Failure of The Clearinghouse: Dodd Frank Fatal Flaw?

VIRGINIA LAW & BUSINESS REVIEW
VOLUME 10
FALL 2015
NUMBER 1
FAILURE OF THE CLEARINGHOUSE: DODDFRANKS FATAL FLAW?

Stephen J. Lubben
INTRODUCTION ..................................................................................................... 127
I. CLEARINGHOUSES AND THE FUTURES MARKETS ....................................... 133
II. CLEARINGHOUSES AND DODD-FRANK ....................................................... 139
III. DODD-FRANK TITLE VIII ............................................................................ 145
IV. CLEARINGHOUSES IN DISTRESS .................................................................. 148
CONCLUSION .......................................................................................................... 160
INTRODUCTION
LEARINGHOUSES reduce risk by acting as a central hub for trades.

Each party to a trade faces only the risk of the clearinghouses nonperformance, rather than the doubtlessly greater risk that the counterparty to
the trade will fail to perform.1

Harvey Washington Wiley Chair in Corporate Governance & Business Ethics, Seton Hall
University School of Law. I am extremely grateful for comments from Jennifer Hoyden,
Colleen Baker, Anthony Casey, Anna Gelpern, Kathryn Judge, Richard Miller, Saule
Omarova, Craig Pirrong, David Skeel, Mark Roe, Art Wilmarth, and others who asked to
remain nameless. Adam Levitin provided extensive and extremely helpful comments on
an earlier draft. I owe him special thanks.
See Kristin N. Johnson, Governing Financial Markets: Regulating Conflicts, 88 WASH. L. REV.
185, 218 (2013); Jeffrey Manns, Insuring Against a Derivative Disaster: The Case for Decentralized
Risk Management, 98 IOWA L. REV. 1575, 1606 (2013); see also 7 U.S.C. 2(h)(2) (2012)
(providing guidelines for the Commodity Futures Trading Commissions review of
clearinghouse submissions). The clearinghouse is actually something more than a hub,
Copyright 2015 Virginia Law & Business Review Association
127
128
Virginia Law & Business Review
10:127 (2015)
For this reason, the Dodd-Frank Wall Street Reform and Consumer
Protection Act 2 now requires that most derivatives trade through
clearinghouses.3
The Dodd-Frank Acts clearinghouse requirement is intended to reduce
systemic risk caused by domino effect failures: if one firm fails, it could result
in the failure of other firms to which it owes money, and so on. Yet the
Dodd-Frank Acts clearinghouse requirement may be self-defeating.
The concentration of derivatives trades into a very small number of
clearinghouses or central counterparties (CCPs) arguably increases systemic
risk.4 As summarized by the International Swaps and Derivatives Association
(ISDA), the derivatives industry trade organization:
The larger CCPs have become critical components of the
financial markets infrastructure and are emerging as major
hubs concentrating the vast majority of global OTC
derivatives transaction flows and risk positions. Great care
needs to be taken to ensure that CCPs are not the new too
big to fail institutions requiring public money to prevent
their failure.5
Clearinghouses are regulated,6 but given the vital place of clearinghouses
in Dodd-Frank, it is surprising that Dodd-Frank makes no provision for the
failure of a clearinghouse.7
2
3
4
5
6
7
since it replaces a single contract between two parties with two contracts. That is, the
clearinghouse replaces a direct contractual relationship, between the two parties having
two distinct relationships, with the clearinghouse. This is discussed more fully below.
Pub. L. No. 111-203, 124 Stat. 1376 (2010).
See John C. Coffee, Jr., The Political Economy of Dodd-Frank: Why Financial Reform Tends to Be
Frustrated and Systemic Risk Perpetuated, 97 CORNELL L. REV. 1019, 1063 (2012).
See Eduard H. Cadmus, An Altered Derivatives Marketplace: Clearing Swaps Under Dodd-Frank,
17 FORDHAM J. CORP. & FIN. L. 189, 224 (2012); Felix B. Chang, The Systemic Risk Paradox:
Banks and Clearinghouses Under Regulation, 2014 COLUM. BUS. L. REV. 747, 775 (2014); Mark
J. Roe, Clearinghouse Overconfidence, 101 CALIF. L. REV. 1641, 1692 (2013); David A. Skeel,
Jr. & Thomas H. Jackson, Transaction Consistency and the New Finance in Bankruptcy, 112
COLUM. L. REV. 152, 196 (2012).
Scott OMalia, Ensuring CCPs Are Not TBTF, DERIVATIVIEWS (Dec. 10, 2014),
http://isda.derivativiews.org/2014/12/10/ensuring-ccps-are-not-tbtf/.
See Colleen Baker, The Federal Reserve as Last Resort, 46 U. MICH. J. L. REFORM 69, 104
(2012).
Chang, supra note 4, at 792. Indeed, it is arguable that the United States is not in
compliance with its commitment to the G-20 on this point. See BANK FOR INTL
SETTLEMENTS & INTL ORG. OF SEC. COMMNS, RECOVERY AND RESOLUTION OF
FINANCIAL MARKET INFRASTRUCTURES: CONSULTATIVE REPORT 1 (2012). Interestingly, a
similar document, but entitled Recovery of Financial Market Infrastructures, was
released in August 2013. Resolution was gone. The relationship between the two is
explained on page 4 of the latter document:
10:127 (2015)
Failure of the Clearinghouse
129
Clearinghouses are presently excluded from the Dodd-Frank Acts new

Orderly Liquidation Authority (OLA).8 Yet the notion that a derivatives
clearinghouse might file a regular bankruptcy petition is farcical, given that
Congress previously decided to exclude derivatives, and most securities
trades, from the most important parts of the Bankruptcy Code,9 and because
a clearinghouse would be required to liquidate in a chapter 7 bankruptcy.10
Given the key role that clearinghouses will play in a post-Dodd-Frank
world, this Article begins the hard discussion of what should happen if the
worst were to happen.
The lack of insolvency mechanisms for clearinghouses is particularly
concerning given the unique way in which clearinghouses are apt to fail.
Unlike most businesses, clearinghouses will never find themselves suffering
from ever-increasing degrees of financial distress. Instead, they will most
likely fail as the result of one of their members failure, or as a result of a
10
In July 2012 the CPSS and IOSCO published a consultative report on recovery
and resolution of financial market infrastructures. That report covered both the need
for FMIs to have effective plans to recover from financial stresses and the need
for jurisdictions to have effective regimes for the resolution of an FMI in
circumstances where recovery is no longer feasible. Many of the commentators
on that consultative report requested more guidance on what recovery tools
would be appropriate for different types of FMI in different circumstances.
This new report provides that guidance. Aspects of the consultation report concerning
FMI resolution have been included in a new draft annex and will be included in an
assessment methodology for the Key attributes. Many recovery tools will also be
relevant to an FMI under resolution, not least because a resolution authority
may wish to enforce implementation of contractual loss allocation rules where
any such rules have not been implemented before entry into resolution.
BANK FOR INTL SETTLEMENTS & INTL ORG. OF SEC. COMMNS, RECOVERY OF
FINANCIAL MARKET INFRASTRUCTURES: CONSULTATIVE REPORT 4 (2013) (emphasis
added).
Some have argued that OLA applies to clearinghouses. E.g., Julia Lees Allen, Note,
Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis, 64 STAN.
L. REV. 1079, 110002 (2012); see also PETER J. GREEN ET AL., MORRISON & FOERSTER
LLP, AVOIDING ARMAGEDDON: RESOLUTION REGIMES FOR CENTRAL CLEARING
COUNTERPARTIES 4 (2013) (In terms of a resolution regime for CCPs, Title II of the
Dodd Frank Act has already provided the Federal Deposit Insurance Corporation (FDIC)
with orderly liquidation authority over certain non-bank financial institutions, such as
CCPs.). But as discussed, infra, that assumption ignores the text and intent of DoddFrank.
See Stephen J. Lubben, Derivatives and Bankruptcy: The Flawed Case for Special Treatment, 12 U.
PA. J. BUS. L. 61, 67 (2009); Mark J. Roe, The Derivatives Markets Payment Priorities as
Financial Crisis Accelerator, 63 STAN. L. REV. 539, 54748 (2011).
11 U.S.C. 101(6), 109(d), 766(i) (2012). Subchapter IV of chapter 7 contains special
provisions for commodity broker liquidation. 11 U.S.C. 767.
130
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massive operational problem.11 In short, they will jump to default, just like
a credit default swap.12
As Congress recognized, all of this places special stress on the need for
risk management at the clearinghouses. 13 But what if a clearinghouse
nonetheless fails?
Industry participants acknowledge that this eventuality, although arguably
unlikely, could happen.14 What happens next is unknown.15
In this paper I suggest two likely outcomes. Congress might be tempted
to adopt an ad hoc statutory solution. The fate of Fannie Mae and Freddie
Mac, the two mortgage companies who were placed in a conservatorship in
September 2008, just after Congress had created that possibility under the
Housing and Economic Recovery Act of 2008,16 looms large here.17
But ad hoc solutions simply exacerbate uncertainty in times of financial
distress, and are subject to litigation risk too. And the sudden creation of a
specialized resolution process is really not anything more than a bailout, since
any solution will require massive capital injections to save the clearinghouses.
Again, consider the mortgage companies, and the U.S. Treasurys outsized
preferred share holdings therein.18

11
12
13
14
15
16
17
18
In theory, a clearinghouse could also fail because of investment losses: clearinghouses

invest the collateral they hold and this could trigger insolvency, though that would have to
involve investment decisions so poor as to amount to an operational problem.
Adam J. Levitin, Response: The Tenuous Case for Derivatives Clearinghouses, 101 GEO. L.J. 445,
455 n.35 (2013) (Jump-to-default is the phenomenon in which protection sellers CDSpayout liability occurs suddenly through triggers such as payment defaults or bankruptcy
filings, rather than incrementally. The effect is to make the liquidity demands on CDSprotection sellers more volatile.).
See 7 U.S.C. 7a1(c)(2)(D) (2012).
INTL SWAPS & DERIVATIVES ASSN, PRINCIPLES FOR CCP RECOVERY 7 (2014) [hereinafter
ISDA],
available
at
http://www2.isda.org/attachment/NzExMw==/Principles%20for%20CCP%20Recover
y%20FINAL.pdf (Although it should be extremely unlikely, the DMP [default
management process] could fail. In this case, regardless of the amount of loss-absorbing
resources utilized (or that remain available), the clearing service is likely to be deemed no
longer viable.).
See id.
Pub. L. No. 110-289, 122 Stat. 2654 (2008).
See Michael S. Barr, The Financial Crisis and the Path of Reform, 29 YALE J. ON REG. 91, 111
(2012). To be sure, Fannie and Freddie did not jump to default. Instead, their
problems built up more gradually. But the creation of a special insolvency proceeding just
for them is the point of similarity.
See FED. HOUS. FIN. AGENCY, TREASURY AND FEDERAL RESERVE PURCHASE PROGRAMS
FOR
GSE AND MORTGAGE-RELATED SECURITIES 2 (2014), available at
http://www.fhfa.gov/DataTools/Downloads/Documents/MarketData/TSYFEDPP_NOV2014r.pdf.
10:127 (2015)
131
So then there will be a temptation to engage in direct bailout, despite

