The Tenuous Case for Derivatives Clearinghouses

Mandatory use of swaps clearinghouses represents the principal 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 related propositions: (1) clearinghouses are better able to manage risk than dealer banks in the over-the-counter derivatives market, and (2) clearinghouses are better able to absorb risk than dealer banks. Both propositions are heavily dependent on the details of clearinghouse design, the structure of the clearinghouse market, and the manner of clearinghouse regulation. In theory, a well-designed clearinghouse boasts one significant advantage over dealer banks: capital. Clearinghouses can have deep capital structures, including callable capital from their members. Clearinghouses thus diffuse losses 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 potentially encourage greater risk taking — via underpricing and reduced capital — to gain market share and increase returns on equity. Therefore, because clearinghouses also concentrate risk, 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