Credit default swaps, clearinghouses, and systemic risk: Why centralized counterparties must have access to central bank liquidity

Harvard Journal on Legislation

Volumn 48, Issue 1, 2011, Pages 49-94

  Kress, Jeremy C ^a  

^a HARVARD UNIVERSITY   (United States)

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EID: 79951567700     PISSN: 0017808X     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (291)

1. Gillian Tett, The Clearing House Rules, FIN. TIMES, Nov. 5, 2009, available at http://www.ft.com/cms/s/0/5874e922-cald-11de-a5b5-00144feabdc0.html.
2. See, e.g., Eileen Glanton, Ten Years After the Crash, Traders Breathe a Little Easier, ASSOCIATED PRESS NEWSWIRES, Oct. 17, 1997, available at Factiva, Doc. No. aprs000020011005dtai0jzz3 ("The traders who work on the floor of the New York Stock Exchange will never forget October 19, 1987.").
3. NICHOLAS F. BRADY, REPORT OF THE PRESIDENTIAL TASK FORCE ON MARKET MECHANISMS, at VI-73 (1988). One CME clearing member faced a $22.6 million margin call, yet held only $8.6 million in net capital. Id.
4. Alan Murray, Fed's New Chairman Wins a Lot of Praise on Handling the Crash, WALL ST. J., Nov. 25, 1987, available at Factiva, Doc. No. j000000020011118djbp00s3j (citing an unnamed Federal Reserve official who said that CBOE "would have shut down" if First Options had been unable to meet its margin calls).
5. Mark Carlson, A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response 11 (Fed. Reserve Bd. Divs. of Research & Statistics & Monetary Affairs, Fin. & Econ. Discussion Series, Working Paper No. 2007-13, 2006), available at http://www.federalreserve.gov/Pubs/Feds/2007/200713/200713pap.pdf.
6. Id. at 13 ("To help make the extensions of credit and transfers of funds proceed smoothly, the Federal Reserve Banks of Chicago and New York reportedly let commercial banks in both districts know that the Federal Reserve would help provide liquidity for the loans. Due in part to the efforts of the Federal Reserve, on Oct. 20-the day following the crash-the settlement banks extended the necessary credit, and the accounts for CME clearinghouse members were fully funded by market opening.").
7. See Ben S. Bernanke, Clearing and Settlement During the Crash, 3 REV. OF FIN. STUD. 133, 148 n.1 (1990).
8. See Carlson, supra note 5, at 11 (noting that there was a "sustained rise" in financial markets during the afternoon of Tuesday, October 20 "as corporations announced stock buyback programs to support demand for their stocks").
9. See Bob Hills et al., Central Counterparty Clearing Houses and Financial Stability, FIN. STABILITY REV., June 1999, at 122, 129-30
10. see also Cheah Cheng Hye & Christopher Hunt, Hong Kong Bails Out Futures Market but Stock Prices Plunge on Reopening, WALL ST. J., Oct. 26, 1987, available at Factiva, Doc. No. j000000020011118djaq00plg (noting that Hong Kong waited until the weekend after the Monday, October 19th stock market crash to bail out the Hong Kong Futures Guarantee Corporation with a $256 million loan; the fund had "only 15 million dollars in capital and 7.5 million dollars in reserves").
11. See infra Part III.C.
12. See, e.g., Stephen G. Cecchetti et al., Central Counterparties for Over-the-Counter Derivatives, BIS Q. REV., Sept. 2009, at 45, 52.
13. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (codified in scattered sections of the U.S.C.).
14. Christopher Cox, Swapping Secrecy for Transparency, N.Y. TIMES, Oct. 19, 2008, at WK12.
15. Letter from Warren Buffett, Chief Exec. Officer, Berkshire Hathaway, Inc., to S'holders of Berkshire Hathaway (Feb. 21, 2003), available at http://www.berkshirehathaway.com/letters/2002pdf.pdf.
16. See EDWARD VINCENT MURPHY, CONG. RESEARCH SERV., RS 22932, CREDIT DEFAULT SWAPS: FREQUENTLY ASKED QUESTIONS 1 (2008).
17. See EUR. CENT. BANK: EUROSYSTEM, CREDIT DEFAULT SWAPS AND COUNTERPARTY RISK 9 (Aug. 2009) [hereinafter "EUR. CENT. BANK"], available at http://www.ecb.int/pub/pdf/other/creditdefaultswapsandcounterpartyrisk2009en.pdf.
18. See MURPHY, supra note 15, at 2.
19. See, e.g., EUR. CENT. BANK, supra note 16, at 10 ("CDSs can be used to hedge the credit risk of on-balance sheet assets (e.g. corporate bonds or asset-backed securities) by acquiring CDS protection on them. Such protection provides capital relief and insures the acquirer of protection against credit losses.").
20. Eric Dinallo, former Superintendent of Insurance for New York State, estimates that nearly 80% of CDSs are "naked." Dawn Kopecki & Shannon D. Harrington, Banning "Naked" Default Swaps May Raise Corporate Funding Costs, BLOOMBERG (July 24, 2009), http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a0W1VTiv9q2A
21. See, e.g., EUR. CENT. BANK, supra note 16, at 11.
22. For a brief and entertaining history of CDSs, see Matthew Phillips, The Monster That Ate Wall Street, NEWSWEEK, Oct. 6, 2008, at 46.
23. Summary of Recent Survey Results, INT'L SWAPS & DERIVATIVES ASS'N, http://www.isda.org/statistics/recent.html#2009end (last visited Oct. 27, 2010).
24. The International Swaps and Derivatives Association 2009 Year-End Market Survey valued the CDS market at $30.4 trillion.
25. Id. The World Federation of Exchanges valued the U.S. stock market capitalization at $15.1 trillion at the end of 2009.
26. See Year-Domestic Market Capitalization (USD Millions), WORLD FED'N OF EXCHS., http://www.world-exchanges.org/statistics/ytd-monthly (select "2009" for "Year"; select "December" for "Month"; select "USD" for "Currency"; select "Domestic Market Capitalization" for "Individual Data Series"; then follow "Download" hyperlink) (last visited Oct. 27, 2010).
27. See Table 19: Amounts Outstanding of Over-the-Counter (OTC) Derivatives, BANK FOR INT'L SETTLEMENTS (June 2010), http://www.bis.org/statistics/otcder/dt1920a.pdf (estimating the gross market value of CDSs to be $1.801 trillion as of December 2009).
28. See, e.g., Nicholas Varchaver & Katie Brenner, The $55 Trillion Question, FORTUNE, Sept. 30, 2008, available at http://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_short.fortune/index.htm (noting that most CDS contracts are transacted "in a oneminute phone conversation or an instant message"). For a full discussion of the differences between OTC and exchange-based markets, see Norman Menachem Feder, Deconstructing Over-the-Counter Derivatives, 2002 COLUM. BUS. L. REV. 677, 731-35
29. see also Henry T.C. Hu, Misunderstood Derivatives: The Causes of Informational Failure and the Promise of Regulatory Incrementalism, 102 YALE L.J. 1457, 1465-66 (1993).
30. See Cecchetti et al., supra note 11, at 49 (noting that bilateral OTC markets "facilitate the creation of new financial instruments at a relatively modest operational cost" and "allow customers to tailor products to their individual needs")
31. see also EUR. CENT. BANK, supra note 16, at 9-10 (describing the proliferation of different varieties of CDSs).
32. See Cecchetti et al., supra note 11, at 45.
33. See MURPHY, supra note 15, at 3.
34. See EUR. CENT. BANK, supra note 16, at 21 (indicating "possible over-concentration in the sense of a scarcity of sellers" in the CDS market).
35. Derivatives: A Closer Look at What New Disclosures in the U.S. Reveal, FITCH RATINGS, July 22, 2009, at 3.
36. See Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, 75 U. CIN. L. REV. 1019, 1023-27 (2007) (discussing the benefits of CDSs).
37. Orice M. Williams, Director of the Government Accountability Office ("GAO") Financial Markets and Community Investment Division, identifies two additional types of CDS risks: operational risk, "the risk that losses could occur from human errors or failures of systems or controls," and concentration risk, "the potential for loss when a financial institution establishes a large net exposure in similar types of CDSs." U.S. GOV'T ACCOUNTABILITY OFFICE, GAO-09-397T, SYSTEMIC RISK: REGULATORY OVERSIGHT AND RECENT INITIATIVES TO ADDRESS RISKS POSED BY CREDIT DEFAULT SWAPS 13-15 (2009). A third additional risk type, jump-to-default risk, is discussed below.
38. The notional amount is "the par amount of credit protection bought or sold." Market Statistics: Understanding Notional Amount, INT'L SWAPS & DERIVATIVES ASS'N, http://www.isdacdsmarketplace.com/market_statistics/understanding_notional_amount (last visited Nov. 5, 2010).
39. Id. at iv ("Collateralization operates through improving the recovery rate in a postdefault situation, and thus decreases the loss given default. This leads to lower expected losses in a collateralized portfolio").
40. See Cecchetti et al., supra note 11, at 47.
41. See U.S. GOV'T ACCOUNTABILITY OFFICE, supra note 33, at 22 ("According to market participants, the jump-to-default risk posed by CDS makes determining sufficient margin requirements difficult.")
42. see also EUR. CENT. BANK, supra note 16, at 47 ("When assessing the risk-mitigating role played by [ ] margin call schemes, one should bear in mind that the mitigation of risk is somewhat more limited for CDS than for other OTC derivatives, due to the possibility of the CDS spread widening too quickly.").
43. As recently as 2009, more than one-third of OTC credit derivative exposure was not subject to a collateralization agreement. ISDA Margin Survey 2009, INT'L SWAPS AND DERIVATIVES ASS'N 7 (2009), http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2009.pdf.
44. Since then, the level of uncollateralized OTC credit derivative exposures has dropped to 7 percent. ISDA Margin Survey 2010, INT'L SWAPS AND DERIVATIVES ASS'N 10 (2010), http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2010.pdf.
45. Commonly used definitions of systemic risk are semantically different but all refer to the same concept of contagion.
46. Compare Michael R. Darby, Over-the-Counter Derivatives and Systemic Risk to the Global Financial System (Nat'l Bureau of Econ. Research, Working Paper No. 4801, 1994) (defining systemic risk as the possibility that "failure of one firm will lead to the failure of a large number of other firms or indeed the collapse of the international financial system")
47. George G. Kaufman & Kenneth E. Scott, What Is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?, 7 INDEP. REV. 371, 371 (2003) (defining systemic risk as "the risk or probability of a breakdown in an entire system, as opposed to breakdowns in individual parts or components").
48. The Global Financial Crisis: A Plan for Regulatory Reform, COMM. ON CAPITAL MARKETS REGULATION 39 (May 26, 2009), http://www.capmktsreg.org/pdfs/TGFC-CCMR_Report_(5-26-09).pdf.
49. One reason Party A might wish to become a protection seller on an entity for which it has already bought protection would be to take advantage of arbitrage profits made possible by changing credit spreads.
50. See supra notes 30-31 and accompanying text.
51. See EUR. CENT. BANK, supra note 16, at 20. 50
52. See, e.g., Rama Cont et al., Too Interconnected to Fail: Contagion and Systemic Risk in Financial Markets (2009), http://cermics.enpc.fr/cnf/Cont.pdf.
53. Fitch found that eight financial institutions (Morgan Stanley, General Electric, Bank of America, General Motors/GMAC, JP Morgan Chase, Royal Bank of Scotland, Citigroup, and Deutsche Bank) were among the top 10 reference entities for which CDS protection was purchased at year-end 2008.
54. See Global Credit Derivatives Survey: Surprises, Challenges and the Future, FITCH RATINGS, Aug. 20, 2009, at 6.
55. See EUR. CENT. BANK, supra note 16, at 26 (using the term "risk circularity" to refer to the failure of a CDS market participant that itself is the reference entity for other CDSs).
56. See, e.g., Houman Shadab, Guilty by Association? Regulating Credit Default Swaps, 4 ENTREPRENEURIAL BUS. L.J. 407, 414 (2009) ("In contrast to the result of their leveraged investments in mortgage-related securities, banking institutions did not fail because of losses from CDS trading or because they were unable to meet their own CDS obligations.")
57. see also Peter Wallison, Systemic Risk and the Financial Crisis, AM. ENTER. INST. FIN. SERV. OUTLOOK (Oct. 31, 2008), http://www.aei.org/outlook/28872 ("There is much more to learn about the role of CDSs in the financial crisis, but it is altogether clear, even now, that whatever role they played, it was a tiny one when compared to the contribution of imprudent investments in junk mortgages and MBS.").
58. See Wallison, supra note 53, at 4 (noting that settlement on CDSs referencing Lehman was "completely orderly, almost humdrum").
59. Shadab, supra note 53, at 415.
60. See, e.g., William K. Sjostrom, Jr., The AIG Bailout, 66 WASH. & LEE L. REV. 943, 978-79 (2009) ("Because of AIG's size and interconnectedness, and the fact that financial markets were already under serious distress, it was feared that AIG's failure would lead to the collapse of the entire financial system.").
61. But see Editorial, AIG and Systemic Risk, WALL ST. J., Nov. 23, 2009, available at Factiva, Doc. No. WSJO000020091122e5bn00466 (arguing that regulators were motivated by systemic risk arising from AIG's insurance business, not from its CDS exposures).
62. For a detailed analysis of AIG's failure, see OFFICE OF THE SPECIAL INSPECTOR GEN. FOR THE TROUBLED ASSET RELIEF PROGRAM, SIGTARP-10-003 FACTORS AFFECTING EFFORTS TO LIMIT PAYMENTS TO AIG COUNTERPARTIES (Nov. 17, 2009), available at http://www.sigtarp.gov/reports/audit/2009/Factors_Affecting_Efforts_to_Limit_Payments_to_AIG_Counterparties.pdf. AIG required three additional government bailouts, including a $40 billion capital injection from the Troubled Asset Relief Program.
63. Id. at 4.
64. Oversight of the Federal Government's Intervention at American International Group: Hearing Before the H. Comm. on Fin. Services, 111th Cong. 11 (2009) (statement of Hon. Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve System).
65. Edmund L. Andrews et al., Fed in an $85 Billion Rescue of an Insurer Near Failure, N.Y. TIMES, Sept. 17, 2008, available at Factiva, Doc. No. NYTF000020080917e49h0003l.
66. The only way to eliminate counterparty risk for bilaterally traded OTC derivatives would be through 100% collateralization. However, full collateralization would require too much capital, rendering CDS trading uneconomic.
67. See Review of CME Group's Credit Default Swap Margin Model and Financial Safeguards for CDS Clearing, CME GROUP 14 (Apr. 18, 2009), available at http://www.cmegroup.com/trading/cds/files/cds-review.pdf ("Conceptually, jump-to-default risk can never be fully covered without requiring clearing members to collateralize any large net sales of protection completely Yet, those benefits must be weighed carefully against certain costs of using a margin system to achieve those ends.").
68. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203 §§ 723, 763, 124 Stat. 1376, 1675-81, 1762-68 (2010) (codified at 7 U.S.C. § 2, 15 U.S.C. § 78a et seq.). For a full discussion of the legislative mandate
69. see infra Part III.C.
70. See infra Parts III.B.1 and III.B.2.
71. COMM. ON PAYMENT AND SETTLEMENT SYS., TECHNICAL COMM. OF THE INT'L ORG. OF SEC. COMM'NS, BANK FOR INT'L SETTLEMENTS, RECOMMENDATIONS FOR CENTRAL COUNTERPARTIES 1 (2004), available at http://www.bis.org/publ/cpss61.pdf
72. see also Hills et al., supra note 9, at 122.
73. For a detailed discussion of novation, see Robert R. Bliss & Chryssa Papathanassiou, Derivatives Clearing, Central Counterparties and Novation: The Economic Implications 19-24 (Mar. 8, 2006) (unpublished manuscript), available at http://www.ecb.int/events/pdf/conferences/ccp/BlissPapathanassiou_final.pdf.
74. See Anupam Chander and Randall Costa, Clearing Credit Default Swaps: A Case Study in Global Legal Convergence, 10 CHI. J. INT'L L. 639, 677 (2010) ("A CCP is perfectly hedged on every market risk, as it has an equal and opposite trade for every exposure it holds.").
75. See, e.g., Robert R. Bliss & Robert S. Steigerwald, Derivatives Clearing and Settlement: A Comparison of Central Counterparties and Alternative Structures, ECON. PERSPECTIVES, 4th Q. 2006, at 22, 25 ("Access restrictions (such as membership requirements) are central structural components of the CCP arrangement.").
76. See id. ("CCPs only deal with parties that meet the CCPs' standards for creditworthiness and operational capability and may revoke access privileges for those who fail to maintain their creditworthiness.").
77. EUR. CENT. BANK, supra note 16, at 52 (noting that non-members are "able to trade with a clearing member," which may pass on the benefits of clearing).
78. See Bliss & Steigerwald, supra note 66, at 25 (explaining that access restrictions "per- mit[ ] the CCPs to limit their risk exposure to those parties they are able to monitor").
79. EUR. CENT. BANK, supra note 16, at 52-53.
80. See id. at 29 (noting that most of AIG's CDS exposures were not collateralized because counterparties accepted AIG's AAA credit rating as sufficient guarantee of performance).
81. See Cecchetti et al., supra note 11, at 50 ("CCPs control risk by marking positions to market and requiring that a variation margin be paid and received each day. In periods with high volatility, positions may be marked to market intraday to limit the size of uncollateralized exposures."). When positions are marked-to-market, they are "revalued during the course of a transaction" to reflect existing market conditions.
82. Hills et al., supra note 9, at 127.
83. See id. ("As a rule, the CCP will reject new trades from a member whose initial margin is no longer sufficient.").
84. See Bliss & Papathanassiou, supra note 64, at 3 (noting that collateralization rules "are designed to prevent the default of an individual member from imposing costs on the CCP").
85. See, e.g., Bliss & Steigerwald, supra note 66, at 25 ("'[L]oss mutualization' arrange- ments generally include a clearing or capital fund that is either paid in by clearing members or built up through accumulated undistributed profits or transaction fee rebates.")
86. EUR. CENTRAL BANK, supra note 16, at 53 (stating that CCP risk management techniques "typically include[ ] contributions to the default fund by each member").
87. See EUR. CENT. BANK, supra note 16, at 53 ("If a member defaults, the CCP typically allocates the loss first to the members' own margin fund and then to the default fund.")
88. see also DARRELL DUFFIE ET AL., FED. RESERVE BANK OF N.Y., STAFF REP. NO. 424, POLICY PERSPECTIVES ON OTC DERIVATIVES MARKET INFRASTRUCTURE 21 (2010), available at http://www.newyorkfed.org/research/staff_reports/sr424.pdf (discussing resort to capital base).
89. See EUR. CENT. BANK, supra note 16, at 53 (noting that the use of a default fund "effectively mutualises the residual loss from a member's default, sharing it out across clearing members, rather than having losses concentrated in one non-defaulting member").
90. For a comprehensive account of the development of CCPs, see Randall S. Kroszner, Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearinghouses and Recent Over-the-Counter Innovations, 31 J. MONEY, CREDIT, & BANKING 596, 598-604 (1999)
91. see also Bliss & Papathanassiou, supra note 64, at 11-12.
92. See Alexander D. Noyes, Stock Exchange Clearing Houses, 8 POL. SCI. Q. 252, 256 (1893) ("The system of clearing houses for stocks is not new. It was adopted by the New York Stock Exchange only in the early months of 1892, but it has been in existence elsewhere for at least twenty-five years.").
93. See Kroszner, supra note 78, at 600 (noting that the Chicago Board of Trade began regulating futures contracts in 1865).
94. Kroszner notes that central clearing for derivatives is significantly more important than for equities because derivative contracts are settled at the expiration of the contract, and losses can accumulate over months or years; equity trades experience no such time lag and are settled nearly instantaneously.
95. See id. ("Credit or nonperformance risk in futures contracts is particularly acute due to the potentially long time between entering the contract and the delivery date. Losses can accumulate over time.")
96. see also Bliss & Steigerwald, supra note 66, at 23 ("The combination of a much longer time horizon for completing transactions, greater uncertainty as to the value (and even direction) of the ultimate transfer obligations, and the unavoidable significance of counterparty credit risk in derivatives transactions means that substantial performance (that is, credit) risk is an integral factor in the completion of derivatives transactions, compared with securities or payments transactions.").
97. See Kroszner, supra note 78, at 601 (noting the development of formal rules, including solvency thresholds and margin requirements).
98. Id. (noting that the first clearinghouses "provided no direct insurance function but simply [were] a means to reduce transaction costs").
99. Id. at 602.
100. See id. at 603.
101. See id. ("Derivatives clearinghouses have weathered the Great Depression, the Second World War, failures of major players such as Barings, and high levels of volatility without a collapse.").
102. See Cecchetti et al., supra note 11, at 55 ("[D]uring the recent financial crisis, existing CCP arrangements have performed well.").
103. Andrew M. Kulpa, Minimal Deterrence: The Market Impact, Legal Fallout, and Impending Regulation of Credit Default Swaps, 5 J.L. ECON. & POL'Y 293, 309 (2009).
104. See, e.g., U.S. GOV'T ACCOUNTABILITY OFFICE, supra note 33, at 21 (A CCP "can limit counterparty credit risk by absorbing counterparty defaults and preventing transmission of their impacts to other market participants." (emphasis added)).
105. See Hills et al., supra note 9, at 128 ("Market participants may prefer to replace th[e] risk of a potentially large loss with a more predictable chance of a smaller loss In this way, central counterparties with a member default fund have the potential to improve social welfare.").
106. See Bliss & Papathanassiou, supra note 64, at 7 (CCP loss mutualization "greatly re- duce[s] the probability that the insolvency of any one market participant would cause the failure of one or more other participants."); Squam Lake Working Grp. on Fin. Regulation, Credit Default Swaps, Clearinghouses, and Exchanges 4 (Council on Foreign Relations Working Paper, July 2000), available at http://cfr.org/content/publications/attachments/Squam_Lake_Working_Paper5.pdf [hereinafter CFR Working Group] ("[W]ith adequate capitalization, the clearinghouse can reduce systemic risk by insulating the financial system from the failure of large participants.").
107. See Hills et al., supra note 9, at 126 ("[A] central counterparty redistributes counterparty risk, replacing a firm's exposure to bilateral credit risks (of variable quality) with the standard credit risk of the central counterparty.").
108. See Bliss & Papathanassiou, supra note 64, at 3 ("[R]ather than monitoring and man- aging credit risk vis-̀a-vis original counterparties individually, each market participant need only be concerned with the CCP's credit risk. This greatly reduces monitoring costs.").
109. See Hills et al., supra note 9, at 128 (stating that decentralized counterparties might not fully disclose their aggregate exposures to "potential competitors")
110. see also Bliss & Papathanassiou, supra note 64, at 8 ("In a bilaterally-cleared market, a given dealer will know their own positions vis-̀a-vis their counterparties, but they cannot know their counterparties [sic] positions vis-̀a-vis other dealers, and thus cannot form a clear picture of their counterparties' risks.").
111. See Hills et al., supra note 9, at 128 (A CCP is likely to be better at counterparty risk mitigation because the "firms may be more open with a central counterparty than with bilateral counterparties which are also potential competitors.").
112. Figures 4 and 5 are adapted from diagrams in Hills et al., supra note 9, at 124.
113. See supra Part II.C.
114. See, e.g., Craig Pirrong, The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks Through a Central Counterparty 26 (Jan. 8, 2009) (unpublished manuscript) (on file with the Univ. of Houston Dep't of Fin.), available at http://ssrn.com/abstract=1340660 ("[A] firm with offsetting positions often has to post collateral on the [sic] both the purchased and sold contracts.").
115. See Bliss & Papathanassiou, supra note 64, at 5 ("If counterparties to matched offset- ting contracts differ and one counterparty fails, netting does not occur and the position is no longer market neutral.").
116. See Cecchetti et al., supra note 11, at 49 (estimating that multilateral netting reduces gross notional exposures of CDSs by 90 percent).
117. But see Pirrong, supra note 98, at 25 ("Netting merely redistributes wealth among a defaulter's creditors, and this redistribution does not necessarily enhance welfare.").
118. See Cecchetti et al., supra note 11, at 49 (noting that centralized clearing "increases the efficiency of collateral management").
119. See Bliss & Papathanassiou, supra note 64, at 4 ("A market participant with a no- longer-desired position need only enter into an offsetting but otherwise identical position to be free of all residual legal, market, and credit risks, and to the degree that exit frees up collateral, to reallocate the collateral they had posted to other uses.").
120. See Bliss & Steigerwald, supra note 66, at 26 ("Multilateral netting requires knowledge and analysis of all the positions of all members in the network-however, the information needed to accomplish multilateral netting may include proprietary information that the traders involved may not wish to share with outsiders. That concern may inhibit the cooperation and disclosure needed in the bilateral markets to accomplish multilateral netting.").
121. See Cecchetti et al., supra note 11, at 49 n.6 (discussing multilateral netting arrangements by third party providers).
122. Id. at 51 ("The centralisation of information in a CCP makes it possible to provide market participants, policymakers and researchers with the information to better gauge developments in various markets.").
123. See U.S. GOV'T ACCOUNTABILITY OFFICE, supra note 33, at 22.
124. See, e.g., Cecchetti et al., supra note 11, at 51 (noting that aggregate information "should help ensure that adequate collateral is posted by CDS protection sellers").
125. See U.S. GOV'T ACCOUNTABILITY OFFICE supra note 33, at 20 (discussing voluntary submission of CDS trade information to the Depository Trust and Clearing Corporation's Trade Information Warehouse).
126. See id. (noting that the Trade Information Warehouse does not include all CDS trades, particularly customized contracts, and cannot ensure the quality of its data).
127. See Shadab, supra note 53, at 453.
128. Jacob Bunge, CME Group Reports First Credit Derivatives Trades Cleared, DOW JONES NEWSWIRES, Dec. 15, 2009, available at Factiva, Doc. No. DJ00000020091215e5cf 00cz
129. Kevin Kingsbury, ICE Opens CDS Clearinghouse, WALL ST. J. ONLINE, Mar. 10, 2009, http://online.wsj.com/article/SB123668920159782863.html
130. Letter from Senior Managers of G15 Member Banks, to William C. Dudley, President, Fed. Reserve Bank of N.Y. (Sept. 8, 2009), http://www.ny.frb.org/newsevents/news/markets/2009/ma090908c.pdf.
131. For reasons why market participants would not want to submit trades to a CCP, see infra notes 115 and 118.
132. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 723, 763, 124 Stat. 1376, 1675-81, 1762-68 (2010) (codified at 7 U.S.C. § 2, 15 U.S.C. § 78a et seq.).
133. th Cong. § 13 (2009) (as reported by H. Comm. on Agric., Feb. 12, 2009)
134. Financial System Stabilization and Reform Act of 2009, H.R. 1754, 111th Cong. § 120(c) (2009) ("Any person that engages in a credit-default swap transaction shall utilize a clearinghouse designated by the [Securities and Exchange] Commission for such purpose."); Financial System Stabilization and Reform Act of 2009, S. 664, 111th Cong. § 120(c) (2009) (same).
135. See, e.g., Eric Burroughs, Regulators Need to Coordinate on CDS Oversight-NY Fed, REUTERS, Apr. 22, 2009, available at http://www.reuters.com/article/idUSHKG13563320090422 (noting that "market participants have opposed proposals to require mandatory clearing" of CDSs and other derivatives because mandatory clearing would make it "impossible to customize trades for specific client's [sic] needs").
136. DEP'T OF THE TREASURY, FINANCIAL REGULATORY REFORM: A NEW FOUNDATION 47 (2009), http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.
137. See Hearing to Review Proposed Legislation by the U.S. Department of the Treasury Regarding the Regulation of Over-the-Counter Derivatives Markets Before the H. Comm. On Agric., 111th Cong. 72 (2009) (testimony of Robert Pickel, Chief Exec. Officer, Int'l Swaps and Derivatives Ass'n) ("Not all standardized contracts can be cleared. Contracts that are infrequently traded, for example, are difficult if not impossible to clear even if they contain standardized economic terms. That's because the ability of a central counterparty clearing facility to clear a contract depends on such factors as liquidity, trading volume and daily pricing. Standardized, illiquid contracts are hard to price daily, which makes it difficult for the clearinghouse to calculate collateral requirements consistent with prudent risk management.").
138. For background on the end-user exemption, see Gretchen Morgenson, Don't Let Exceptions Kill the Rule, N.Y. TIMES, Oct. 18, 2009, available at Factiva, Doc. No. NYTF00002 0091018e5ai0001w.
139. In determining whether a class of derivatives is suitable for clearing, regulators must take into account, inter alia, the existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data, as well as the effect on the mitigation of systemic risk. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 723 (a), 763(a), 124 Stat. 1376, 1675-81, 1762-68 (2010) (codified at 7 U.S.C. § 2, 15 U.S.C. § 78a et seq.).
140. See id. § 723(a), 124 Stat. at 1675-76 ("It shall be unlawful for any person to engage in a [security-based] swap unless that person submits such [security-based] swap for clearing if the [security-based] swap is required to be cleared."). A swap or security-based swap must be cleared if a derivatives clearing organization or clearing agency plans to accept the contract for clearing and the Commodity Futures Trading Commission ("CFTC") or Securities and Exchange Commission ("SEC") determines that the contract should be cleared.
141. Id. ("A clearing agency shall submit to the Commission each [security-based] swap, or any group, category, type, or class of [security-based] swaps that it plans to accept for clearing"). In addition, the CFTC and SEC may initiate their own rules for mandatory review to determine whether a class of derivatives must be centrally cleared without waiting for submission by a clearinghouse.
142. Id. ("The Commission on an ongoing basis shall review each [security-based] swap, or any group, category, type, or class of [security-based] swaps to make a determination as to whether the [security-based] swap or group, category, type, or class of [security-based] swaps should be required to be cleared.").