Dodd-Franks claim to have ended bailouts.19 Bailouts of individual financial
institutions may end, but bailouts of clearinghouses might become more
common in a post-Dodd-Frank world.20 Given that most clearinghouses are
themselves publicly traded companies, with strong connections to all the
major banks, there are good reasons to wonder if we will not simply be
bailing out the same group of banks indirectly in the next financial crisis.
Academics decry bailouts because of the moral hazard they create.
Clearinghouses will run their businesses with less caution if they know that
the government will save them from losses. From a broader perspective,
taxpayers might rightly wonder why they should save investors from losses
those investors willingly undertookrecall again that all major derivatives
clearinghouses are now publicly held firms.21
On the other hand, the very aim of Dodd-Frank is to place
clearinghouses at the heart of the nations financial system.22 And it is not
credible to think that any government will allow its entire banking system to
collapse if something could be done to prevent that. 23 Central banking
lending that overcomes mere illiquidity is generally innocuous, but in times
of crisis it will be difficult to separate illiquidity from insolvency.
What to do?
I propose that the government should nationalize the clearinghouses
upon failure, and that the intention to do so should be made clear ex ante.
That is, the government should expressly state that clearinghouses that
ultimately fail will be nationalized, with specific consequences to investors,
and an expectation of member participation in the recapitalization of the

19
20
21
22
23
See Sean J. Griffith, Governing Systemic Risk: Towards a Governance Structure for Derivatives
Clearinghouses, 61 EMORY L.J. 1153, 1201 (2012); see also Dodd-Frank Wall Street Reform
and Consumer Protection Act of 2010 214, 12 U.S.C. 5394 (2012) (providing that
[t]axpayers shall bear no losses from the exercise of any authority under OLA).
In a recent paper, Adam Levitin argues that structuring bailouts this way will be more
politically palatable. Adam J. Levitin, Prioritization and Mutualization: Clearinghouses and the
Redundancy of the Bankruptcy Safe Harbors, 10 BROOK. J. CORP. FIN. & COM. L. (forthcoming
2015)
(manuscript
at
25),
available
at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2610469.
Cf. John Patrick Hunt, Credit Ratings in Insurance Regulation: The Missing Piece of Financial
Reform, 68 WASH. & LEE L. REV. 1667, 1692 (2011) (describing the moral hazard
associated with so-called rule bailouts).
Whether this was wise is of course subject to debate. See Craig Pirrong, The Economics
of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of
Default Risks Through a Central Counterparty 45 (Jan. 8, 2009) (unpublished
manuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1340660.
See Adam J. Levitin, In Defense of Bailouts, 99 GEO. L.J. 435, 439 (2011).
132
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clearinghouse, once that becomes systemically viable. This should provide

stakeholders in the clearinghouses with strong incentives to oversee the
clearinghouses management and avoid such a fate.24
In essence, what I propose is a system of precommitment or structured
bailouts.25 Bailouts of clearinghouses seem inevitable. We must specify
what would happen today, both to discourage an avoidable situation, and to
facilitate an organized response, in the event of an essential bailout.
In a world of limited liability, this may not be enough to get the
incentives just right. But it is better than the status quo.
***
This Article makes three basic claims. First, bailouts of clearinghouses
are now foreseeable, because the important, central place of clearinghouses
after Dodd-Frank makes their failure too disruptive to be politically tolerated.
Second, the United States needs to enact a clear, ex ante procedure to deal
with the failure of a clearinghouse and address the consequences of a bailout.
Third, those consequences must include clearly delineated outcomes for the
stakeholders best situated to avoid problems at the clearinghouse.
In short, both shareholders and members must incur real costs if a
clearinghouse fails. Hence, upon failure, clearinghouses must be nationalized
and memberships cancelled.26
The Article commences with a discussion of the structure and nature of
clearinghouses. Part II then sketches the central role of clearinghouses in
Dodd-Franks regulation of derivatives, while Part III turns to the new, postfinancial crisis regulation of clearinghouses.
Part IV then considers the clearinghouse in financial distress. My focus is
on the clearing of derivatives trades, although much of what I have to say
applies to clearinghouses generally. I note that the only Dodd-Frank
provision remotely addressing the failure of systemically important
clearinghouses is the section that allows clearinghouses to access the Federal
Reserves discount window.27 That presupposes that the clearinghouse will
have assets to discount.28

24
25
26
27
28
See Sarah Pei Woo, Regulatory Bankruptcy: How Bank Regulation Causes Fire Sales, 99 GEO. L.J.
1615, 1626 (2011).
Alternatively, this could be seen as an instance of containment. See Anna Gelpern,
Financial Crisis Containment, 41 CONN. L. REV. 1051, 1057 (2009).
In essence, both types of equity in the clearinghousememberships and formal equity
must be forfeited in exchange for the bailout.
12 U.S.C. 5465(b) (2012).
Or maybe not. See Christian Chamorro-Courtland, The Trillion Dollar Question: Can a
Central Bank Bail Out a Central Counterparty Clearing House Which Is "Too Big to Fail"?, 6
BROOK. J. CORP. FIN. & COM. L. 433, 464 (2012) (Notwithstanding the Feds power,
10:127 (2015)
133
Nonetheless, this provision might provide the basis for a Federal Reserve
bailout of important clearinghouses. Alternatively, the Treasury will face
strong pressure to bail out the clearinghouse, since failure to do so might well
produce a broader systemic collapse. None of this is very consistent with
Congress stated desire to end bailouts of the financial system.29
I conclude with a sketch of a proposal to nationalize systemically
important clearinghouses upon failure. Clearinghouses are too important to
fail, but failure should have real consequences for investors and the members
of the clearinghouse. Anything less provides little more than no-cost
government insurance, something to which taxpayers and voters should
rightly object.
At this point, the academic literature on the bankruptcy of clearinghouses
is almost non-existent.30 As recent events have shown, it is never too early to
consider the impossible.
This Article also surfaces the important question of whether such
important financial system infrastructure should remain with publicly traded
firms. There is an obvious conflict of interest between the public role these
firms play and the normal duties their boards owe to their shareholders.
I. CLEARINGHOUSES AND THE FUTURES MARKETS
Transactions in futures have long been cleared and settled through a
clearinghouse. 31 A future, which is a specialized kind of forward, is a
standardized contract to purchase or sell an underlying asset in the future at a
specified price and date.32 The seller of the futures contract (the short party)
29
30
31
32
[Dodd-Frank] Title VIII is ambiguous for several reasons. First, it does not specify
whether the CCP must provide good collateral in exchange for access to the discount
window.).
As provided in the preamble to Dodd-Frank, the laws stated goal is [t]o promote the
financial stability of the United States by improving accountability and transparency in the
financial system, to end too big to fail, to protect the American taxpayer by ending
bailouts . . . . Pub. L. No. 111-203, pmbl., 124 Stat. 1376, 1376 (2010).
The exception being a single student note. See Allen, supra note 8.
One historian notes the first U.S. clearinghouse to set off multiple transactions at once
appeared in Chicago in 1884. The first clearinghouse in produce was actually adopted in
Liverpool in cotton in 1876. Jonathan Ira Levy, Contemplating Delivery: Futures Trading and
the Problem of Commodity Exchange in the United States, 18751905, 111 AM. HIST. REV. 307,
314 n.29 (2006). Clearinghouses for banknotes developed a few decades earlier. See Gary
Gorton, Clearinghouses and the Origin of Central Banking in the United States, 45 J. ECON. HIST.
277, 278 (1985).
STEPHEN J. LUBBEN, CORPORATE FINANCE 317 (2014).
134
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incurs a liability to the futures market, and the buyer (the long party) acquires
an asset from the market.33
Historically the futures markets were devoted to agricultural and other
similar commodities, and thus were centered in Chicago, the agricultural hub
of the United States.34 Beginning in the 1970s, however, the futures markets
expanded to include contracts based on stock indexes and other securities.
Nonetheless, the basic model remained the same.
The clearinghouse in all cases becomes a central party to each trade,
joining the parties and assuming the obligation of each party so that there is
no counterparty risk between the original buyer and seller.35 In short, once a
futures trade is clearedthat is, matched and confirmedthe clearinghouse
becomes a party to both legs of a trade.36
Either of the original parties can leave the trade without the consent of
their original counterparty, because the original contract is replaced by two
contracts, each with the clearinghouse.37 The two halves of the trade no
longer have any necessary connection, and each party now holds one of many
fungible contracts with the clearinghouse.
Given this setup, the clearinghouse would not be long for this world if it
did not take steps to prevent being left holding the bag.38 And in the more

33
34
35
36
37
38
Lester G. Telser & Harlow N. Higginbotham, Organized Futures Markets: Costs and Benefits,
85 J. POL. ECON. 969, 970 (1977).
See Randall S. Kroszner, Can the Financial Markets Privately Regulate Risk?: The Development of
Derivatives Clearinghouses and Recent Over-the-Counter Innovations, 31 J. MONEY, CREDIT &
BANKING 596, 598604 (1999). For a concise overview of this history, see PHILIP
MCBRIDE JOHNSON ET AL., DERIVATIVES REGULATION: 2015 CUMULATIVE SUPPLEMENT
1.19[1] (2015).
For empirical evidence of the reduction in counterparty risk in the swaps context, see Yee
Cheng Loon & Zhaodong Ken Zhong, The Impact of Central Clearing on Counterparty Risk,
Liquidity, and Trading: Evidence From the Credit Default Swap Market, 112 J. FIN. ECON. 91, 92
(2014).
BANK FOR INTL SETTLEMENTS, COMM. ON PAYMENT & SETTLEMENT SYS. & INTL ORG.
OF SEC. COMMNS, PRINCIPLES FOR FINANCIAL MARKET INFRASTRUCTURES 9 (2012)
[hereinafter CPSS-IOSCO PRINCIPLES].
Contracts are terminated by purchasing an equal, offsetting position from the
clearinghouse. Robert R. Bliss & Robert S. Steigerwald, Derivatives Clearing and Settlement:
A Comparison of Central Counterparties and Alternative Structures, ECON. PERSPECTIVES, Nov.
2006,
at
22,
26,
available
at
http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2006/ep
_ 4qtr2006_part2_bliss_steigerwald.pdf. The authors argue that this increases liquidity in
the market, since positions are not subject to lengthy renegotiation.
See 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, 62
(2011).
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135
than century-long history of clearinghouses, several routine tools have been

developed to reduce the risk to the clearinghouse.
On the front end, the clearinghouse has membership requirements. 39
Every clearing model currently in use permits access to the clearinghouse only
by or through members of the clearinghouse. That is, the clearinghouse
limits membership to certain financial institutions that meet set requirements,
and everyone else who wants to trade on the clearinghouse must do so
through a member.
These membership requirements are typically
substantially higher than the requirements for membership in an underlying
trading market.40
The clearinghouse screens its members, and the members then screen
their customers. 41 Ideally. But at the very least, the members will be
responsible for any performance lapses of its customers, so the clearinghouse
is protected from most routine problems.
Next, members have to post margin (collateral) to vouch for their
performance on trades conducted through a clearinghouse.42
For example, imagine a member broker-dealers trading desk43 takes a
long position in four hundred S&P 500 futures contracts. For simplicity,
assume the index is at 1,000, so that this position represents $100 million in
exposure to the S&P 500 index,44 and the member will typically have to post
5% margin to open this position, or $5 million. This initial margin will
typically take the form of Treasury or other high-quality securities.45

39
40
41
42
43
44
45
Bliss & Steigerwald, supra note 37, at 25.

