Five Years Later, Dodd-Frank Is Looking Pretty Haggard

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Dodd-Frank is rounding the bend to its five-year mark. Its vocal cheering section does not seem to notice that it's looking a bit haggard. One area in which its weakness is evident is over-the-counter derivatives reform, which accounts for approximately 20 percent of Dodd-Frank's pages and much of its rhetoric. Dodd-Frank relies on central counterparty clearinghouses to bring order to over-the-counter derivatives-financial contracts that help companies manage their risks. Although Title VIII of the Act gives a nod to clearinghouses as a potential source of new risk, that concern gets lost in all the cheering for clearing.

Before the crisis, large financial firms entered into many derivatives transactions directly with one another and with their customers. These contracts bound firms into long-term relationships, which meant that a failure by one large firm would directly affect all the firms with which it had relationships.

By contrast, other types of derivatives trade on exchanges and are centrally cleared; once a transaction is executed, each original party to the trade replaces the contract with its original counterparty with a new contract with the clearinghouse. As many others have explained, the clearinghouse becomes the buyer to the seller and the seller to the buyer.

Dodd-Frank's drafters decided to impose this central counterparty clearinghouse model on the over-the-counter derivatives markets. Under Dodd-Frank, standardized derivatives contracts must be centrally cleared. The rationale is that moving as many derivatives transactions into clearinghouses as possible makes it easier for financial firms and their regulators to comprehend and manage risk.

That hardly sounds radical when one considers that clearinghouses have been around for centuries with a relatively-although certainly not completely-unsullied record. Moreover, the United States is not alone in moving to mandatory clearing. And, because of certain efficiencies that clearinghouses can offer, the industry was working voluntarily before the crisis to move more standardized derivatives into clearinghouses. What harm could there be in a little regulatory shove?

Regulatory mandates like this look better on paper than they do in practice. Now that the plans sketched out on Dodd-Frank's pages are coming to life, lots of people are getting scared. Big financial firms are trying to understand their risk exposures to clearinghouses. They are demanding that clearinghouses be clear about how they plan to handle member defaults and ready to pony up their own money in the event of a default. A banking industry association warned the Financial Stability Oversight Council earlier this year that, if clearinghouses don't whip their risk management programs into shape, they "could become a source of contagion to their clearing members and customers during periods of market stress."

Regulators are worried, too. The Office of Financial Research issued two papers this month on central clearing and discussed central clearinghouses in its last annual report. The report argued that the "new central clearing system concentrates risks in a small number of large central counterparties, transforming the network to a hub-and-spoke system that can better manage a larger number of dealer failures but is highly vulnerable to the failure of a [clearinghouse] that can transmit risk to all members." The report warned specifically of the trouble that could follow a "joint default" of a clearinghouse "and one or more clearing members." The director of the Office of Financial Research echoed these concerns in a recent Reuters Financial Regulation Summit.

At a hearing last week, Commodity Futures Trading Commission Chairman Timothy Massad similarly pointed out that "a small number of clearinghouses are becoming increasingly important single points of risk in the global financial system." His colleague Commissioner Mark Wetjen brought that concern home in a recent speech highlighting a December 2013 scare at a South Korean clearinghouse when one of its members defaulted. Building on that speech's cautionary tone, Commissioner Wetjen held a clearing roundtable last week.

Clearinghouses protect themselves in a number of ways: First, they establish membership standards to keep weak firms out. Second, members contribute to a guaranty fund, which can be tapped if the clearinghouse gets into trouble. Third, members pay initial margin at the beginning of a trade and variation margin through the life of the derivatives contract to reflect changes in the markets. Clearinghouses set these margin payments at a level to ensure that the member will be able to meet its responsibilities to the clearinghouse and limits the types of collateral members can provide. Fourth, clearinghouses only accept contracts they can understand and manage. They try to avoid taking on complex or illiquid contracts. Finally, clearinghouses establish committees to manage risk and plan for defaults.

Getting all of these aspects of risk management right is difficult. The regulatory interest in central clearing completely alters the dynamics. Regulators are conflicted. They are likely to view all risk management measures skeptically. They may assume a decision not to clear a contract is a way to avoid the clearing mandate.

Once a clearing mandate is in place, regulators need to make sure that firms have easy access to clearinghouses and don't have to pony up too much in guaranty fund contributions or margin. The Justice Department's antitrust lawyers even weighed in to warn the Commodity Futures Trading Commission that existing clearing members might restrict "access to new clearing members in an effort to insulate themselves from competition in making markets" all in the name of sound risk management. Such regulatory conflicts could inhibit legitimate risk management efforts.

Central clearing has a valuable place in the derivatives markets, but regulatory attempts to force it come at a cost. These clearinghouses will not only be big and important, but will be managed with one eye toward placating pro-clearing regulators and another toward managing risk. As former Fed Chairman Ben Bernanke cautioned four years ago, although clearinghouses "generally performed well in the highly stressed financial environment of the recent crisis ... we should not take for granted that we will be as lucky in the future." Dodd-Frank's clearing mandate and other regulatory inducements to clear might bring that lucky streak to an abrupt and painful end.

Hester Peirce is a senior research fellow at the Mercatus Center at George Mason University. 

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