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Tuesday, July 15, 2014

Lubben on Clearinghouses

Stephen J. Lubben has posted Nationalize the Clearinghouses! on SSRN with the following abstract:

Given the vital place of clearinghouses in Dodd-Frank, it is perhaps surprising that Dodd-Frank makes no provision for the failure of a clearinghouse. Indeed, it is arguable that the United States is not in compliance with its commitment to the G-20 on this point.

Clearinghouses are presently excluded from the new Orderly Liquidation Authority under title II, title II and titles VII and VIII do not work well together in any event, and 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. A clearinghouse might file, but there would be little point.

And because clearinghouses are oddly defined as "commodities brokers" under the Bankruptcy Code, they are only permitted to file a chapter 7 liquidation cases.

In this paper I suggest two likely outcomes upon the onset of clearinghouse financial distress. First, Congress will 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, shortly after Congress had created that possibility under the Housing and Economic Recovery Act of 2008, looms large here. 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. Treasury’s large preferred share holdings therein.

So there will be a temptation to engage in direct bailout, despite Dodd-Frank’s claim to have ended bailouts. Bailouts of individual financial institutions may end, but bailouts of clearinghouses might become more common in a post-Dodd-Frank world. 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 a new type of financial institution in the future.

What to do? I suggest that the government should nationalize the clearinghouses upon failure, and the intention to exercise this option should be made clear ex ante. That is, the government should expressly state that clearinghouses designated under title VIII of Dodd-Frank that ultimately fail will be nationalized, with specific consequences to investors, and an expectation of member participation in the recapitalization of the clearinghouse, once that becomes systemically viable. This should provide stakeholders in the clearinghouses with strong incentives to oversee the clearinghouse’s management, and avoid such a fate.

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