Sunday, August 25, 2019

Clearinghouses, Housing GSEs, and Stakeholders

September 11, 2019, will mark the one-year anniversary of a clearinghouse-related event reported on in the NYT as: How a Lone Norwegian Trader Shook the World’s Financial System.  Ironically, the story unfolded during the ten-year anniversary week of Lehman Brothers’ collapse and AIG’s $180B+ rescue by the U.S. government.  Global policymakers’ clearinghouse mandates, implemented in the U.S. in Title VII of Dodd-Frank, were supposed to be the solution to the AIG problem, not potentially the next big problem.    

And speaking of the financial crisis, resolving the ownership status of Fannie Mae and Freddie Mac is once again in the news.  These institutions have been in government conservatorship for over 10 years.  I’m skeptical that a long-term, viable solution has been found to return the housing GSEs to private ownership that will not return us right back to where we are now the next time these institutions get into trouble.          

I’m no expert in housing finance, but I do know a good deal about clearinghouses.  Important parallels exist between the housing GSEs and systemically-significant clearinghouses.  Most such clearinghouses are privately-owned, publicly-traded corporations.  Yet here too, the government holds the tail risk of these institutions.  As I’ve argued in The Federal Reserve As Last Resort, this is the “why” behind the Federal Reserve’s expansive new lending authority in Title VIII of Dodd-Frank. 

Stakeholders have also been much in the news lately (see BLPB posts herehere, and here).  We’re all clearinghouse stakeholders.

In Incomplete Clearinghouse Mandates, 56 Am. Bus. L. J. 507 (2019), I argue that it’s time to find a workable solution for the recovery of a troubled clearinghouse.  My article focuses on the three areas of time-critical cooperation that will, at a minimum, be necessary between the clearinghouse and its members for a successful recovery: continuation of clearing member membership; assistance to the clearinghouse if one or more clearing members has defaulted; and, continuity of any critical services clearing members (or their affiliates) provide to the clearinghouse.  Yet it also uses transaction cost economics to examine underlying legal and regulatory structures that will increase the cost of this necessary cooperation.  Those structures include: ownership arrangements, federal lending limits for national banks, interdependent security problems, and the organization of client-clearing.  It ends by proposing reforms designed to ensure that the incentives of the clearinghouse and its members promote a successful recovery. 

Let’s not repeat the ongoing history of the housing GSEs in the clearinghouse area.  Here’s an abstract of my article (draft recently posted to SSRN):

In the 2007-2008 financial crisis, over-the-counter (OTC) derivatives triggered the collapse of colossal financial institutions.  In response, global policymakers instituted clearinghouse mandates.  As a result, all standardized OTC derivatives must now use clearinghouses, and global financial market stability now depends upon these institutions.  Yet certain underlying legal and regulatory structures threaten to undermine clearinghouse stability, particularly were a significant clearinghouse to become distressed.  This article argues that the clearinghouse mandates are incomplete in falling short of also reforming these problematic arrangements.      

As with electric utilities, the lights at the financial market infrastructures known as clearinghouses must always be on.  Yet the legal frameworks for handling a distressed clearinghouse, the problem of clearinghouse recovery and resolution, remain uncertain.  This article advances debate on this issue.  It argues that recovery, a private market restructuring process, can be conceptualized as a bargaining game dependent upon time-critical cooperation between a clearinghouse and members.  This article uses transaction cost economics to demonstrate, however, that certain underlying legal and regulatory structures could work at cross-purposes to this necessary cooperation, and actually increase its cost.  Based upon this analysis, it proposes reforms designed to ensure that parties’ incentives promote efficient recovery.  In the absence of efficient recovery frameworks, the path of a distressed, significant clearinghouse is likely to resemble that of the government-backed mortgage lenders whose fate more than ten years after their entry into conservatorship remains uncertain.  This article aims to help avoid a repeat of this history.


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