 This creates cascades in the market as potential transferees for the distressed counterparty’s obligations are contacted, when these potential transferees themselves have derivatives contracts with the distressed counterparty. In these circumstances, those contacted may themselves then go out in the market looking for potential transferees. During the 2007–2009 financial crisis, these dynamics singled out distressed firms that counterparties were abandoning. This herd behavior in swap markets may have contributed to runs against the distressed firms in other markets, such as overnight repo and other short-term funding markets. Clearing obviates the reasons to seek a novation or assignment after executing a trade with a party that becomes financially distressed. Payments under a cleared trade can continue notwithstanding that a counterparty has failed because it is the clearinghouse rather than the counterparty that makes the payments due under the trade. Accordingly, clearing mutes an important pathway for spreading panic during a crisis.203

Second, clearing increases market resiliency to counterparty distress. Derivatives are fundamentally a means to managing financial risk. Losing access to derivatives markets can disrupt risk management, precipitating insolvency. Market dynamics observed during the deterioration of Bear Stearns demonstrate the fragility of bilateral markets where a significant swap dealer becomes distressed. The fragility manifests itself in two forms: (1) incapacity to enter into new transactions, and (2) incapacity to manage existing transactions. A swap dealer may become unable to continue managing its risks as counterparties seek to avoid further credit exposure to the weakening

201. See THE FIN. CRISIS INQUIRY COMM’N, supra note 15, at 287 (explaining how in its final days Bear Stearns was increasingly substituted out of derivatives transactions through assignments and novations). 202. Id. at 386 (“The scale and nature of the over-the-counter (OTC) derivatives market created significant systemic risk throughout the financial system and helped fuel the panic in the fall of 2008 . . . . Enormous positions concentrated in the hands of systemically significant institutions that were major OTC derivatives dealers added to uncertainty in the market. The ‘bank runs’ on these institutions included runs on their derivatives operations through novations, collateral demands, and refusals to act as counterparties.”). 203. See id.



dealer. This is a corollary to the novations discussion above. Just as parties desire to step out of existing trades with a weakening counterparty, they also desire not to enter into new trades with that counterparty.204 However, continued trading may be necessary for the distressed counterparty to reduce the risk of its insolvency, such as where it is pursuing a dynamic hedging strategy.205 Central clearing can allow a weakening counterparty to continue managing its risk through swap transactions so long as the counterparty meets collateral requirements and other credit standards imposed by its clearing member. The capacity to continue trading provided by clearing to distressed market participants, however, should not be viewed as a justification of mandatory clearing. Prior to swap market reforms, parties had the option (but not the obligation) to submit their trades for clearing; if distress prevented a party from entering into trades bilaterally, it could have sought to clear the trade provided that it and its counterparty had established clearing relationships prior to execution.

In addition to enabling a distressed dealer to continue to manage its risk through new transactions, central clearing enables the dealer and its counterparties to reduce or terminate existing transactions.206 In the bilateral context, terminating a trade requires transacting with the counterparty to the original trade.207 During a crisis, counterparties may become unresponsive to trading requests. For example, a distressed party may be unable to simultaneously negotiate unwinds, amendments or new trades with a range of counterparties because of the sheer number of requests or because the distress is occupying the attention of key decisionmakers.208 In the cleared context, terminating a trade does not require cooperation from the counterparty to that trade. Rather, termination may be accomplished through entering into a

204. Id. at 287 (explaining that counterparties that were increasingly reluctant to be exposed to Bear Stearns ceased trading). 205. ZVI BODIE, ALEX KANE & ALAN J. MARCUS, ESSENTIALS OF INVESTMENTS 764–65 (7th ed. 2008). 206. INT’L MONETARY FUND, supra note 20, at 92 (“While CCPs worldwide functioned relatively well, where such CCPs were not involved, there were difficulties in unwinding derivatives contracts.”). 207. In the bilateral context, entering into a reverse of the original trade with a third party does not cancel the original trade because the third party may become insolvent so that there are insufficient cash flows under the reverse trade to meet payment obligations under the original trade. 208. “[T]he sharp contraction in the OTC derivatives market in the fall of 2008 greatly diminished the ability of institutions to enter or unwind their contracts or to effectively hedge their business risks at a time when uncertainty in the financial system made risk management a top priority.” THE FIN. CRISIS INQUIRY COMM’N, supra note 15, at 365.