143. § 723(h)(7)(A), 124 Stat. at 1679.
144. Id. In addition, in order for the exception to apply, the counterparty must notify the relevant Commission "how it generally meets its financial obligations associated with entering into non-cleared swaps." Id.
145. See Bliss & Papathanassiou, supra note 64, at 8 ("While CCPs limit the risks to other market participants and to the functioning of markets associated with the failure of a major participant, CCPs themselves become a critical component of the market so that their own failure becomes a potential systemic event.").
146. See, e.g., Kirsi Ripatti, Central Counterparty Clearing: Constructing a Framework for Evaluation of Risks and Benefits 43 (Bank of Finland Discussion Paper No. 30/2004, Dec. 30, 2004), available at http://papers.ssrn.com/abstract=787606 (deeming the risk of CCP failure to be "an 'all eggs in one basket' risk").
147. Compare Hills et al., supra note 9, at 131 (noting that "the presence of a central counterparty in a market may serve to exacerbate systemic risk"), with Risk Management and Its Implications for Systemic Risk: Hearing Before the Subcomm. on Securities, Ins., and Inv. of the S. Banking, Hous., and Urban Affairs Comm., 111th Cong. 14 (2009) (statement of Donald L. Kohn, Vice Chairman, Bd. of Governors of the Fed. Reserve Sys.) (arguing that a CCP "can reduce risk, but it concentrates risk").
148. See Bliss & Papathanassiou, supra note 64, at 8-9 ("[T]he failure of a CCP would necessarily lead to at least a temporary breakdown of the market as the whole structure through which positions are established, maintained, and closed-out would be disrupted.").
149. See Ripatti, supra note 125, at 43 (noting that "the probability of a CCP failure may be very small, but the consequences of a systemic failure are huge")
150. Stephen Cecchetti, Centralized Counterparties and Systemic Risk, http://www.mhhe.com/economics/cecchetti/Cecchetti2_Ch09_CentralCounterparties.pdf (last visited Oct. 26, 2010) (noting that a CCP failure "would be potentially catastrophic for the financial system").
151. Shadab, supra note 53, at 455
152. see also Bliss & Papathanassiou, supra note 64, at 9 (arguing that the effects of a CCP failure "might well outweigh the effects of the failure of a major dealer in a bilaterally-cleared market").
153. Craig Pirrong, The Clearinghouse Cure, REGULATION, Winter 2008-09, at 44, 49
154. see also Michael H. Moskow, Public Policy and Central Counterparty Clearing, ECON. PERSPECTIVES, 4th Q. 2006, at 46, 49 ("[A] CCP also concentrates risks and responsibility for risk management, making it a potential single point of failure. Concentration carries with it systemic implications, since the failure of a CCP would be, by definition, a major systemic event.").
155. See, e.g., Hills et al., supra note 9, at 131-32 ("Even if the central counterparty's risk management procedures are in theory sound, their effectiveness is still dependent on the competent implementation of those procedures by its management. The concentration of operational risk in a central counterparty is considerably greater than that in any individual participant in a decentralised market, and the repercussions of incompetent management would be correspondingly larger.")
156. see also Ripatti, supra note 125, at 43 (discussing various rea- sons why a CCP might fail).
157. See, e.g., Cecchetti, supra note 128 (noting that "a CCP may come to be viewed as a kind of public utility that cannot be allowed to fail")
158. see also Satyajit Das, OTC Derivative Regulation Proposals-Neat, Plausible, and Wrong!, WILMOTT (July 17, 2009, 4:24 AM), http://www.wilmott.com/blogs/satyajitdas/index.cfm/2009/7/17/ ("The CCP centralises all performance in a single entity, surely the ultimate case of 'too big to fail.'").
159. Supporters of Dodd-Frank argue that the bill solves the TBTF problem by establishing a resolution process through which failing complex financial institutions can be liquidated.
160. See, e.g., S. COMM. ON BANKING, HOUS., & URBAN AFFAIRS, BRIEF SUMMARY OF THE DODDFRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT, available at http://banking.senate.gov/public/_files/070110_Dodd_Frank_Wall_Street_Reform_comprehensive_summary_Final.pdf (asserting that Dodd-Frank "ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy")
161. see also Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 201-17, 124 Stat. 1442-1520 (2010). However, skeptics question whether, notwithstanding the new resolution authority, regulators would actually allow troubled complex institutions, including clearinghouses, to fail.
162. See, e.g., Gretchen Morgenson, Count on Sequels to TARP, N.Y. TIMES, Oct. 3, 2010, at BU1 (arguing that, despite attempts to end TBTF, Dodd-Frank "has created a new set of institutions that will almost certainly be deemed too important to fail" and noting that clearinghouses remain on the "roster of bailout candidates").
163. For a primer on TBTF and moral hazard, see Daniel K. Tarullo, Governor, Fed. Reserve Bd. Of Governors, Confronting Too Big to Fail, Address at the Exchequer Club of Washington, D.C. (Oct. 21, 2009), available at http://www.federalreserve.gov/newsevents/speech/tarullo20091021a.htm.
164. See Shadab, supra note 53, at 455 ("[C]entral counterparties may have an incentive to reduce the amount of margin collateral they require their customers to post in order to attract business.").
165. One of the consequences of the TBTF problem is that it leads to inadequate monitoring by those market participants that could otherwise avert the failure of the institution through diligent oversight.
166. See GARY H. STERN & RON J. FELDMAN, TOO BIG TO FAIL: THE HAZARDS OF BANK BAILOUTS 11-28 (The Brookings Institution, 2004).
167. Cf. Bernanke, supra note 7, at 143-44 ("[W]hile a conservative clearinghouse might try to prepare itself for even a very large shock, there must be some eventualities for which, ex ante, insurance is just too costly.").
168. See Shadab, supra note 53, at 455 (noting that CCPs "are likely to be subject to defi- cient prudential supervision and risk-based capital requirements").
169. Craig Pirrong has pointed out additional drawbacks to centralized clearing, including the difficulty of pricing each clearing member's balance sheet risk.
170. See Pirrong, supra note 130, at 48.
171. See supra notes 86-88 and accompanying text.
172. See, e.g., Bliss & Papathanassiou, supra note 64, at 9 (concluding that "CCP failure [is] less likely than the failure of a major dealer" in decentralized OTC markets).
173. See infra note 147 and accompanying text.
174. See supra Part II.C.1.
175. See supra Part IV.A.1 (noting the systemic importance of CCPs and possible "bulldozer effect" of a CCP failure).
176. See supra Part II.C.1.
177. Over the Counter, Out of Sight, ECONOMIST, Nov. 14, 2009, available at http://www.economist.com/displaystory.cfm?story_id=14843667
178. see also Mark J. Roe, Derivatives Clearinghouses are No Magic Bullet, WALL ST. J., May 6, 2010, available at Factiva, Doc. No. EC00000020091112e5be0000d ("Collateralizing and monitoring such discontinuous obligations will not be so easy for the clearinghouse.").
179. See U.S. GOV'T ACCOUNTABILITY OFFICE, supra note 33, at 22 (emphasizing that jump- to-default risk "has the potential to create significant losses for [ ] clearinghouses")
180. CFR Working Group, supra note 91, at 2 (noting that CDS CCPs "may actually increase counterparty and systemic risk, contrary to the assumption of many policy makers").
181. See CME GROUP, supra note 60, at vi ("Catastrophic 'jumps to default' by reference entities underlying single-name CDSs may precipitate margin coverage shortfalls on portfolios with highly concentrated exposures to the defaulting reference name(s)."). Further, some market commentators have noted that legislative proposals requiring centralized clearing of illiquid CDSs might exacerbate the volatility of margining given the difficulty of marking-tomarket in the absence of robust price discovery.