2 PHILIP MCBRIDE JOHNSON & THOMAS LEE HAZEN, DERIVATIVES REGULATION
3.09[5] (2004).
See Customer Clearing Documentation, Timing of Acceptance for Clearing, and Clearing
Member Risk Management, 77 C.F.R. 21,278, 21,278 (Apr. 9, 2012) (to be codified at 17
C.F.R. pts. 1, 23, 37, 38, 39).
David S. Bates & Roger Craine, Valuing the Futures Market Clearinghouses Default Exposure
During the Crash of 1987, 31 J. MONEY, CREDIT & BANKING 248, 248 (1999) (The margin
system is the clearinghouses first line of defense against default risk.).
Ignore the future effects of the Volker Rule for purposes of the example. Brokermembers are referred to as futures commission merchants, or FCMs in the CFTC
world. See 17 C.F.R. 255.6 (2014). But I continue to use broker, dealer, or
member for readability in the text.
Each contract represents $250 multiplied by the index value.
CME accepts Treasuries, agencies, certain sovereign debt, gold, select S&P 500 shares,
letters of credit, and of course, cash. The clearinghouse has various concentration and
diversification limits with regard to the margin, and cash that is not in USD is sometimes
subject to a haircut (reduction in crediting value). Brokers might accept margin that
would be unacceptable to the clearinghouse, and thus provide their customers with a
service by transforming the margin into an acceptable form. Laura Dicioccio & Christian
136
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Moreover, trades are subject to daily settlement payments, called

variation margin, so that the margin account remains at 5% in all cases, and
the clearinghouse never faces more than one days trading exposure. If, for
example, the index goes down by 200 points one day, at the end of that day
the broker will have to provide the clearinghouse with $20 million.46
If the broker fails to provide these funds, the position will be taken over
by the clearinghouse, and the clearinghouse will attempt to recoup losses
from the member.47 Note that before this default, the clearinghouse had a
net market exposure of zero: the long and short positions in the S&P 500
index cancelled out.48 Its only exposure was to the credit risk of its members.
After the default, the clearinghouse takes on the long positionthat is,
until the clearinghouse is able to remedy the situation, it holds a directional
bet in the market.49 In times of financial stress, there may be few clearing
members who are capable of executing a covering transaction that will relieve
the clearinghouse of its predicament, and those members will have strong
incentives to price the transaction assertively, since the clearinghouse must act
quickly.
Because the clearinghouse only holds $5 million in initial margin in this
example, the clearinghouse faces a $15 million loss if the broker-dealer cannot
or will not pay. Nonetheless, the counterparty to the trade, who is short the
S&P 500 index, will receive its full $20 million of variation margin from the
clearinghouse. From its perspective, the fate of its original counterparty
ceased to matter the moment its trade was accepted by the clearinghouse.
If the dealer fails to pay, the clearinghouse will turn to its next risk
reduction feature, the default fund. Each member of the clearinghouse is
required to contribute to a general fund that protects the clearinghouse from
default. Contributions are based on the size of the members positions and

46
47
48
49
Johnson, A Primer on Clearing OTC Derivatives: A Buyside Blueprint for Implementation, 33 No.
6 FUTURES & DERIVATIVES L. REP. 9, 12 (2013).
$50,000 loss per contract 400 contracts.
CME GROUP, NYMEX RULEBOOK R. 802.A.1 (2009). Specifically, in the period
following a default, the clearinghouse will attempt to return to a matched book by
entering into offsetting transactions or by holding an auction of the defaulters positions.
Id. R. 802.A.2.
See Anupam Chander & Randall Costa, Clearing Credit Default Swaps: A Case Study in Global
Legal Convergence, 10 CHI. J. INTL L. 639, 67677 (2010).
CPSS-IOSCO PRINCIPLES, supra note 36, at 42 ([D]uring the period in which a CCP
neutralises or closes out a position following the default of a participant, the market value
of the position or asset being cleared may change, which could increase the CCPs credit
exposure, potentially significantly. A CCP can also face potential future exposure due to
the potential for collateral (initial margin) to decline significantly in value over the closeout period.).
10:127 (2015)
137
an evaluation of the risk of those positions. Thus, in this example, the

clearinghouse would first seek to recoup losses from the defaulting members
contribution to the fund, and next from the fund generally.50
This is sometimes the basis of claims that clearinghouses mutualize losses
among members. 51 But that is not quite correct, or at least it is
oversimplified. As Craig Pirrong explains:
Clearinghouses use margins to limit the amount of risk
that is mutualized. Only losses on defaulted positions in
excess of margin posted by the defaulter are mutualized.
The higher the margin cover, the lower the level of risk
sharing.
In practice, CCPs utilize a defaulter pays model in
which margin covers losses on defaulted positions with
extremely high probability, e.g., 99.7 percent of the time. In
a defaulter pays model, the amount of risk mutualization is
very low. CCPs are not, therefore, primarily an insurance
mechanism. They insure only tail risks (which has important
implications for systemic risk and wrong way risk).52
According to CMEs53 own literature, its fund is designed to withstand
the default of its largest single member. Contributions to the default fund are
set at the following:
the greater of $500,000 or the results of a formula under
which 95 percent of the total requirement is based on the
Clearing Members proportionate contribution to aggregate
risk performance bond requirements over the prior three
months and the remaining 5 percent is based on the clearing
members contribution to risk-weighted transaction activity
over the prior three months.54
In the example explored herein, involving the failure of a single, relatively
small trade, that would likely be the end of the matter. In more significant

50
51
52
53
54
Richard Squire, Clearinghouses as Liquidity Partitioning, 99 CORNELL L. REV. 857, 871 (2014).
Id. See also Sean J. Griffith, Substituted Compliance and Systemic Risk: How to Make a Global
Market in Derivatives Regulation, 98 MINN. L. REV. 1291, 1316 (2014); Roe, supra note 4, at
167475; Houman B. Shadab, Credit Risk Transfer Governance: The Good, the Bad, and the
Savvy, 42 SETON HALL L. REV. 1009, 1044 (2012).
Craig Pirrong, Moral Hazard, Defaulter Pays, and the Relative Costs of Cleared and Uncleared
Derivatives Trades, STREETWISE PROFESSOR (Oct. 28, 2013, 3:38 PM),
http://streetwiseprofessor.com/?p=7757.
Chicago Mercantile Exchange Group (CME).
CME GROUP, CME CLEARING: FINANCIAL SAFEGUARDS 23 (2012), available at
http://www.cmegroup.com/market-regulation/files/14-254_App1D.pdf.
138
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situations, in theory the clearinghouse would next turn to its members capital
contribution commitments.55
That is, if the problem were severe enough to deplete the fund, the
clearinghouse has some ability to replenish the fund through capital
contributions.56 Typically these capital contributions would at least allow the
clearinghouse to recreate its default fundalthough the ability to do so is
subject to some degree of counterparty risk, in that a member might struggle
to meet its obligations, especially in times of financial stress.57
Since most clearinghouses are now publicly traded, the clearinghouse also
has its own capital to fall back upon. For example, existing shareholders
could be heavily diluted by a new equity offering, or subordinated by the sale
of preferred shares. Undistributed shareholder surplus could also be used to
fund some degree of losses.
In the example above, a member was directly trading with the
clearinghouse. Most often, it is a members customer who will be trading
with the clearinghouse, but in general the process works the same. In the
United States, the addition of the customer to the transaction means that the
member acts as an agent and guarantor for the customer. The member
collects margin from the customer and passes it on to the clearinghouse,
while providing the clearinghouse with an additional source of recovery if the
customer fails to perform on a trade.
In the futures market, customer margin must be segregated from a
brokers own house account margin, but the broker can commingle all of its
customers collateral in a single, omnibus account at the clearinghouse. 58
Under this model, the clearinghouse does not know individual customers
positions, and there is some risk that a defaulting customer, who causes
financial distress to his broker, will also impose losses on fellow customers.59

55
56
57
58
59
As discussed, infra, there are good reasons to doubt the utility of these provisions in times
of systemic stress.
CME GROUP, supra note 47, R. 802.F (In the event it shall become necessary to apply all
or part of the Base Guaranty Fund contributions to meet obligations to the Clearing
House pursuant to this Rule 802, clearing members shall restore their contribution to the
Base Guaranty Fund to the previously required level prior to the close of business on the
next banking day.).
This issue is discussed in its broader context in Part IV.
Customers Before and After Commodity Broker Bankruptcies, 75 Fed. Reg. 75,162,
75,16263 (Dec. 2, 2010) (to be codified at 17 C.F.R. pt. 190). See also Andrea M.
Corcoran & Susan C. Ervin, Maintenance of Market Strategies in Futures Broker Insolvencies:
Futures Position Transfers from Troubled Firms, 44 WASH. & LEE L. REV. 849, 866 (1987);
Grede v. FCStone, LLC, 746 F.3d 244, 24748 (7th Cir. 2014).
James V. Jordan & George Emir Morgan, Default Risk in Futures Markets: The CustomerBroker Relationship, 45 J. FIN. 909, 910 (1990). See also Protection of Cleared Swaps
10:127 (2015)
139
The clearinghouse cuts its own risk of default, in situations where a

member defaults, by maintaining revolving credit lines at major financial
institutions. Indeed, as the foregoing example illustrates, the clearinghouses
own solvency is closely tied to its liquidity. It must be able to perform on the
non-defaulted leg of a trade, or the benefits of central clearing are lost.
In addition to maintaining a credit line at a major financial institution, the
clearinghouses margin is also held by one or more custodian banks. Given
that the financial institutions that are apt to provide the credit lines and
custodian services to the clearinghouse are also apt to be members of the
clearinghouse, certain member defaults could be more painful than others.
II. CLEARINGHOUSES AND DODD-FRANK
It is this basic model that Dodd-Frank extends to the broader derivatives
market, most notably the over-the-counter (OTC) part of the market.60
OTC derivatives are commonly termed swaps although, strictly
speaking, swaps are only those contracts that are exempt from the
Commodity Exchange Act under section 2(g) thereof.61 More precisely, an
OTC derivative can refer to any trade that (before Dodd-Frank) was not
executed through a regulated exchange, and that was exempt from most
provisions of the federal securities and commodities laws.
A small number of very large broker-dealers make the market in OTC
derivatives globally. That is, these big brokers-dealers are parties to the vast
bulk of OTC contracts outstanding, typically with a customer-counterparty
taking the other side of a trade.
The key difference between futures and swaps is that, until recently,
swaps involved a direct contractual relationship between the parties to a trade,
and thus exposed the parties to risk of nonperformance that varied with each
counterparty. These contracts benefited from reduced cost and theoretically
greater tailoring to the needs of the parties, although the frequent use of
standardized documents provided by ISDA might call the latter benefits into
question.
60
61
Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker

Bankruptcy Provisions, 77 Fed. Reg. 6336, 6336, 633839 (Feb. 7, 2012) (to be codified at
17 C.F.R. pts. 22, 190).
See Gabriel D. Rosenberg & Jai R. Massari, Regulation Through Substitution as Policy Tool: Swap
Futurization Under Dodd-Frank, 2013 COLUM. BUS. L. REV. 667, 68992 (2013).
See generally Commodity Exchange Act 2(g), 7 U.S.C. 2(g) (2012).
140
10:127 (2015)
Much of the reduced cost of OTC trades may reflect the failure to
adequately manage the risks associated with them.62 But central clearing is
not free. For example, it is anticipated that fees associated with cleared swaps
will include a clearing member fee, a clearinghouse fee, and an execution fee if
the instrument is traded on a swap execution facility. Uncleared swaps are
not subject to such fees.63
For example, a bank might want to reduce its exposure to General
Motors by buying a credit default swap from a dealer.64 Under the contract,
the dealer promises to pay the bank if GM defaults. But if the dealer is
Lehman Brothers, the bank faces counterparty risk, the risk that its
counterparty will fail to live up to its obligations.
Clearinghouses solve this problem by interjecting themselves in the
middle. 65 In the example, the clearinghouse would continue to perform,
leaving the bank largely unconcerned about Lehmans financial woes.
The Dodd-Frank Act requires that standardized swaps clear through a
registered clearinghouse, if a clearinghouse accepts the contract for clearing.66
If a counterparty wishes to enter into a trade involving such a swap, it must
either be cleared or the counterparty must point to a relevant exemption, such
as the exemption for non-financial end users who are hedging.67
Certain types of swaps, like foreign exchange swaps, are also subject to a
wholesale exemption from the clearing requirements of Dodd-Frank. 68

62
63
64
65
66
67
68
Jean Tirole, Illiquidity and All Its Friends, 49 J. ECON. LIT. 287, 309 (2011) ([I]t has become
clear that contracts in OTC markets often have been motivated more by the prospect of
fees and by underpriced capital requirements than by first-order hedging benefits.).
Matthew Leising, Saving World from Swaps Blowup Seen Raising Trade Costs 92-Fold,
BLOOMBERG, Apr. 10, 2014, available at http://www.bloomberg.com/news/2014-0410/saving-world-from-swaps-blowup-seen-raising-trade-costs-92-fold.html.
Stephen J. Lubben, Credit Derivatives and the Future of Chapter 11, 81 AM. BANKR. L.J. 405,
411 (2007).
See Tirole, supra note 62, at 30708.
Dodd-Frank Wall Street Reform & Consumer Protection Act, Pub. L. No. 111-203,
724(a), 124 Stat. 1376, 1682 (2010).
Commodity Exchange Act 2(h)(7)(8), 7 U.S.C. 2(h)(7)(8) (2012); End-User
Exception to the Clearing Requirement for Swaps, 77 Fed. Reg. 42,560, 42,560 (July 19,
2012) (to be codified at 17 C.F.R. pts. 39, 50). See also Ed Nosal, Clearing Over-the-Counter
Derivatives, ECON. PERSPECTIVES, Oct. 2011, at 137, 145, available at
http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2011/4q
tr2011_part1_nosal.pdf (arguing against the end-user exemption) (Nonfinancial
corporate end-users represent a relatively large share of the OTC market, 10 percent to 15
percent. If these firms receive a correlated shock that weakens their ability to perform,
they may transmit this adverse shock to the balance sheets of the dealers.).
On November 16, 2012, the U.S. Department of the Treasury announced that the central
clearing and exchange trading requirements would not apply to FX swaps and forwards.
Press Release, U.S. Dept. of the Treasury, Fact Sheet: Final Determination on Foreign
10:127 (2015)
141
Options and futures on physical commodities are also technically exempt

from clearing under Dodd-Frank, but as noted in the prior section, these
trades were already subject to clearing long before Dodd-Frank was enacted.
In 2013, clearing began for trades in index-based CDS and interest rate
swaps. 69 According to ISDA, as of late 2014 more than two-thirds of
outstanding interest rate derivatives have been centrally cleared. 70 The
CFTC expects to extend the clearing requirement to other trades in the near
future.71
The clearinghouses themselves are divided between derivatives clearing
organizations (DCOs), regulated by the CFTC, and securities clearing
agencies (SCAs), regulated by the SEC.72 But in general, the regulation of
the clearinghouse, for now, appears to be quite similar.
The market is also heavily concentrated, as commentators have noted:
The global market structure of the provision of clearing
services is monopolistic within a number of risk or product
classes. Global clearing of OTC-interest rate products
occurs almost exclusively through the SwapClear subsidiary
of the U.K., CCP LCH.Clearnet. And, global clearing of
OTC-CDS is dominated by the CCP InterContinental
Exchanges (ICE) U.S. and U.K. subsidiaries, ICE Clear
Credit and ICE Clear Europe.

69
70
71
72
Exchange
Swaps
and
Forwards
(Nov.
16,
2012),
available
at
http://www.treasury.gov/press-center/press-releases/Pages/tg1773.aspx.
See Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg.
74,284, 74,33536 (Dec. 13, 2012) (to be codified at 17 C.F.R. pts. 39, 50) (adopting final
rules specifying mandatory clearing requirements for four classes of interest rate swaps
and two classes of credit default swaps).
ISDA, supra note 14, at 1.
The CEA provides the CFTC with exclusive jurisdiction over, among other things, U.S.
commodity futures trading, swaps trading (other than security-based swaps and mixed
swaps), futures exchanges, clearinghouses that clear U.S. futures contracts, swaps,
commodity options and FCMs. The CEA and CFTC rules require all FCMs to register
and become a member of the National Futures Association (NFA), and they also may
be members of one or more designated contract markets (i.e., futures exchanges) and
affiliated clearinghouses. The SEC has jurisdiction over security-based swaps, and the
agencies share jurisdiction over mixed swaps. Dodd-Frank Act 712(a)(8).
For present purposes, the most important class of trades that will be subject to SEC
jurisdiction will be single-name CDS contracts. While the SEC has not published all of its
rules in this area, in general the treatment will be quite similar, and thus I focus on the
CFTC in the text.
The division corresponds to the types of swaps cleared by the clearinghouse. See supra
notes 6971 and accompanying text. Most major swap clearinghouses will likely be
classified as both a DCO and an SCA by the CFTC and the SEC, respectively.
142
10:127 (2015)
The market power of these major CCPs creates

necessary conditions for them to be globally systemic
financial institutions. Since the lions share of these CCPs
risk exposures is to the largest global banks, this also makes
them especially effective shock transmitters. The post-crisis
commitment of the G20 countries to mandate clearing of all
standardized OTC-D trades will, in the absence of a change
to the market structure of global clearing services, serve to
exacerbate the global systemic importance of these CCPs.73
Broadly speaking, in the United States, interest rate swaps are cleared
through LCH.Clearnet and CME Group, and credit default swaps are cleared
through ICE (Intercontinental Exchange) and CME Group.74 That is, the
United States market uses the two major global clearinghouses, supplemented
by CME.
Swaps that are approved for clearing must be traded on a registered
exchange that has been approved by the applicable regulator, unless no
registered exchange accepts the swap for trading.75 In practice, it is common
to subdivide the exchanges into designated contract markets (DCMs), which
include the pre-Dodd-Frank futures exchanges, and swap execution facilities
(SEFs), electronic platforms on which some degree of interest rate swap
trading was already taking place before Dodd-Frank.76
Margining of cleared swap trades under Dodd-Frank is handled
somewhat differently than in the futures world. Namely, under a recently
enacted CFTC rule, brokers and clearinghouses are allowed to commingle all
of a brokers customers collateral in one account. 77 But the broker is
required to provide the clearinghouse with information about the identity of
each of its customers and the amount of cleared swap collateral held at the
clearinghouse and attributable to each customer, on a daily basis.78

73
74
75
76
77
78
Li Lin & Jay Surti, Capital Requirements for Over-the-Counter Derivatives Central Counterparties 5
(Intl Monetary Fund, Working Paper No. 13/3, 2013), available at
http://www.imf.org/external/pubs/ft/wp/2013/wp1303.pdf.
Uncleared swaps will continue to be traded on a bilateral basis with a swap counterparty
under an ISDA Master Agreement between the parties. See Kress, supra note 38, at 71
(describing the end user exemption).
7 U.S.C. 2(h)(8) (2012). Under the Commodities Exchange Act, exchanges are referred
to as boards of trade.
Bloomberg L.P. v. Commodity Futures Trading Commn, 949 F. Supp. 2d 91, 98 (D.D.C.
2013).
17 C.F.R. 22.2(e)(3)(i) (2015).
17 C.F.R. 22.11(e) (2015). See also CPSS-IOSCO PRINCIPLES, supra note 36, at 2
(Principle 14: Segregation and Portability: A CCP should have rules and procedures that
10:127 (2015)
143
This is referred to as the Legally Segregated Operationally Commingled,

or LSOC, model.79 It will protect a non-defaulting customer from the
default of its fellow customers,80 although the customer still faces risk from
operational problems of the broker or the clearinghouse.81
In addition, CFTC rules require swap clearinghouses to collect from
members the initial margin amounts that the clearinghouse would require of
each individual customer within the account if each individual customer were
a clearing member.82 Thus, members are not allowed to setoff customers for
purposes of initial margineach customer must be independently margined.
The Dodd-Frank Act also rejects the close relationship that historically
has existed between futures clearinghouses and specific futures markets. The
Act requires a clearinghouse to accept transactions without regard to the
platform on which they were executed.83
And the CFTC has adopted open access rules that require entities with
net capital of $50 million or greater to be given access to clearinghouses as
members for swap clearing purposes.84 Before the financial crisis, ICE Clear
Credit, the worlds largest credit default swap clearinghouse, had required $5
billion of net capital to become a member.85 ICE Clear Credit LLC itself
reports equity of just under $92 million.86
At the clearinghouse level, CME has chosen to establish separate default
funds for interest rate and credit default swaps, respectively. Thus, upon a
default, the type of underlying trade becomes relevant.87 For example, if a
CME member defaulted on CDS trades to an extent that exceeds available
margin, the clearinghouse would then turn to its CDS fund, which is

