When the Dodd-Frank financial reform act passed in 2010, it contained a number of provisions that many saw as no-brainers for a financial system that had just been brought to the brink of collapse by banks and other firms that were unable to determine the true value of securities on their books.
But one of the law’s rules, which gives the Federal Reserve Board back-up supervisory authority over entities that clear and settle derivatives trades, has created a concentrated center of risk in the financial markets that could require a federal bailout in the event of a crisis. Experts warn the law that was intended in part to do away with the concept of banks that are “too big to fail” may have created something else – clearing houses that are too big to fail.
Related: Why Jack Lew Is Kidding Himself about Too Big To Fail
Derivatives, a class of financial products not many Americans had heard of, and which even fewer understood, were widely derided as one of the root causes of the financial system’s meltdown in 2008. A particular class of derivatives, known as credit default swaps, were derided by billionaire investor Warren Buffet as “financial weapons of mass destruction.”
So when Dodd-Frank mandated that derivatives trading, which had frequently taken place on an over-the-counter basis in bank-to-bank transactions, be moved onto centralized exchanges, many in the financial services world thought this was a wise move.
A clearinghouse essentially inserts itself between two parties in a derivatives trade, assuming the risk of default itself, so that each of the original participants in the trade are insulated from credit risk. The move was seen as a way to move risk out of large, systemically important banks whose failure could endanger the economy.
However, as Georgetown University Law Center Professor Adam J. Levitin asked in a recent paper, it raises the questions, “Are we merely engaged in a risk-shifting game or are we actually managing to reduce risk?”
Related: FDIC Plan to Combat “Too Big To Fail” Is Flawed
Clearing houses fall into a category of financial institutions known as “financial market utilities,” and the Financial Stability Oversight Council has designated eight of them as “systemically important,” which means that their failure could cause widespread economic problems.
Last week the Fed finalized a rule allowing those eight institutions to open accounts at the Federal Reserve, making them eligible for “certain financial services” from the Federal Reserve Banks. Another section of Dodd-Frank, not addressed by last week’s release, allows the Fed to lend to these FMUs in “unusual or exigent” circumstances.
Some analysts are concerned that FMUs’ importance to the economy and the Dodd-Frank requirement that a large portion of derivatives trading be moved to exchanges creates the possibility that the Federal Reserve, and by extension, the American taxpayer, will be forced to bail out one or more of them in the event of a crisis.
“We are not owning up to the fact that Dodd-Frank creates a new set of entities that would create massive disruption if they failed,” said Hester Peirce, a senior research fellow at the Mercatus Center at George Mason University who has also worked as a staff attorney at the Securities and Exchange Commission and senior council to the head Republican on the Senate Banking Committee.
Related: JPMorgan’s Whale of a Fine: $920 Million and An Admission of Guilt
Peirce cites a speech from 2011 in which Fed Chair Ben Bernanke himself notes that “the failure of, or loss of confidence in, a major clearinghouse would create enormous uncertainty about the status of initiated transactions and, consequently, about the financial positions of clearinghouse participants and their customers.”
One of Peirce’s main concerns is that in the push to move a large volume of derivatives trades into clearing houses, FMUs will be pressured to take on counterparties that they might not have done business with in the past.
But that’s not her only concern. She notes that the Commodity Futures Trading Commission and the SEC do not have a good record of close supervision of clearing houses’ risk management practices.
In a comment letter written to the Fed, she quoted CFTC chairman Gary Gensler’s warning in congressional testimony earlier this year that “we’re…not doing the examinations that we really should be doing of the clearinghouses . . . we do not have staff examining clearinghouses annually for their risk management and we’re pushing— statutorily pushing—all sorts of additional transactions into clearinghouses.”
Whether the clearinghouses will hold up in the face of a financial crisis, of course, remains to be seen. As Levitin said, “Hopefully clearinghouses will be a belt-and-suspenders approach that results in better risk management and more resilience to losses. But on both counts, the devil lies in the details.”
Follow Rob Garver on Twitter @rrgarver
Top Reads from The Fiscal Times: