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Sunday, August 12, 2012

Levitin on Derivatives Clearinghouses

The Tenuous Case for Derivatives Clearinghouses, by Adam J. Levitin, Georgetown University Law Center, was recently posted on SSRN.  Here is the abstract:

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

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

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

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

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