182. See, e.g., On Clearinghouses, ECONOMICS OF CONTEMPT (Mar. 25, 2010, 1:19 AM), http://economicsofcontempt.blogspot.com/2010/03/onclearinghouses.html ("[F]orcing OTC derivatives that aren't sufficiently liquid onto clearinghouses is not necessarily 'playing it safe' from a regulatory perspective. It greatly increases the chances that a clearinghouse will misprice its counterparty risk, and end up not having collected enough variation margin to cover the losses from a default.").
183. See supra note 60 and accompanying text.
184. See, e.g., Yves Smith, The Fantasy of the Clearinghouse Magic Bullet, NAKED CAPITALISM (Nov. 6, 2009, 5:32 AM), http://www.nakedcapitalism.com/2009/11/the-fantasy-ofthe-clearing-house-magic-bullet.html ("A large enough margin to allow for jump-to-default risk will make CDS uneconomic so dealers and counterparties will fight for a lower margin, meaning the [CCP] will be undercapitalized relative to the risks it faces.").
185. See Pirrong, supra note 130, at 49 ("An AIG default would have imposed huge losses on the clearinghouse, and hence on its members-other big financial intermediaries. Such a large default would have threatened the viability of the clearinghouse and its members").
186. See, e.g., Michael D. Bordo, The Lender of Last Resort: Some Historical Insights 3 (Nat'l Bureau of Econ. Research, Working Paper No. 3011, 1989), available at http://www.nber.org/papers/w3011.pdf.
187. See Shadab, supra note 135 and accompanying text.
188. See Shadab, supra note 138 and accompanying text.
189. See CME GROUP, supra note 60 and accompanying text.
190. See Bernanke, supra note 137 and accompanying text.
191. See, e.g., Nina Mehta, Options Clearinghouse Lobbies for Access to Fed Funding During Emergencies, BLOOMBERG (June 23, 2010, 2:25 PM), http://www.bloomberg.com/news/2010-06-23/options-clearinghouse-lobbies-for-access-to-fed-funding-during-emergencies.html (citing OCC Chairman Wayne Luthringhausen's claim that access to Federal Reserve liquidity could, in a crisis, allow OCC to satisfy its obligations to its counterparties and thereby "help the financial system").
192. See DUFFIE ET AL., supra note 76, at 21 (noting that clearinghouses generally have "a contractual claim to additional contributions by CCP participants, contingent on losses to the guarantee fund").
193. A comparable pre-funded default account for systemically important depository institutions faced significant industry opposition.
194. See, e.g., Letter from Am. Council of Life Insurers et al. to Christopher Dodd, Chairman, and Richard Shelby, Ranking Member, of the Senate Comm. on Banking, Hous., and Urban Affairs (Dec. 7, 2009), available at http://www.financialservicesforum.org/attachments/365_joint_trade_letter.pdf (opposing a pre-funded systemic risk resolution fund in light of, inter alia, costly assessments and increased moral hazard).
195. See, e.g., Jack Guttentag and Richard Herring, The Lender of Last Resort Function in an International Context 9 (U. of Penn. Wharton Sch., Working Paper No. 9-81, 1981), available at http://finance.wharton.upenn.edu/~rlwctr/papers/8109.PDF (noting that a LoLR "may well have better information regarding the condition of [a financial institution] than the private markets").
196. Given market conditions likely to prevail at a time of CCP distress, private banks might also lack the necessary liquidity to support a troubled clearinghouse.
197. For an example of possible complications arising out of multi-party lending arrangements through the Federal Reserve
198. see ROGER LOWENSTEIN, WHEN GENIUS FAILED: THE RISE AND FALL OF LONG TERM CAPITAL MANAGEMENT 185-219 (Random House, 2000).
199. Ben Bernanke, in describing the emergency liquidity provision to save OCC in October 1987, notes that the Federal Reserve had to lend to First Options of Chicago, through its parent bank, Continental Illinois.
200. Bernanke, supra note 7, at 148-50. However, "if First Options had not had access to the 'deep pockets' of Continental Illinois [or] if the crash had occurred on the previous Monday, Columbus Day, when the banks were closed much more severe consequences might have ensued."
201. Id. at 150. Had the Federal Reserve lent directly to the clearinghouse, Continental Illinois' deep pockets and bank closures would have been less relevant.
202. Clearinghouse board members would still have to agree to accept an emergency loan from the Federal Reserve, but such an agreement could be made by majority or supermajority vote, as provided in the CCP's rules.
203. See, e.g., CME GROUP, CME RULE 230.K, available at http://www.cmegroup.com/rulebook/CME/I/2/30.html (providing that "in the event that an emergency situation exists [the Board] may, upon a majority vote take such action as may in the Board's sole discretion appear necessary to prevent, correct or alleviate the emergency condition."). On the other hand, a multiparty indirect lending agreement, in order to be effective, might need to be unanimous, or near unanimous, among all member firms.
204. See generally LOWENSTEIN, supra note 163, at 185-219 (referencing the importance of unanimity in multi-party lending agreements).
205. For a discussion of how Federal Reserve lending can provide signals to the market about the borrower's financial condition
206. see Renee Courtois and Huberto M. Ennis, Is There Stigma Associated with Discount Window Borrowing? 1-4 (Fed. Reserve Bank of Richmond, Economic Brief No. 10-05, 2010), available at http://www.richmondfed.org/publications/research/economic_brief/2010/pdf/eb_10-05.pdf.
207. See, e.g., EUR. CENT. BANK, supra note 16, at 51 (noting that CCPs should "have access to central bank liquidity in the currency in which the products cleared are denominated")
208. Cecchetti et al., supra note 11, at 55 (indicating that "CCPs may require public sector support")
209. Jeremy Grant, Call For Central Banks to Regulate Clearing Houses, FIN. TIMES, Dec. 29, 2009, available at Factiva, Doc. No. FTFT000020091229e5ct0000v (quoting Xavier Rolet, the CEO of the London Stock Exchange, as saying that "central banks should have at least a funding relationship to clearing houses"). Members of the British Parliament have argued that the European Union ("EU") should not be permitted to regulate CCPs because the EU has insufficient resources to bail out a failing CCP. Instead, the members of Parliament prefer that CCPs be regulated by the countries in which they are located, since the host countries could provide support through their central banks.
210. Jeremy Grant, Lords Raise Questions Over Clearing Houses, FIN. TIMES, Mar. 31, 2010, available at Factiva, Doc. No. FTCOM00020100331e63v004v2.
211. See infra notes 170, 179-181 and accompanying text.
212. Federal Reserve Act, 12 U.S.C. § 226 (2006).
213. See Federal Reserve Act § 10B, 12 U.S.C. § 347b(a) (2006) (advances on time or demand notes); § 13(2), 12 U.S.C. § 343(2) (2006) (discounts on real bills arising out of commercial transactions); § 13(4), 12 U.S.C. § 344 (2006) (discounts on bills of exchange arising out of shipment of agricultural goods); § 13(6), 12 U.S.C. § 346 (2006) (discounts on acceptances); § 13(8), 12 U.S.C. § 347 (2006) (advances to depositories on promissory notes); § 13A, 12 U.S.C. § 348 (2006) (discounts on agricultural paper).
214. As written, the aforementioned provisions allow the Federal Reserve to lend only to banks that are members of the Federal Reserve System; however, § 19(b)(7) provides that "any depository institution in which transaction accounts or nonpersonal time deposits are held shall be entitled to the same discount and borrowing privileges as member banks." 12 U.S.C. § 461(b)(7) (2006).