79
80
81
82
83
84
85
86
87
enable the segregation and portability of positions of a participants customers and the
collateral provided to the CCP with respect to those positions.).
See Protection of Cleared Swaps Customer Contracts and Collateral; Conforming
Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. at 6339.
See 17 C.F.R. 22.2(d)(1) (2015).
Protection of Cleared Swaps Contracts and Collateral; Conforming Amendments to the
Commodity Broker Bankruptcy Provisions, 76 Fed. Reg. 33,818, 33,826 n.72 (June 9,
2011) (to be codified at 17 C.F.R. pts. 22, 190).
17 C.F.R. 39.13(g)(8)(i) (2015).
See 7 U.S.C. 2(h)(1)(B) (2012).
17 C.F.R 39.12(a)(2)(iii) (2015).
Silla Brush & Matthew Leising, CFTC Approves Rule Expanding Access to Swaps
Clearinghouses,
BLOOMBERG
BUS.
(Oct.
18,
2011),
http://www.bloomberg.com/news/2011-10-18/cftc-may-complete-rule-broadeningaccess-to-swaps-clearinghouses.html.
ICE CLEAR CREDIT LLC, FINANCIAL STATEMENTS 3 (2013), available at
https://www.theice.com/publicdocs/regulatory_filings/ICC_FinancialStatement.pdf.
It is not clear that these divisions would be respected if the clearinghouse were placed into
a resolution process like bankruptcy or OLA.
144
10:127 (2015)
comprised of $650 billion in member fund contributions and $50 billion of

CMEs own capital.88 This fund is designed to cover the largest theoretical
aggregate losses caused by the default of any two CDS Clearing Members.89
Should the unmargined loss exceed the fund, CME would then proceed
to assess its CDS members.90 Under its rules, the total assessment will be
equal to the largest theoretical aggregate losses caused by the default of any
two CDS Clearing Members, but this time excluding the two members that
were the subject of the creation of the original default fund. Thus, if we
assume the default fund was created to protect against the default of the two
largest dealers, the assessment will generate a new fund that will be somewhat
smaller, protecting against the default of dealers three and four.
What would happen next? CME cryptically explains: Should the
applicable financial safeguard package be exhausted, beyond maximum
assessment powers, the terms of Rule 818 Close-Out Netting would apply.91
Presumably this is a reference to CME Rule 818.C, which provides for a
closeout and setoff of positions following a bankruptcy or insolvency of the
exchange.92 Its connection to a default of the clearinghouse, as distinct from
the exchange, is somewhat unclear, but apparently CME intends for all
members, and their customers, to face a realization event at this point. The
implications of that for the broader issue of systemic risk are addressed in
Part IV.

88
89
90
91
92
For current numbers, see CME GROUP, CME CLEARINGS FINANCIAL SAFEGUARDS
SYSTEM (2015), available at http://www.cmegroup.com/clearing/cme-clearingoverview/safeguards.html.
CME GROUP, CME RULEBOOK R. 8H07.1(i)(a) (2015), available
at
https://www.cmegroup.com/rulebook/CME/I/8H/8H.pdf.
See also CPSS-IOSCO
PRINCIPLES, supra note 36, at 1 (Principle 4: [A] CCP that is involved in activities with a
more-complex risk profile or that is systemically important in multiple jurisdictions should
maintain additional financial resources sufficient to cover a wide range of potential stress
scenarios that should include, but not be limited to, the default of the two participants and
their affiliates that would potentially cause the largest aggregate credit exposure to the
CCP in extreme but plausible market conditions.).
Membership can be had in some or all of the three basic categories (futures and other
traditional products, CDS, and interest rate swaps).
CME GROUP, supra note 54, at 16.
In this case, Exchange is defined as Chicago Mercantile Exchange Inc. CME GROUP,
DEFINITIONS
(2015),
available
at
http://www.cmegroup.com/rulebook/files/CME_Definitions.pdf.
10:127 (2015)
145
III. DODD-FRANK TITLE VIII

As evident from the prior example, clearinghouses are highly dependent
on their ability to properly set margin levels. At CME, if margin is
insufficient in its CDS clearing operation, it can survive, at most, two major
member defaults before it will need to extract funds from its remaining
members. Even assuming that is possible, the assessment process can only
absorb, at most, two more defaults before the process grinds to a halt. 93
In short, a clearinghouse is particularly vulnerable to systemic crisis, and
thus there is a strong need for prudential regulation that might prevent such a
scenario.
Congress, for all its faults, was not totally oblivious in this regard, and
hence it enacted the Payment, Clearing, and Settlement Supervision Act of
2010 (Dodd-Frank title VIII).94
This introduces the term financial market utility (FMU) for those
multilateral systems that transfer, clear, or settle payments, securities, or other
financial transactions among financial institutions. Dodd-Frank does not
apply to every single payment or clearance system that fits the definition of an
FMU; it only applies to systemically important FMUs.95
In the context of FMUs, Dodd-Frank title VIII defines systemically
important and systemic importance by the following description: a
situation where the failure of or a disruption to the functioning of a financial
market utility . . . could create, or increase, the risk of significant liquidity or
credit problems spreading among financial institutions or markets and thereby
threaten the stability of the financial system of the United States.
Accordingly, on July 18, 2012, the Financial Stability Oversight Council
designated eight FMUs as systemically important under title VIII of DoddFrank.96 Five of the designated FMUs are clearinghouses:
Chicago Mercantile Exchange, Inc.
Fixed Income Clearing Corporation

93
94
95
96
Admittedly, the CDS waterfall is smaller than some others at CME. The largest
separate waterfall, the base waterfall (covering all futures, and swaps other than interest
rate swaps and CDS), has an assessment power of 275% of the prefunded contribution of
each member for one default, and 550% of the prefunded contribution of each member
for two or more defaults within a cooling off period.
Dodd-Frank Act 802, 12 U.S.C. 5461 (2012).
Baker, supra note 6, at 107.
Dodd-Frank Act 803, 12 U.S.C. 5462(9) (2012). See also Press Release, Sec. & Exch.
Commn, Financial Stability Oversight Council Makes First Designations in Effort to
Protect Against Future Financial Crises (July 18, 2012), available at
http://www.treasury.gov/press-center/press-releases/Pages/tg1645.aspx.
146
10:127 (2015)
ICE Clear Credit LLC

National Securities Clearing Corporation
The Options Clearing Corporation
FMUs that have been designated are then subject to enhanced regulation
by a federal supervisory agency, which can be the SEC, the CFTC, the Board
of Governors of the Federal Reserve System, or another financial-institution
supervisor.97 For a designated FMU that is regulated by both the SEC, as a
clearing agency (CA), and by the CFTC, as a derivatives clearing organization
(DCO), only one of these agencies will be the supervisory agency under
Dodd-Frank. The Act directs the SEC and CFTC to determine which agency
is the supervisory agency for each clearing agency; if the agencies are unable
to agree, FSOC decides the issue.98
Both the SEC and the CFTC are directed to promote additional
prudential requirements for systemically important clearing agencies.99 Under
this authority, the agencies may enforce the Act with respect to a systemically
important clearinghouse using the tools provided in section 8(b)(n) of the
Federal Deposit Insurance Act. 100 This will permit the agencies to use
administrative cease-and-desist proceedings and bar individual systemically
important clearinghouse officers and employees from continuing in their
roles, in instances where the CFTC or SEC has reasonable cause to believe
the systemically important clearinghouse is about to engage in a practice that
is unsafe or unsound, or violates any applicable law or regulation.101
If the Fed determines that the agencies prudential requirements are
insufficient, it may recommend new risk management standards for SEC or
CFTC adoption. 102 If the agencies disagree with the recommendation,
FSOCby a two-thirds votemay require them to adopt the new standards
recommended by the Fed. In short, the Fed backstops the agencies
traditional regulation of the clearinghouses.103
The Act authorizes the Fed to participate in the examinations of
designated FMUs for which the Fed is not the supervisory agency.104 And it

97
98
99
100
101
102
103
104
12 U.S.C. 5462(8) (2012).

12 U.S.C. 5462(8)(B).
Dodd-Frank Act 805, 12 U.S.C. 5464(a)(2) (2012). See also Enhanced Risk
Management Standards for Systemically Important Derivatives Clearing Organizations, 78
Fed. Reg. 49,663, 49,66566 (Aug. 15, 2013) (to be codified at 17 C.F.R. pt. 39).
12 U.S.C. 5466(c) (2012); see also 12 U.S.C. 1818(b)(n) (2012).
Enhanced Risk Management Standards for Systemically Important Derivatives Clearing
Organizations, 78 Fed. Reg. at 49,674; see also 12 U.S.C. 1818(b)(1) (2012).
12 U.S.C. 5464(a)(2)(B).
See Dodd-Frank 811, 12 U.S.C. 5470 (2012).
12 U.S.C. 5466(a), (d).
10:127 (2015)
147
grants the regulators the power to make any rules necessary to properly carry
out their duties, a very broad grant of rulemaking authority.105
Section 806 authorizes the Fed to provide systemically important FMUs
with Federal Reserve Bank services that are traditionally only available to
depository institutions.106 This will allow designated utilities to have the same
accounts at Federal Reserve Banks as those provided to depository
institutions.107 Having an account at the Fed might reduce a clearinghouses
dependence on other important pieces of financial infrastructure, and it
obviously avoids the problem of the clearinghouses cash becoming involved
in the insolvency process that results from a key members failure.
Under this section, the Fed may authorize a Federal Reserve Bank to
provide a designated utility with discount and borrowing privileges, pursuant
to section 10B of the Federal Reserve Act. 108 But such authorization is
permitted only in unusual or exigent circumstances, and only upon majority
vote of the Fed, after consultation with the Secretary of the Treasury.109
Accordingly, the utility would have to show that it is unable to secure
adequate credit accommodations from other banking institutions, a
requirement somewhat akin to the Bankruptcy Codes provisions for chapter
11 DIP loans.110
The procedural mechanics of lending under this provision remain to be
developed, but since the statute expressly refers to section 10B, it would seem
that the Federal Reserve Banks, when authorized, may extend secured credit
to clearinghouses.111 Given the context in which this lending might be used,
it might often be appropriate to treat advances under this provision as
secondary credit, which would then be priced at a premium to the discount
rate.112 In light of the post-Dodd-Frank limitations on the Federal Reserves

105
106
107
108
109
110
111
112
12 U.S.C. 5469 (2012).

