Central Clearing of Financial Contracts: Theory and Regulatory Implications
Since the global financial crisis, an increasing number of countries, including the United States, have been requiring most derivatives contracts to be cleared and settled through central counterparties (CCPs). The CCP legally substitutes its credit for that of the contracting parties, making the CCP the primary counterparty on both sides of the contract—for example, the buyer to every seller and the seller to every buyer. The CCP thus ensures the performance of a financial contract even if a contracting party fails, thereby reducing counterparty risk—the risk that a contracting party’s default will harm other parties to the contract. Regulators believe this reduction of counterparty risk will reduce ‘systemic’ risk—the risk that, in this context, a failure of one or more counterparties could lead to events that impair the financial system’s ability to function as a network and cause an economic collapse.
This emerging regulatory norm raises an important question: should regulators also require other types of financial contracts (‘non-derivative financial contracts’) to be centrally cleared and settled, in order to reduce systemic risk? This inquiry has real practical significance because the aggregate counterparty exposure on non-derivative financial contracts—and thus the systemic risk that could be triggered by that exposure—greatly exceeds that on derivatives contracts. Centrally clearing derivatives contracts through CCPs also has a unique feature: the mutualization of default losses. Expanding central clearing to non-derivative financial contracts therefore raises fundamental issues about whether regulators should require financial institutions to mutualize, or otherwise specifically control, their risk.
My article first shows that regulators require central clearing of derivatives contracts because they assume—driven in part by media pressure—that those contracts are inherently systemically risky. The article then explains why that assumption is misleading: the systemic riskiness of derivatives contracts comes not from their inherent nature but, rather, from their systemically important counterparties. This insight indicates that non-derivative financial contracts with systemically important counterparties could also be systemically risky. In theory, requiring those financial contracts to be centrally cleared could therefore help to reduce systemic costs arising from that counterparty risk.
Regulation imposing that requirement would be justified only if its overall reduction of systemic costs outweighs the requirement’s transaction costs. To reduce transaction costs, the article proposes that any such regulation be further limited to material non-derivative financial contracts that are standardized. Because non-derivative financial contracts are increasingly being documented in standardized format, this proposal should not unduly limit the benefits of extending central clearing.
In principle, the regulation should also achieve an overall reduction of systemic costs. Central clearing reduces systemic costs arising from the counterparty risk of individual systemically important firms. Although central clearing can also increase systemic costs by concentrating counterparty risk in CCPs, CCPs used to clear derivatives contracts are significantly protected from that risk concentration. The article examines how those protections could be adapted to, and possibly also enhanced for, CCPs used to clear non-derivative financial contracts.
Because its cost-benefit balancing is based on rough approximations, an untested premise, and possible differences in the benefits of multilateral netting, this article does not conclude that regulation should necessarily require central clearing of non-derivative financial contracts. Instead, it argues that if the benefits of centrally clearing derivatives contracts exceed its costs, then the benefits of centrally clearing non-derivative financial contracts might also exceed its costs. The analysis nonetheless should help regulators think about expanding the central clearing requirement to non-derivative financial contracts. It also helps answer important legal questions about why, and the extent to which, regulators should mandate how financial institutions should control risk, and whether they should require financial institutions to mutualize risk.
Steven L. Schwarcz is the Stanley A. Star Professor of Law & Business at Duke University, and a Senior Fellow at the Centre for International Governance Innovation (CIGI).
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