215. The Federal Reserve Discount Window, FEDERAL RESERVE DISCOUNT WINDOW & PAYMENT SYSTEM RISK WEBSITE 1 (2010), http://www.frbdiscountwindow.org/discountwindow_pf.doc.
216. See Press Release, Bd. of Governors of the Fed. Reserve Sys. (Mar. 16, 2008), available at http://www.federalreserve.gov/newsevents/press/monetary/20080316a.htm.
217. For a discussion of the differences between advances and discounts, see HOWARD H. HACKLEY, LENDING FUNCTION OF THE FEDERAL RESERVE BANKS: A HISTORY 83 (1973).
218. The Federal Reserve has traditionally lent to depository institutions through advances under §§ 10B and 13(8) because of their relative simplicity.
219. See David H. Small & James A. Clouse, The Limits the Federal Reserve Act Places on the Monetary Policy Actions of the Federal Reserve, 19 ANN. REV. BANKING L. 553, 561 (2000).
220. Small & Clouse, supra note 173, at 561 (noting the flexibility of the "satisfaction" standard).
221. The Federal Reserve Discount Window, supra note 171, at 2.
222. Id. at 1.
223. Federal Reserve Act § 19(b)(1)(A), 12 U.S.C. § 461(b)(1)(A) (2006) (defining "depository institution" as, inter alia, an FDIC insured bank, mutual savings bank, insured credit union, or savings association).
224. See infra note 184 and accompanying text. 179 Federal Reserve Act § 13(3), 12 U.S.C. § 343(3).
225. 12 C.F.R. § 201.4(d) (2009). In addition, § 13(3) makes the grant of emergency loans, unlike ordinary discount window loans, contingent on an affirmative vote of five members of the Federal Reserve Board of Governors. 12 U.S.C. § 343(3). Before extending credit under § 13(3), the Federal Reserve must also obtain evidence that the borrower is unable to secure credit from other banking institutions. Id.
226. 12 U.S.C. § 343(3).
227. Small & Clouse, supra note 173, at 564
228. see also Thomas O. Porter, The Federal Re- serve's Catch-22: A Legal Analysis of the Federal Reserve's Emergency Powers, 13 N.C. BANKING INST. 483, 508 (2009) (noting that the Fed had "complete discretion to accept any types of collateral for a discount" under § 13(3)).
229. But see HACKLEY, supra note 173, at 129 ("[I]t seems clear that it was the intent of Congress that loans should be made only to creditworthy borrowers; in other words, the Reserve Bank should be satisfied that a loan under this authority would be repaid in due-course, either by the borrower or by resort to security "). For his part, Federal Reserve Chairman Ben Bernanke has insisted that the Fed may make § 13(3) loans only if the credit risk it assumes is equivalent to AAA.
230. See Oversight of the Federal Government's Intervention at American International Group: Hearing Before the H. Comm. on Fin. Servs., 111th Cong. 42 (2009) (statement of Ben Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Bank). However, other Federal Reserve officials have subsequently backed off of Bernanke's rigid construction of the statutory terms. Former Federal Reserve Board Vice Chairman Donald Kohn has, for instance, stated that "secured to the satisfaction of the Federal Reserve bank" means only that "[w]e need to have enough security that we feel the loan has a good prospect of being repaid." Regulatory Restructuring: Balancing the Independence of the Federal Reserve in Monetary Policy with Systemic Risk Regulation: Hearing Before the H. Comm. on Fin. Servs., 111th Cong. 15 (2009) (statement of Donald L. Kohn, Vice Chairman, Bd. of Governors of the Fed. Reserve Bank). Similarly, Federal Reserve Board General Counsel Scott Alvarez has implied that security for a § 13(3) loan need not be equivalent to a AAA credit risk so long as the Federal Reserve thinks the loan "would be fully repaid." H.R. 1207, the Federal Reserve Transparency Act of 2009: Hearing Before the H. Comm. on Fin. Servs., 111th Cong. 24 (2009) (statement of Scott G. Alvarez, Gen. Counsel, Bd. of Governors of the Fed. Reserve Bank).
231. The Federal Reserve prepared to lend under § 13(3) two times in the 1960s, but no borrowers accepted the credit. An Examination of the Extraordinary Efforts by the Federal Reserve Bank to Provide Liquidity in the Current Financial Crisis: Hearing Before the H. Comm. on Fin. Servs., 111th Cong. 72 n.1 (2009) [hereinafter House Hearing on § 13(3)] (statement of Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Bank).
232. David Fettig, Lender of More Than Last Resort, REGION, Dec. 2002, at 14, 18-19, http://www.minneapolisfed.org/pubs/region/02-12/lender.pdf (noting that one reason for the Federal Reserve's minimal reliance on § 13(3) during the Great Depression was its temporary authority, under a separate provision, to supply $280 million in working capital directly to industrial and commercial businesses).
233. FED. RESERVE BANK OF N.Y., SUMMARY OF TERMS AND CONDITIONS REGARDING THE JPMORGAN CHASE FACILITY (2008), available at http://www.newyorkfed.org/newsevents/news/markets/2008/rp080324b.html.
234. See, e.g., FED. RESERVE BD. OF GOVERNORS, MONTHLY REPORT ON CREDIT AND LIQUIDITY PROGRAMS AND THE BALANCE SHEET (2010), available at http://www.federalreserve.gov/monetarypolicy/files/monthlyclbsreport201002.pdf.
235. FED. RESERVE BD. OF GOVERNORS, STATISTICAL RELEASE H.4.1: FACTORS AFFECTING RESERVE BALANCES OF DEPOSITORY INSTITUTIONS (2008), available at http://www.federalreserve.gov/releases/h41/20081211/ ($309 billion for the CPFF, $52 billion for the PDCF, $41 billion for the AMLF, $27 billion for JPMorgan Chase's purchase of Bear Stearns, and a total of $78 billion for AIG).
236. See infra notes 191-192 and accompanying text.
237. See infra notes 193-194.
238. See, e.g., Porter, supra note 183, at 512-13 (questioning at what point circumstances cease to be unusual).
239. See, e.g., Chad D. Emerson, The Illegal Actions of the Federal Reserve: An Analysis of How the Nation's Central Bank has Acted Outside the Law in Responding to the Current Financial Crisis, 1 WM. & MARY BUS. L. REV. 109, 128-29 (2010).
240. House Hearing on § 13(3), supra note 184, at 3 (statement of Rep. Spencer Bachus (R- Ala.)) (decrying "unprecedented interventions into the financial markets" with "no disclosure" and "little oversight or accountability").
241. Id. at 26 (statement of Rep. Jeb Hensarling (R-Tex.)) (implying a lack of temporal restrictions on Federal Reserve lending under § 13(3)); id. at 27 (statement of Rep. Brad Sherman (D-Cal.)) (expressing concern over the Federal Reserve's ability to determine whether collateral is satisfactory).
242. See supra notes 193-194.
243. See infra Part VI.A.
244. See infra Part VI.B.
245. Oct. 2, 2009 Draft of Amendment #27 to the Over-the-Counter Derivatives Markets Act of 2009, H.R. 3795, 111th Cong. (2009), available at http://www.house.gov/apps/list/speech/financialsvcs_dem/bachus_amendment_(revised).pdf.
246. Id. (emphasis added).
247. Id. There may be a legitimate question as to whether loans from the Federal Reserve constitute the use of "public funds"; however, given the inclusion of the Federal Reserve Act in the enumerated lists of statutes to which the amendment would apply, it is likely that Rep. Bachus intended to bar Federal Reserve loans to CCPs.