12 U.S.C. 5465(a) (2012).
A recent rule recognizes that the possible extension of Federal Reserve accounts and
services to designated FMUs presents credit, settlement and other risks to the Federal
Reserve Banks. Financial Market Utilities, 78 Fed. Reg. 76,973, 76, 97578 (Dec. 20,
2013) (to be codified at 12 C.F.R. pt. 234).
12 U.S.C. 347b (2012).
12 U.S.C. 5465(b).
11 U.S.C. 364(c)(d) (2012). More directly, it also tracks the 1991 version of section
13(3) of the Federal Reserve Act. See 12 U.S.C. 343 (2012).
See 12 C.F.R. 201.3(a) (2010). See also Kathryn Judge, Three Discount Windows, 99
CORNELL L. REV. 795, 80910 (2014).
12 C.F.R. 201.4(b) (2007). For a description of secondary credit and the current
interest rates, see FED. RESERVE DISCOUNT WINDOW, DISCOUNT WINDOW BOOK (2015),
available
at
www.frbdiscountwindow.org/discountwindowbook.cfm?hdrID=14&dtlID=43.
148
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13(3) emergency lending powers, this provision might have important

implications, as discussed in Part IV below.
This part of Dodd-Frank also provides that clearinghouses must provide
their lead supervisory agency with 60 days advance notice of a proposed
change that could materially affect the nature or level of risks presented by
the utility. 113 If the agency objects within 60 days, the utility may not
implement the change. However, a designated utility may implement changes
on an emergency basis, in order for the utility to provide its services in a safe
and sound manner.
In short, Dodd-Frank provides an important basis for ex ante prudential
regulation of clearinghouses, combined with rulemaking and lending powers
that might be especially important in addressing financial distress at the
clearinghouse. The next section considers these issues in the broader context
of the collapse of a systemically important FMU.
IV. CLEARINGHOUSES IN DISTRESS
As publicly traded companies answerable to shareholders, clearinghouses,
like all financial institutions, have incentives to undercapitalize.114 Indeed,
industry participants have recently noted that clearinghouses are relatively
thinly capitalized in comparison with their SIFI counterparts.115 Members
who may have effective control over the clearinghouse also have incentives to
push for reduced margin and default fund contribution requirements.116 In
short, despite the best efforts of regulators, a clearinghouse might be
fragile.117

113
114
115
116
117
12 U.S.C. 5465(e) (2012). The Fed recently adopted Regulation HH to implement these
provisions. Regulation HH 234.5 defines and describes changes that the Fed considers
to be material and thus subject to its review. 12 C.F.R. 234.5(b) (2014).
See Michael Simkovic, Competition and Crisis in Mortgage Securitization, 88 IND. L.J. 213, 216
(2013).
Lukas Becker & Cecile Sourbes, UniCredits Mustier Frightened by CCP Capital Levels, RISK
MAGAZINE
(Apr.
9,
2014),
http://www.risk.net/riskmagazine/news/2338899/unicredits-mustier-frightened-by-ccp-capital-levels
(UniCredits head of corporate and investment banking is frightened by the low capital
levels at central counterparties (CCPs) such as Eurex and LCH.Clearnet and has suggested
that users should either provide unlimited contingent funding for CCPs or that clearing
should not be run for profit at all.).
See Michael Greenberger, Diversifying Clearinghouse Ownership in Order to Safeguard Free and
Open Access to the Derivatives Clearing Market, 18 FORDHAM J. CORP. & FIN. L. 245, 251
(2013).
Johnson, supra note 1, at 227.
10:127 (2015)
149
Clearinghouses have external insurance mechanisms to protect against

failure. These take the form of either capital contribution obligations of
members, or formal insurance policies.118 Both link the clearinghouse to
other SIFIs, and thus present a potential transmission mechanism for
financial distress.
Moreover, both expose the clearinghouse to counterparty risk, which
could arise either from a direct default by the counterparty, or a default
triggered by regulatory pressures at the counterparty. For example, if a major
broker-dealer would be rendered insolvent by its performance on a
clearinghouse capital call, would its regulator allow the payment? If the
clearinghouse is in one jurisdiction, but the financial institution is in another,
these concerns become even more extreme.119
Because the clearinghouse maintains a net zero position in the market it
clears and, given market concentration, likely has an ability to price its services
above its costs, clearinghouses are unlikely to experience financial distress as
the result of a slow erosion of their business. Instead, the two most likely
causes of financial distress in the clearinghouse are the failure of one or more
members120 or a major operational failure.121
Given events of still-recent memory, it would be easy enough to imagine
that two, three, or four large broker-dealers might fail simultaneously, or in
rapid succession. If the clearinghouse faced losses in excess of the default
fund and its ability to recapitalize the same, what would happen next?122
The SEC recently proposed a rule that would force the clearing agencies
it regulates to answer that question.123 The difficulty with such planning, at

118
119
120
121
122
123
Matthew Leising, Catastrophe Prevention Drives Insurance Pitch to Clearinghouse, BLOOMBERG

BUS. (Mar. 11, 2014), http://www.bloomberg.com/news/2014-03-11/catastropheprevention-drives-insurance-pitch-to-clearinghouses.html.
See Stephen J. Lubben & Sarah Pei Woo, Reconceptualizing Lehman, 49 TEX. INTL L.J. 297,
32223 (2014).
Colleen Baker, The Federal Reserves Supporting Role Behind Dodd-Franks Clearinghouse Reforms,
3 HARV. BUS. L. REV. ONLINE 177, 180 (2013), http://www.hblr.org/?p=3283.
Cf. Huberto M. Ennis & David A. Price, Discount Window Lending: Policy Trade-Offs and the
1985 BoNY Computer Failure, FED. RESERVE BANK OF RICHMOND (2015), available at
https://www.richmondfed.org/publications/research/economic_brief/2015/pdf/eb_1505.pdf. In general, the full default waterfall is not available to cover such losses; rather,
the clearinghouse must rely on its own capital. But other than the reduction of assets to
avoid insolvency, the basic problem remains the same.
See CPSS-IOSCO PRINCIPLES, supra note 36, at 35 (A CCP should determine and test
regularly the sufficiency of its financial resources to cover its current and potential future
exposures by rigorous backtesting and stress testing.).
SEC. & EXCH. COMMN, PROPOSED RULE: STANDARDS FOR COVERED CLEARING
AGENCIES 142 (proposed (May 27, 2014)) (to be codified at 17 C.F.R. pt. 240) (17Ad22(e)(13)), available at http://www.sec.gov/rules/proposed/2014/34-71699.pdf.
150
10:127 (2015)
present, is that there is no obvious legal mechanism for resolving a

clearinghouse in financial distress, 124 and many of the stated plans seem
mostly designed to highlight the too big to fail status of the clearinghouses.
The most obvious tool for addressing a distressed clearinghouse is the
new orderly liquidation authority under the Dodd-Frank Act. Indeed, many
have assumed that OLA applies to clearinghouses.125 But a close reading of
Dodd-Frank indicates otherwise.
OLA applies to covered financial companies, which are defined as
financial companies that have been the subject of a decision to invoke
OLA, under the intricate process provided, but not including insured
banks.126 Financial companies are in turn comprised of the following:
1. Bank holding companies
2. A nonbank financial company supervised by the Board of
Governors
3. [A]ny company that is predominantly engaged in activities
that the Board of Governors has determined are financial in
nature or incidental thereto for purposes of section 1843(k)
of [title 12].127
Clearinghouses are not bank holding companies, and are also not
included on the list of financial activities kept under section 4(k) of the
Federal Reserve Act. 128 If the provision was intended to incorporate
Regulation Ythe current source of the list of financial activitiesthen
clearinghouses are expressly outside of OLA.

124
125
126
127
128
This is in contrast to the United Kingdom, where the Bank of England recently obtained
such authority as part of the recent revision to Britains regulatory scheme. E. Murphy &
S. Senior, Changes to the Bank of England, 53 BANK OF ENG. Q. BULL., no.1, 2013, at 23, 25.
See Allen, supra note 8, at 1101.
12 U.S.C. 5381(8) (2012).
12 U.S.C. 5381(11). Section 1843(k) of title 12 is more commonly referred to as section
4(k) of the Federal Reserve Act.
See 12 C.F.R. 225.85(a)(1)(2) (2005). Presumably the Fed could amend the list, but as
discussed herein, there might be little point in putting a clearinghouse into OLA, and
doing so would arguably conflict with the apparent intent of Dodd-Frank. Moreover,
adding a clearinghouse to the list would at least open the door to the possible ownership
of a clearinghouse by a financial holding company, although the Fed has other tools to
prevent that from happening. Cf. 15 U.S.C. 8323(a) (2012) (conferring on the CFTC the
power to adopt limits on the control of, or the voting rights with respect to, any
derivatives clearing organization that clears swaps, or swap execution facility or board of
trade designated as a contract market that posts swaps or makes swaps available for
trading, by a bank holding company . . . with total consolidated assets of $50,000,000,000
or more).
10:127 (2015)
151
It could be argued, however, that this is not an express reference to

Regulation Y, but rather to a more abstract determination by the Fed under
section 4(k) of the Federal Reserve Act. The statute is ambiguous in this
regard, but if this latter interpretation were adopted, then a clearinghouse
certainly, in the abstract, seems to engage in activities that are financial in
nature.
But putting a clearinghouse into OLA would place the FDIC in charge of
the clearinghouse, despite the FDICs complete lack of involvement in the
regulation of clearinghouses under Dodd-Frank.129 And the CFTC is given
no role in triggering an OLA proceedingindeed, it goes unmentioned in
OLA entirelydespite its central role in regulating clearinghouses, and in
regulating the OTC market more generally.130 Both indicate that Congress
never intended OLA to apply to clearinghouses regulated under Dodd-Frank.
Thus, we turn to the question of whether a clearinghouse is a nonbank
financial company supervised by the Board of Governors.
That seemingly straightforward phrase is defined in title II, but the
definition sends us to title I.131 Once in title I, we are told that the term
nonbank financial company supervised by the Board of Governors means a
nonbank financial company that the Council has determined under section
5323 of this title shall be supervised by the Board of Governors.132
That presents two obvious problems. First, clearinghouses have been
designated systemically important under section 5462 rather than under
section 5323.133 Thus, to be eligible for OLA, the clearinghouse would have
to have been designated under title I, and not under title VIII, of DoddFrank.
Second, designating a clearinghouse under title I would undermine the
very structure of title VIII, inasmuch as title VIII is deliberately meant to
leave the SEC and the CFTC in charge of overseeing the clearinghouses, with
the Fed acting as a rampart. 134 The Fed does not habitually oversee
clearinghouses, and changing that reality would require FSOC to ignore the
obvious intent of title VIII.

129
130
131
132
133
134
See Stephen J. Lubben, Resolution, Orderly and Otherwise: B of A in OLA, 81 U. CIN. L. REV.
485, 508 (2012).
In every other instance, title II gives the financial institutions main regulator a vote on
whether to put the institution into OLA. E.g., 12 U.S.C. 5383(a)(1)(A)(C) (2012).
12 U.S.C. 5381(15).
12 U.S.C. 5311(a)(4)(D) (2012).
Compare 12 U.S.C. 5462 (2012), with 12 U.S.C. 5323 (2012).
See 12 U.S.C. 5464(a)(2) (2012); see also BD. OF GOVERNORS OF THE FED. RESERVE SYS.
ET AL., RISK MANAGEMENT SUPERVISION OF DESIGNATED CLEARING ENTITIES 35
(2011), available at http://www.sec.gov/news/studies/2011/813study.pdf.
152
10:127 (2015)
That leaves the generally applicable provisions of the Bankruptcy Code.

