The Tenuous Case for Swaps Clearinghouses

I've got a new short article out about swaps clearinghouses.  It's a response piece to an article by Prof. Yesha Yadav.

Swaps clearinghouses, mandated by the Dodd-Frank Act, are a pretty natural point of interest for bankruptcy and commercial law scholars, especially in the context of credit default swaps.  Clearinghouses are financial institutions used for mutualizing credit risk using collateral and set-off and netting.  Sounds like an institutional version of bankruptcy. There's surprisingly little legal scholarship there is on derivatives--securities law scholars have largely eschewed the derivatives space, and bankruptcy scholars have been interested only to the extent of the automatic stay safe-harbors for derivatives.  Hopefully clearinghouses will provide a entry-point for a broader legal scholarship exploration of derivatives.   

My basic take on clearinghouses is that their systemic risk benefits will depend heavily on how clearinghouses are regulated.  In particular, there is a real risk of a competitive race-to-the-bottom between clearinghouses seeking to increase market share.  That said, if clearinghouses are well-regulated, they help diffuse losses and thus reduce systemic risk. The abstract is below the break:

Mandatory use of swaps clearinghouses represent the major regulatory response to the systemic risk from credit derivatives. Scholars are divided on the merits of clearinghouses; some scholars see them as reducing systemic risk, others contend they increase it. 

The case for swaps clearinghouses comes down to two propositions: (1) that clearinghouses are better able to manage risk than dealer banks in the over-the-counter derivatives market, and (2) that clearinghouses are better able to absorb risk than dealer banks. Both propositions are heavily dependent on the details of clearinghouse design, the shape of the clearinghouse market, and the manner of its regulation. 

In theory, however, a well-designed clearinghouse boasts one major advantage over dealer-banks: capital. Clearinghouses can have deep capital structures, including callable capital from their members. Clearinghouses thus diffuse losses out across their membership, thereby avoiding catastrophic losses to any single institution. If designed properly, a clearinghouse should be much more resilient to losses than an individual dealer bank. Clearinghouse owners, however, are likely to pursue lower capitalization, leaving it up to regulators to ensure sufficient capitalization.

Clearinghouses concentrate risk and also potentially encourage greater risk taking via underpricing to gain market share. Therefore, if they lack sufficient capital, they can present a dangerous increase in systemic risk relative to dealer banks. Thus, the case for clearinghouses remains tenuous and ultimately dependent upon the still-to-be-determined particulars of their regulation.