248. See Webcast: Mark-Up of OTC Derivatives Market Act, House Comm. on Fin. Servs. (Oct. 14, 2009), http://financialserv.edgeboss.net/wmedia/financialserv/markup101409.wvx (exchange between Rep. Frank and Rep. Bachus concerning Amendment no. 27).
249. Wall Street Reform and Consumer Protection Act of 2009, H.R. 4173, 111th Cong. § 3004(a) (as passed by House, Dec. 11, 2009) (emphasis added).
250. Rep. Jeb Hensarling noted at the mark-up that nothing in the amendment, as revised, "curtails the Federal Reserve's [§] 13(3) exigent powers." Webcast: Mark-Up of OTC Derivatives Market Act, supra note 201 (statement of Rep. Hensarling in response to exchange between Rep. Frank and Rep. Bachus narrowing the scope of the amendment).
251. See Michael R. Crittenden, US Rep. Frank: Will Limit Fed's Lending Leeway, DOW JONES NEWSWIRES, Nov. 3, 2009, available at Factiva, Doc. No. DJI0000020091103e5b30 01ho (quoting Rep. Frank as saying that policymakers adopted restrictions on § 13(3) to ensure that there would be "[n]o more Fed to AIG, no more Fed to Bear Stearns").
252. H.R. 4173 § 1701.
253. Id. A substandard asset-the highest quality of the three prohibited classifications-is an asset that is "inadequately protected by the current sound worth and paying capacity of the obligor." OFFICE OF THRIFT SUPERVISION, EXAMINATION HANDBOOK 260.3 (2009), available at files.ots.treas.gov/422089.pdf.
254. H.R. 4173 § 1701.
255. See supra notes 179-181 and accompanying text.
256. See supra note 183.
257. H.R. 4173 § 1701.
258. See DUFFIE ET AL., supra note 76, at 21 (discussing contingent claims of the CCP on its members).
259. See supra notes 163-166 and accompanying text.
260. Restoring American Financial Stability Act of 2010, S. 3217, 111th Cong. § 802(a)(2), (as passed by Senate May 20, 2010), available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:s3217as.txt.pdf (emphasis added).
261. See supra Part V.B for a discussion of the Federal Reserve's powers to lend to CCPs prior to Dodd-Frank.
262. S. 3217 § 802(b)(3).
263. Id. § 806(b). A "financial market utility" was defined as "any person that manages or operates a multilateral system for the purpose of transferring, clearing, or settling payments, securities, or other financial transactions among financial institutions or between financial institutions." Id. § 803(5). A financial market utility was eligible to be designated as systemically important if its failure or disruption "could create, or increase, the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the financial system."
264. Id. § 803(8). Applying these definitions, many large CCPs likely would have fallen within the § 806 designation of systemically important financial market utilities.
265. See supra notes 170-177 and accompanying text.
266. S. 3217 § 1151(2).
267. Id. In its initial draft, the Senate had presciently included among potential § 13(3) credit recipients any "financial market utility" that a systemic risk council "determines is, or is likely to become, systemically important." Id. §§ 804(a)(2), 806(a) (as introduced Apr. 15, 2010). These provisions would have ensured that large, interconnected CCPs had access to Federal Reserve credit in emergency situations. However, after complaints from Federal Deposit Insurance Corporation Chairman Sheila Bair that this formulation of § 13(3) would allow for "backdoor bailouts" of any large financial corporation that performed clearing or settlement services
268. see, e.g., Michael R. Crittenden, Dodd Bill May Allow for "Backdoor Bailouts," Bair Says, WALL ST. J., Mar. 19, 2010, available at http://online.wsj.com/article/SB10001424052748703580904575131462323522590.html, Sen. Dodd dropped the provision preserving financial market utilities' access to § 13(3) funds.
269. See S. 3217 § 1151 (Manager's Amendment released Mar. 23, 2010) (striking permission for the Federal Reserve to extend credit to financial market utilities under § 13(3)), available at http://banking.senate.gov/public/_files/032310MangersAmendmentAYO10627.pdf.
270. See supra notes 205-206 and accompanying text.
271. S. 3217 § 716(a).
272. Id. § 716(b)(2).
273. Id. § 716(b)(1) (defining "Federal assistance" as "the use of any funds, including advances from any Federal Reserve credit facility, discount window, or pursuant to [§ 13(3)] of the Federal Reserve Act").
274. See supra notes 198-200 and accompanying text.
275. See Damian Paletta and Victoria McGrane, Snags Slow Financial Overhaul, WALL ST. J., June 25, 2010, available at Factiva, Doc. No. J000000020100625e66p00047 (describing Sen. Lincoln's support for § 716 and calling it "the most divisive issue" in ongoing congressional negotiations)
276. see also Kevin Drawbaugh and Andy Sullivan, Senate Fails to End Debate on Bank Reform Bill, REUTERS, May 19, 2010, available at Factiva, Doc. No. LBA 0000020100519e65j001fh ("In a move to defuse tension with fellow Democrat Blanche Lincoln, Dodd dropped an attempt to kill Lincoln['s] proposal.").
277. See, e.g., Sarah N. Lynch, Sen. Dodd: Banking and Agriculture Committees in Talks on Derivatives, DOW JONES NEWSWIRES, Apr. 20, 2010 (describing the Senate bill's derivatives language as a "placeholder"). Perhaps the best evidence for the intended transience of the § 716 prohibition on lending to CCPs is that the conference committee agreed to delete the provision shortly after Sen. Lincoln won her party's primary for re-nomination to her Senate seat.
278. See, e.g., Damian Paletta, Senator Pitches a Tamer Bank Bill, WALL ST. J., June 15, 2010, at C1, available at Factiva, Doc. No. J000000020100615e66f00043.
279. Compare supra notes 211-214 and accompanying text, with Dodd-Frank § 1101(a) (setting no repayment threshold).
280. Dodd-Frank requires simply that "the security for emergency loans [be] sufficient to protect taxpayers from losses." § 1101(a)(6). Compare supra note 207 and accompanying text.
281. § 1101(a)(2), 124 Stat. at 2113.
282. § 1101(a)(6), 124 Stat. at 2114.
283. § 803(6)(A), 124 Stat. at 1805; § 806(b), 124 Stat. at 1811.
284. § 803(6)(A), 124 Stat. at 1805.
285. Like the Senate bill, Dodd-Frank prohibits "swaps entities" from receiving federal assistance; however, Dodd-Frank changes the Senate bill's definition of a swaps entity so that clearinghouses are no longer disqualified. § 716(b)(2)(A), 124 Stat. at 1648.
286. Although granting clearinghouses routine access to the discount window might foster moral hazard, many market observers already believe that CCPs are TBTF.
287. See supra Part IV.A.2. Thus, routine access could reduce the likelihood that CCPs reach emergency conditions without appreciably increasing moral hazard.
288. The Dow Jones Industrial Average opened at 2,164.16 on October 19, 1987 and closed at 1,793.93 on October 26, 1987.
289. Dow Jones Industrial Average Historical Prices for Oct. 19- 26, 1987, YAHOO! FINANCE, http://finance.yahoo.com/q/hp?s=^DJI&a=09&b=19&c=1987&d=09&e=26&f=1987&g=d (last visited Oct. 27, 2010).
290. The Hang Seng Index opened at 3,665.70 on October 19, 1987 and closed at 2,241.70 on October 26, 1987.
291. Hang Seng Index Historical Prices for Oct. 19-26, 1987, YAHOO! FINANCE, http://finance.yahoo.com/q/hp?s=^HSI&a=09&b=19&c=1987&d=09&e=26&f=1987&g=d (last visited Oct. 27, 2010).