There is no legal reason to bar a clearinghouse from bankruptcy court.135 But
the so-called safe harbors provide a practical impediment to the use of the
Bankruptcy Code.136
These provisions exempt derivatives and securities trades, and their
associated margin, from three key provisions of the Bankruptcy Codethe
automatic stay, the assumption and rejection power, and the various
avoidance powers. 137 And without securities and derivatives contracts in
place, there will be little left to reorganize at a clearinghouseassuming
reorganize is the right term for a proceeding that could only happen under
chapter 7 of the Bankruptcy Code.138
Instead of a formal insolvency proceeding, most clearinghouse rules state
that, upon exhaustion of the default fund and any assessment rights, all
contracts will be closed and member positions netted.
Given the
concentration of certain trades in one or two clearinghouses, the sudden
termination of more than half of the index CDS trades, to take one example,
could not help but have systemic effects.139
In Europe, clearinghouses often also provide for reduction of variation
margin payments when the default fund has been fully tapped. For example,
LCH.Clearnet, a key clearinghouse for interest rate swaps, provides for
variation margin payments to be cut by the higher of 100 million or the
amount of the members default fund contribution.140
In essence, the haircutting of margin is simply a capital contribution that
eliminates the counterparty, nonpayment risk to the clearinghouse. This

135
136
137
138
139
140
See 11 U.S.C. 109(a)(c) (2012).

In re Quebecor World (USA) Inc., 453 B.R. 201, 204 (Bankr. S.D.N.Y. 2011), affd, 480
B.R. 468 (S.D.N.Y. 2012), affd, 719 F.3d 94 (2d Cir. 2013).
Stephen J. Lubben, The Bankruptcy Code Without Safe Harbors, 84 AM. BANKR. L.J. 123, 129
(2010).
Under the terms of section 109(d), the clearinghouse would not be allowed into chapter
11. See 11 U.S.C. 101(6), 109(d), 766(i) (2012). Subchapter IV of chapter 7 contains
special provisions for commodity broker liquidation, which would pick up
clearinghouses. See 11 U.S.C. 767 (2012).
STANDARD & POORS, ARE EXCHANGES AND CLEARINGHOUSES TOO BIG TO FAIL? 56
(2010),
available
at
http://www.standardandpoors.com/ratings/articles/en/us/?articleType=PDF&assetID
=1245236164429 (noting the monolithic nature of clearinghouses in the United States
that specialize in a particular product and the unlikelihood that the positions would be
transferable to another clearinghouse).
LCH.CLEARNET,
LIMITED
DEFAULT
RULES
95
(2014),
available
at
http://www.lchclearnet.com/Images/lch%20default%20fund%20rules%20%2030.12.13_tcm6-43735.pdf.
10:127 (2015)
153
seems like an attempt to save the clearinghouse at the expense of its members
and their customers.
In situations where this power would be invoked, the effect of these
additional losses on members, and likely their customers, would make a bad
situation worse. Although in the absence of a resolution mechanism for
clearinghouses, at least such an approach moves the financial distress to an
area where regulators (in theory) have tools to address it.
It is plain that the consequences of a clearinghouse insolvency would be
severe, and thus quite unattractive to policymakers. As one commentator
summarizes:
The failure of a CCP could be very disruptive. In the
absence of an appropriate resolution regime, the CCP would
have to stop trading and enter liquidation. [Members] would
not receive payments due from the CCP and might not be
able to access their margin and any remaining default fund
contributions for some time. There could be uncertainty
over the status of open cleared contracts. The final
determination of losses could take a considerable period of
time. And trading would be disrupted in the markets that
the CCP clears . . . .141
Thus, there will be a strong temptation to conduct a bailout, keep the
clearinghouse operating, and avoid these disruptions.142
First, Dodd-Franks discount window provision might provide a statutory
means of injecting the Feds money into a failing clearinghouse. Indeed,
Colleen Baker has argued that Dodd-Franks special clearinghouse provisions
might become the basis for a wholesale purchase of a clearinghouses entire
derivatives portfolio, as in the rescue of AIG.143
That would seem to be the outer edge of what might be reasonably
accomplished under the Act, but even a more modest use of the discount
window power could facilitate something that might rightly be called a bailout
of a clearinghouse. For example, it could well be imagined that the
clearinghouses own assets would suffer from depressed values during times
141
142
143
David Elliot, BANK OF ENG., CENTRAL COUNTERPARTY LOSS-ALLOCATION RULES 6

(2013),
available
at
http://www.bankofengland.co.uk/financialstability/Documents/fpc/fspapers/fs_paper2
0.pdf.
E.g., Peter Conti-Brown, Elective Shareholder Liability, 64 STAN. L. REV. 409, 424 (2012) (In
the event of pure financial terror, where, as in the fall of 2008, panic sweeps through a
large number of financial institutions, bailouts are likely the only mechanism available to
governments and regulators that could possibly work to stem the tide of failures.).
Baker, supra note 6, at 11415.
154
10:127 (2015)
of financial crisis. If the local Federal Reserve Bank were to nonetheless

allow borrowing against the assets true value, that might provide the
margin of funding the clearinghouse needs to avoid failure. 144 In such a
circumstance, the Fed would effectively convert illiquid, low-value assets into
liquid, high-value assets.145
Some might argue that such lending is not a bailout, but instead is just a
classic Bagehot-inspired lender-of-last-resort mechanism. 146
That
presupposes the answer to two concerns: first, that the Fed will charge a
penalty rate, and second, that the in crisis asset value reflects liquidity
problems, and not simply a revaluation of the assets.147
Bagehots dictum provides that central banks should lend freely to
solvent institutionsbut only against good collateral, and at interest rates that
are high enough to dissuade overuse of the government purse.148 In the
recent financial crisis, the government generally recouped its principal, but it
remains unclear if above-market interest rates were actually charged.149
Moreover, only with the benefit of hindsight, and after the effects of the
governments actions muddied the analysis, can it be argued that lending
during the crisis was secured. If, for example, the value of mortgage-backed
securities had not returned to pre-crisis levels, it seems quite clear that the
government would have been undersecured in many cases.150
In short, it is undoubtedly true that liquidity lending, if fully
collateralized and short-term, is neither a central bank subsidy nor a
bailout.151 But it is often impossible to know if the lending is fully secured
or if an appropriate interest rate is being charged.

144
145
146
147
148
149
150
151
See Thomas C. Baxter, Jr. & Joseph H. Sommer, Liquidity Crises, 34 INTL LAW. 87, 95
(2000).
See Manmohan Singh, The Changing Collateral Space 56 (Intl Monetary Fund, Working
Paper,
2013),
available
at
http://www.imf.org/external/pubs/cat/longres.aspx?sk=40280.0.
See, e.g., Randall D. Guynn, Are Bailouts Inevitable?, 29 YALE J. ON REG. 121, 126 (2012).
Brian F. Madigan, Director, Div. of Monetary Affairs, Bagehots Dictum in Practice:
Formulating and Implementing Policies to Combat the Financial Crisis, Speech at the
Federal Reserve Bank of Kansas Citys Annual Economic Symposium in Jackson Hole,
Wyoming
12
(Aug.
21,
2009),
available
at
http://www.federalreserve.gov/newsevents/speech/madigan20090821a.htm.
WALTER BAGEHOT, LOMBARD STREET: A DESCRIPTION OF THE MONEY MARKET 5152,
18789 (9th ed. 1888).
See Steven R. Blau, The Federal Reserve and European Central Bank as Lenders-of-Last-Resort:
Different Needles in Their Compasses, 21 N.Y. INTL L. REV. 39, 50 (2008).
See Adam J. Levitin, The Politics of Financial Regulation and the Regulation of Financial Politics: A
Review Essay, 127 HARV. L. REV. 1991, 199798 (2014).
Baxter & Sommer, supra note 144, at 100.
10:127 (2015)
155
And the Fed might not have intended, subjectively, to give a bailout, but
it could end up bailing out the clearinghouses nonetheless. Indeed, the
discount window might be used to recapitalize the clearinghouse. Much will
depend on what the Board of Governors makes of its instructions under
Dodd-Frank, when placed in the broader context of Dodd-Franks general
disdain for anything that looks like a bailout.152
In the absence of a bailout through the discount window, Congress might
be tempted to create a special one off insolvency proceeding for
clearinghouses.
Here, Congress approach to the GSEs might be
instructive.153
In 2008, the GSEs financial condition had weakened, and there were
concerns over their ability to meet their obligations on $1.2 trillion in bonds
they had issued and $3.7 trillion in MBSs that they had guaranteed.154 In
response, Congress passed the Housing and Economic Recovery Act and the
Safety and Soundness Act, which created a special conservatorship process
for the GSEs.155
Shortly thereafter, the boards of both GSEs assented to the order of the
Federal Housing Finance Agency appointing the Agency as conservator of
Fannie Mae and Freddie Mac. 156 Under the conservatorship, the U.S.
Treasury has purchased massive quantities of preferred sharesmore than
$200 billion to dateto keep the GSEs operational.157 Under revised terms

152
153
154
155
156
157
See DoddFrank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No.
111-203, pmbl., 124 Stat. 1376 (2010) (An Act [t]o promote the financial stability of the
United States by improving accountability and transparency in the financial system, to end
too big to fail, to protect the American taxpayer by ending bailouts, . . . and for other
purposes.).
See DeKalb Cnty. v. Fed. Hous. Fin. Agency, 741 F.3d 795, 79798 (7th Cir. 2013)
(illustrating that Congress characterizes Fannie Mae and Freddie Mac as governmentsponsored enterprises (GSEs) to provide liquidity in the mortgage market and to promote
homeownership).
See Richard Boyd, Bringing the GSEs Back In?: Bailouts, U.S. Housing Policy, and the Moral Case
for Fannie Mae, 11 GEO. J.L. & PUB. POLY 457, 466 (2013); see also Avni P. Patel,
Development Article, The Bailout of Fannie Mae and Freddie Mac, 28 REV. BANKING & FIN.
L. 21, 25 (2008); N. ERIC WEISS, CONG. RESEARCH SERV., R42760, FANNIE MAES AND
FREDDIE MACS FINANCIAL STATUS: FREQUENTLY ASKED QUESTIONS 1 (2013), available at
http://www.fas.org/sgp/crs/misc/R42760.pdf (Congressional charters give the GSEs a
special relationship with the federal government, and it is widely believed that the federal
government implicitly guarantees their $1.2 trillion in bonds and $3.7 trillion in MBSs.).
12 U.S.C. 4617 (2012).
Winston Sale, Effect of the Conservatorship of Fannie Mae and Freddie Mac on Affordable Housing,
18 J. AFFORDABLE HOUS. & CMTY. DEV. L. 287, 299 (2009).
Janice Kay McClendon, The Perfect Storm: How Mortgage-Backed Securities, Federal Deregulation,
and Corporate Greed Provide a Wake-Up Call for Reforming Executive Compensation, 12 U. PA. J.
BUS. L. 131, 149 (2009).
156
10:127 (2015)
of the governments support, the GSEs pay the Treasury all of their quarterly
profits. Under the original terms, the GSEs paid annual dividends of $20
billion.158
The terms were changed at a point when it became necessary for the
GSEs to sell shares to the Treasury to fund the dividends, creating an absurd
circularity. But in recent months the GSEs financial picture has improved,
meaning that the Treasury is receiving greater dividends than it would have
under the earlier arrangement. That, in turn, has led to litigation against the
Treasury Department, in most cases brought by pre-conservatorship
preferred shareholders who are now subordinated to the preferred shares held
by the government.159
It had long been noted that the GSEs were ill-suited to a conventional
bankruptcy case, yet Congress only acted when the two entities were on the
brink of failure.160 It is easy enough to imagine a similar outcome with regard
to the clearinghouses, especially since their failure is most likely to occur in
the context of a systemic crisis and occur quite suddenly, following the failure
of other large financial institutions.
The problem, of course, is that the conservatorship of the GSEs is much
more bailout than resolution proceeding. 161 Indeed, almost any company
could successfully stabilize its business with several hundred billion dollars of
the U.S. Treasurys money.
The bailout-conservatorship might be the best way to save an
indispensable GSE, or clearinghouse, but doing so well in advance of a
problem, when the system can be thoughtfully designed, is key.
For example, CME Clearing is an unincorporated division of Chicago
Mercantile Exchange Inc., a Delaware corporation that is wholly owned by
CME Group Inc., a publicly traded Delaware corporation.162 The parent
company has $1.5 billion in outstanding bond debt.163 The parent company