reverse of the original transaction with any counterparty. This is the case because payments due to the clearinghouse under the original trade will be perfectly offset by payments owed by the clearinghouse under the reverse trade and vice-versa, thus cancelling out the payments receivable and payable under the two trades. Similarly, instead of terminating the original trade, a party may downsize a trade through entering into a reverse trade with a smaller notional amount than the original trade. This enables positions to be unwound during a crisis notwithstanding that the party to the original trade is preoccupied or otherwise unable to trade.209 Unwinding trades through clearing reverse trades relies on the initial trade having been cleared. The clearing mandate helps ensure this predicate condition is satisfied, thus enabling continued risk management during a crisis.

D. The Clearing Mandate Enables Disintermediation of Derivatives Markets

In combination with the platform execution mandate, the clearing mandate also serves as a predicate to disintermediating swaps markets. As discussed above, historically swap market participants have obtained liquidity from swap dealers. The liquidity operations of swap dealers have, in turn, implicated the largest banking organizations in the intermediation of risk. End-users, such as the natural gas producer and hedge fund discussed above, turned to swap dealers when seeking a counterparty to a swap. Swap dealers then warehoused the risk obtained through the transaction, or offloaded the risk to another dealer or counterparty. Through operating as intermediaries, swap dealers built up their risk inventory and interconnectedness with the financial system.

As discussed above, a second component of swaps reform under the G-20 program is the introduction of regulated trading platforms for the execution of standardized swaps. In the United States, this component has already taken effect as a range of interest rate and index credit default swaps must be executed on a SEF or DCM in the absence of an exception. Together with the clearing mandate, the introduction of platforms, which operate subject to open access requirements and provide their participants with central order books, enable the market

209. Bliss & Kaufman, supra note 8, at 67 (explaining that in the non-cleared context, “[r]emoval of any one dealer may seriously disrupt the derivatives markets. Even if no knock-on failures occurred, a very large number of contracts would need to be replaced and new working relationships would need to be established for end users.”).



to sidestep swap dealers. Through submitting long and short orders to order books

maintained by SEFs and DCMs, swap market participants provide liquidity to the opposite side of the trade. For example, the natural gas producer desiring to go long in interest rates (to hedge the short position it acquired through issuing floating rate bonds) may submit an order to a SEF for the relevant type of floating-for-fixed interest rate swap, stating the amount of notional it wished to hedge and the price (expressed as, e.g., the fixed rate it was willing to pay in return for receiving the floating rate). Then a hedge fund could observe that order in the order book, and place a contra-order for some or all of that notional at the offered price if it wished to go short interest rates. In this fashion, natural longs and natural shorts could find each other and other counterparties willing to take on their risk without intermediating the trades through swap dealers.

Use of central order books to disintermediate trades, however, depends on a key factor generally missing from over-the-counter swap markets: information regarding counterparty creditworthiness. Neither the hedge fund nor the natural gas provider would, generally speaking, be interested in directly trading with one another as neither had a basis for judging the other’s creditworthiness without intensive diligence. Without an understanding of a counterparty’s creditworthiness, a party is not interested in trading because it cannot answer the fundamental question as to the likelihood that the counterparty will make good on its payment obligations. For that reason, a central order book that collects supply and demand for a given swap position is generally ineffective. Too much depends on counterparty creditworthiness for parties to trade solely based on amount and price. This is the reason that in over-the-counter swap markets, parties with enormous and longstanding balance sheets (as well as expertise in pricing risk, including counterparty credit risk) emerged as swap dealers.

Clearing substitutes for intensive counterparty diligence. Transactions cleared by the same clearinghouse have the same creditworthiness. So long as parties trust the creditworthiness of the clearinghouse, they can trade with one another. For that reason, orders placed into an order book become truly fungible and units of notional for a given type of swap become commodities when mandatory clearing is introduced. Mandatory clearing serves a coordinating function, fixing the credit quality behind orders so they can be matched solely on the basis of amount and price.

In this manner, clearinghouses in combination with trading platforms have the potential to disintermediate swap markets.



Disintermediation can reduce systemic risk through reducing the risk transmitted to and through the banking sector. Notably, the decrease in swap dealers’ involvement comes without further involving what is disparagingly called the shadow banking system, e.g., hedge funds, proprietary trading shops and other parties falling outside the purview of banking regulators. Instead, mandatory clearing may substitute clearinghouses for swap dealers as intermediaries to swap markets. Clearinghouses should be better suited to managing risk than swap dealers. First, clearinghouses are dedicated exclusively to managing derivatives risk and have no discretion to engage in operations beyond clearing unlike swap dealers, which coordinate their derivatives dealing operations alongside myriad other financial activities such as lending and underwriting. Second, clearinghouses do not participate in short-term financing markets to the extent that swap dealers do; as we saw in the last financial crisis, the exposure of banks to short-term funding created liquidity crises as overnight repo, commercial paper and other forms of short-term financing became unavailable. Clearinghouses do not participate to the same extent in short-term financing markets, and thus are not as susceptible to runs and other liquidity shortages.210 As derivatives transactions bypass banks and other multiservice financial institutions, the management challenges raised during a crisis at these financial institutions are reduced. Prior to the Dodd-Frank Act, large financial institutions undertook dizzying amounts and varieties of financial operations. As those operations are slimmed down and simplified, the burden falling on management in steering the institution through a crisis is lightened.

PART V. CONCLUSION

This article is written as a continuation of prior literature criticizing and justifying the clearing mandate as a mitigant of systemic risk. In addition to organizing and commenting on prior scholarship, this article proposes a new set of considerations for assessing the clearing mandate. In particular, this article observes a number of changes we should expect to see in the trading behavior of counterparties following the advent of mandatory clearing. To summarize:

• Greater costs of transacting reduce swap volumes. The net

result of these reductions on systemic risk is uncertain. The reduction could reduce net transfers of risk into the

210. See Squire, supra note 5, at 921.



financial system, and in particular, major financial institutions that act as swap dealers. Alternately, the reduction could disproportionately affect hedging by the financial industry, and in particular, reduce swap dealers’ risk reducing trading.

• Attempts to evade the clearing mandate, as well as attempts to avoid being penalized under the anti-evasion provisions of CFTC regulations, may lead to more or less standardized documentation. Increased standardization, should it occur, may reduce systemic risk (and conversely, if parties respond to the clearing mandate through further customizing their transactions, opacity and systemic risk may increase).

• 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.

• 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 order books without using swap dealers to intermediate the flow of risk in the economy.

Looking beyond prior literature and this article, several pathways

for further research present themselves. If the clearing mandate does not reduce systemic risk, then the

express justification for the mandate is absent and it becomes difficult to defend the mandate against charges that it represents costly government meddling in private markets. On the other hand, building a credible defense of the mandate as a mitigant to systemic risk does not end the debate over the mandate. Other considerations, such as the relative competitiveness of bilateral and cleared markets, should be considered as should any compliance and other costs imposed by the clearing mandate. Ultimately, only a holistic cost-benefit assessment can guide enlightened policy. Further studies, particularly empirical



inquiries, will be useful to understanding the desirability of the mandate.

Even if the mandate dampens crises, can the costs of its constant constraint be justified?

eassessment of the clearing andate how the clearing ... · 1/4/2017 · 04_beylin.docx 1/20/17...

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