158
159
160
161
162
163
See Stephen F.J. Ornstein et al., Fannie Mae and Freddie Mac Conservatorship and Liquidity
Support, 62 CONSUMER FIN. L. Q. REP. 52, 53 (2008).
See, e.g., Perry Capital LLC v. Lew, 70 F. Supp. 3d 208 (D.D.C. 2014); Fairholme Funds,
Inc. v. United States, 114 Fed Cl. 718 (2014).
See Richard Scott Carnell, Handling the Failure of a Government-Sponsored Enterprise, 80 WASH.
L. REV. 565, 567 (2005) (Prudence calls for having a legal mechanism adequate for
handling their failure. Yet no adequate insolvency mechanism currently exists for them.).
See Carol J. Perry, Rethinking Fannie and Freddies New Insolvency Regime, 109 COLUM. L. REV.
1752, 1776 (2009).
CME GROUP, CLEARING MEMBERSHIP HANDBOOK 1-1 (2015), available at
http://www.cmegroup.com/company/membership/files/cme-group-clearingmembership-handbook.pdf.
CME
Company
Financials,
NASDAQ,
http://www.nasdaq.com/symbol/cme/financials?query=balance-sheet.
10:127 (2015)
157
and Chicago Mercantile Exchange are parties to separate syndicated loan

agreements. The bond debt is largely held by major insurance companies, and
large mutual fund companies own the biggest parts of the equity.
Which corporation should be the subject of the resolution proceeding?
Or maybe the clearinghouse should be treated as if it were a separate legal
entity, somewhat like the treatment of U.S. branches of foreign banks?164 The
latter would require significant preplanning, to allow easy separation of the
clearinghouse from the other parts of Chicago Mercantile Exchange.
Stabilizing a clearinghouse means taking directional positions in trading
markets when the clearinghouse assumes trades from defaulting members. It
also entails removing counterparty risk to non-defaulting members. This
counterparty risk is broader than the positions assumed: it entails all of the
positions traded through the clearinghouse. If the assumption of a batch of
defaulted members positions would cause a failure of the clearinghouse, and
the sudden termination of all cleared positions in times of market stress, the
bailout averts this risk to all participants in the clearinghouse.
Both moves are unavoidable if regulators are to dodge systemic
contagion from the failure of a clearinghouse, but the government must
ensure that it is not just compensated for performing these functions, but that
such compensation reflects the real risk to taxpayers, or the central bank, that
a bailout entails.165 Moreover, consistent with the basic wisdom of Bagehot,
the price of a bailout must be sufficiently high to discourage reliance on the
bailout.166
Adequate compensation involves either a particularly high interest rate, or
the combination of a more moderate, although still significant, interest rate,
along with other forms of compensation like equity in the clearinghouse. The
results should be harsh, and made quite apparent ex ante, to provide the
appropriate incentives to clearinghouse management, and its members, to
avoid this fate. Thus, unlike the approach taken with the GSEs, the
resolution process should be specified now, rather than after, the onset of a
crisis.
A simple statute would be sufficient, so long as it provided clarity about
the degree of losses that would be imposed on investors and members in the
clearinghouse. For example, upon a determination by the clearinghouses

164
165
166
See, e.g., 12 U.S.C. 3106(j) (2012); N.Y. BANKING L. 606(4)(a); see also Robert R. Bliss &
George G. Kaufman, U.S. Corporate and Bank Insolvency Regimes: A Comparison and
Evaluation, 2 VA. L. & BUS. REV. 143, 170 (2007).
See Cheryl D. Block, Overt and Covert Bailouts: Developing a Public Bailout Policy, 67 IND. L.J.
951, 1033 (1992).
Baxter & Sommer, supra note 144, at 97.
158
10:127 (2015)
regulatorthe SEC or the CFTCand the Fed that a clearinghouse was on

the verge of a catastrophic failure, the clearinghouse could be detached from
its parent and placed in a federally chartered bridge institution.167
Indeed, it may be prudent to give the Fed, and perhaps the
clearinghouses senior management, an ability to trigger the mechanism on its
own. Historically, the SEC has proven itself a miserable prudential regulator,
and there are few signs the CFTC will be any better. Overreliance on them
would be risky.
All equity in the clearinghouse would be cancelled, and the Fed, or more
precisely the local Federal Reserve Bank, would provide new capital to the
clearinghouse in exchange for the equity in the bridge company. The funding
would allow the clearinghouse to survive with an unbalanced book until the
financial system was sufficiently settled and the situation could be addressed.
The bridge would succeed to all assets of the clearinghouse, and all
cleared positions, by operation of law. Any bond or bank debt would remain
with the old parent company. Among the transferred assets would be the
right to obtain capital contributions from members in the old
clearinghousea right that might only be enforceable in the insolvency
proceeding of the member, but which might provide at least a partial recovery
to the recapitalized clearinghouse in the future.
Memberships would not be transferred to the bridge. To prevent
systemic disruption, old members would be permitted to continue clearing
through the bridge for some interim period of time, on a fee-for-services
basis. But once the broader financial system was sufficiently stabilized, new
memberships would be issued, in exchange for new contributions to the
default fund and new capital commitments. Shortly thereafter, the Fed could
arrange for the sale of the clearinghouses equity in the capital markets.
In short, the clearinghouses equity, memberships, and investor debt
would be valued at zero and automatically discharged. The clearinghouse
would continue operations, but would effectively be a new, governmentowned clearinghousea successor to the failed clearinghouses operations.
Fed funding would smooth over the transition.
The statute need not provide much more, because once in control of the
equity of the clearinghouse, the Fed would have broad discretion to conduct
the clearinghouses operations in any way it deemed appropriate.
Congressional oversight, perhaps combined with some reporting
requirements, would help provide the necessary transparency.

167
Paul Melaschenko & Noel Reynolds, A Template for Recapitalising Too-Big-to-Fail Banks, BIS
Q. REV., June 2013, at 25, 33, available at http://www.bis.org/publ/qtrpdf/r_qt1306e.pdf.
10:127 (2015)
159
The operation of the statute could be combined with the pending

regulatory proposals, in order to encourage resolution planning by the
clearinghouses. Indeed, the statute could provide a specific context or
framework toward which to direct the planning. Moreover, once a specific
resolution framework is in place, it might provide the basis for other
regulatory tools, such as a source of strength regime between the
clearinghouse and its publicly traded parent company.
The statute might be buttressed by other, related regulatory changes. For
example, we might wonder if the incentive effects of the statute would not be
enhanced by greater capital requirements at clearinghouses, and larger upfront
membership obligations to the clearinghouses default fund.
Hopefully the statute would never be used. Indeed, if never used, the
statute would have proven its value, serving as an incentive for owners and
managers to improve the resiliency of clearinghouses.168 This would avoid
the litigation that has been seen in connection with the bailouts of the
automakers, AIG, and the GSEs.169
Why not simply amend Dodd-Franks OLA provisions to address
clearinghouses, rather than invent yet another insolvency statute? In short,
OLA is designed to backstop the Bankruptcy Code.170 Clearinghouses, on the
other hand, need a directly applicable resolution devicea backstop is simply
insufficient.171
Moreover, OLA is structured around the role of the FDIC.172 But the
FDIC plays absolutely no role in regulating clearinghouses, and its recently
proposed single point of entry approach to OLA makes very little sense
when applied to a clearinghouse. Thus, even if OLA were made applicable to
clearinghouses, it would not likely provide a useful tool.
The statute I propose could be housed under the OLA, title II umbrella.
But we should be clear that clearinghouses are not apt to be liquidated, even
given the broad definition of liquidation currently in use by the FDIC.
The need for a special statute, and federal funding, to save a vital piece of
market infrastructure raises the possibility that clearinghouses should not be
publicly owned. At the very least, it might make sense for clearinghouses to
168
169
170
171
172
See David A. Skeel, Jr., States of Bankruptcy, 79 U. CHI. L. REV. 677, 690 (2012).
See Gina Chon, Fannie Case Papers Spark Anger, FIN. TIMES (May 13, 2004, 5:45 PM),
http://www.ft.com/intl/cms/s/0/cd1585fa-daaf-11e3-827300144feabdc0.html?siteedition=intl#axzz31cNCFO90.
See Stephen J. Lubben, Transaction Simplicity, 112 COLUM. L. REV. SIDEBAR 194, 202 (2012).
And thus I argue that clearinghouses, or at least clearinghouses subject to Dodd-Frank,
have no place in chapter 7 of the Bankruptcy Code.
See Chrystin Ondersma, Shadow Banking and Financial Distress: The Treatment of MoneyClaims in Bankruptcy, 2013 COLUM. BUS. L. REV. 79, 13536.
160
10:127 (2015)
move to some sort of quasi-public ownership structure, with management

that could be freed from the normal duties that boards owe to shareholders.
Full development of this idea must await a separate article.
CONCLUSION
Clearinghouses are a key part of Dodd-Frank, yet inexplicably DoddFrank makes no provision for the failure of a clearinghouse. Recent events
have shown that such confidence is unjustifiable.
Because a true liquidation of a clearinghouse is unlikely, I argue instead
for a structured bailout of the clearinghouse. Such a clear, upfront legal
structure would provide the basis for imposing losses on shareholders and
creditors in the event of failure, and thus provide clearinghouses some
incentive to avoid such a fate. And in any event, planning for the potential
failure of a clearinghouse in good times avoids the risk and chaos that result
from attempting to solve problems on an ad hoc basis in the bad times.

Failure of The Clearinghouse: Dodd Frank Fatal Flaw?

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VIRGINIA LAW & BUSINESS REVIEW

FAILURE OF THE CLEARINGHOUSE: DODDFRANKS FATAL FLAW?

LEARINGHOUSES reduce risk by acting as a central hub for trades.

Copyright 2015 Virginia Law & Business Review Association

Virginia Law & Business Review