Derivatives clearinghouses and systemic risk: A bankruptcy and Dodd-Frank analysis

Stanford Law Review

Volumn 64, Issue 4, 2012, Pages 1079-1108

  Allen, Julia Lees ^a  

^a STANFORD LAW SCHOOL   (United States)

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EID: 84861464943     PISSN: 00389765     EISSN: None     Source Type: Journal    
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References (153)

1. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376, 1376 (2010).
2. See Stephen G. Cecchetti et al., Central Counterparties for Over-the-Counter Derivatives, BIS Q. REV., Sept. 2009, at 45, 50.
3. Effective September 26, 2011, the CFTC finalized regulations for the process for review of swaps for mandatory clearing. Process for Review of Swaps for Mandatory Clearing, 76 Fed. Reg. 44,464, 44,473-74 (July 26, 2011) (to be codified at 17 C.F.R. § 39.5). Regulation 39.5(b)(3)(ii) provides certain factors to be considered by the CFTC in determining which swaps require mandatory clearing (either in reviewing swaps on its own initiative or by clearinghouse submission): (A) The existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data; (B) The availability of rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the contract on terms that are consistent with the material terms and trading conventions on which the contract is then traded; (C) The effect on the mitigation of systemic risk, taking into account the size of the market for such contract and the resources of the derivatives clearing organization available to clear the contract; (D) The effect on competition, including appropriate fees and charges applied to clearing; and (E) The existence of reasonable legal certainty in the event of the insolvency of the relevant derivatives clearing organization or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property.
4. Id. (to be codified at 17 C.F.R. § 39.5(b)(3)(ii)).
5. Dodd-Frank also identifies certain entities, dealers, and major swap participants who must clear trades and meet capital and margin requirements.
6. See Dodd-Frank Wall Street Reform and Consumer Protection Act § 723, 7 U.S.C. § 2 (2006 & Supp. IV 2010). However, specifics remain unclear and require rulemaking by regulatory authorities.
7. See Dodd-Frank Act Rulemaking: Derivatives, SEC, http://www.sec.gov/spotlight/dodd-frank/derivatives.shtml (last visited Apr. 13, 2012).
8. Darrell Duffie et al., Policy Perspectives on OTC Derivatives Market Infrastructure 1 n.1 (Fed. Reserve Bank of N.Y., Staff Report No. 424, 2010) (discussing the over-the-counter derivatives market structure and suggesting changes for regulators to improve weakness in the market).
9. Recently, some industry leaders have expressed concern that the mandatory clearing requirements make clearinghouses the new "too big to fail" entities, effectively shifting risk from banks to clearinghouses while not addressing systemic risk concerns.
10. See Mark J. Roe, The Derivatives Market's Payment Priorities as Financial Crisis Accelerator, 63 STAN. L. REV. 539, 586-87 (2011)
11. Aline van Duyn, IMF Queries Derivatives Reform Effectiveness, FIN. TIMES (Mar. 29, 2011 7:50 PM), http://www.ft.com/cms/s/0/9511df26-5a2b-11e0-86d3-00144feab49a.html ("Manmohan Singh, the author of [an] IMF working paper, said the clearing houses may themselves be 'too-big-to-fail' entities in the making. Present efforts 'may not remove the systemic risk from OTC derivatives but rather shift them from banks to [clearing houses],' he said" (second alteration in original))
12. see also Kevin Brown, Call for Rethink on OTC Deals, FIN. TIMES (Dec. 6, 2009 8:43 PM), http://www.ft.com/cms/s/0/60506e18-e297-11de-b028-00144feab49a.html ("Pierre Gay, Asia-Pacific chief executive of futures broker Newedge, said the creation of a central clearing house to act as counterparty to OTC transactions on exchanges could be dangerous because it would transfer risk from banks to the clearer.").
13. Cecchetti et al., supra note 2, at 50.
14. INT'L SWAPS & DERIVATIVES ASS'N, OTC DERIVATIVES MARKET ANALYSIS, YEAR-END 2010, at 1 (2011), available at http://www2.isda.org/functional-areas/research/studies. The notional amount on a financial instrument is the nominal or face value used to calculate payments made on that instrument.
15. Id.
16. Duffie et al., supra note 4, at 4.
17. See id.
18. Id. at 9-10.
19. See id. at 5.
20. See id. at 5.
21. See id.
22. See id.
23. Id.
24. As a point of reference, the amount of interest rate swaps cleared at the end of 2010 totaled nearly $248 trillion measured in terms of notional amounts (and the total notional amount outstanding of the interest rate swap market reached $364 trillion), illustrating the role clearinghouses currently play in the over-the-counter derivatives markets. See INT'L SWAPS & DERIVATIVES ASS'N, supra note 7, at 1.
25. Cecchetti et al., supra note 2, at 46.
26. Multilateral netting is the process by which mutual payment obligations between parties are set off, partially or entirely canceling each other out.
27. See id. at 49-50.
28. ROBERT E. LITAN, THE BROOKINGS INST., THE DERIVATIVES DEALERS' CLUB AND DERIVATIVES MARKETS REFORM: A GUIDE FOR POLICY MAKERS, CITIZENS AND OTHER INTERESTED PARTIES 12 (2010) (providing a "Cliff's Notes" guide to derivatives).
29. Cecchetti et al., supra note 2, at 49. Collateral is the assets provided to decrease a party's exposure if its counterparty defaults: with collateral, the party will already have assets in its possession that it may liquidate to cover the counterparty's losses.
30. Duffie et al., supra note 4, at 6.
31. See Darrell Duffie & Haoxiang Zhu, Does a Central Clearing Counterparty Reduce Counterparty Risk?, 1 REV. ASSET PRICING STUD. 74, 75 (2011) ("The introduction of a CCP for a particular class [of derivatives]. is effective only if the opportunity for multilateral netting in that class dominates the resulting loss in bilateral netting opportunities across all uncleared derivatives ").
32. Cecchetti et al., supra note 2, at 50.
33. Scholars have also expressed concern about incentive problems resulting from mandatory clearing of financial products, distinct from those explained in this Note, relating to moral hazard and excessive risk taking.
34. See, e.g., Craig Pirrong, The Inefficiency of Clearing Mandates 3 (CATO Inst., Policy Analysis No. 665, 2010), available at http://ssrn.com/abstract=1710802 ("Risk sharing through a clearinghouse makes the balance sheets of the clearinghouse members public goods, and encourages excessive risk taking. That is, the clearing mechanism is vulnerable to moral hazard.").
35. Included in the Dodd-Frank mandatory clearing requirements are provisions that ensure at the most general level that these three risk-management functions exist; however, the lack of specificity creates uncertainty as to how well new clearinghouses or existing clearinghouses will manage risk.
36. See Dodd-Frank Wall Street Reform and Consumer Protection Act § 725, 7 U.S.C. § 7a-1 (2006 & Supp. IV 2010). For example, Dodd-Frank clearinghouse provisions regarding minimum financial resources provide that they must at minimum exceed the amount that would: (I) enable the organization to meet its financial obligations to its members and participants notwithstanding a default by the member or participant creating the largest financial exposure for that organization in extreme but plausible market conditions; and (II) enable the derivatives clearing organization to cover the operating costs of the derivatives clearing organization for a period of 1 year.
37. Id. § 725(c), 7 U.S.C. § 7a-1(c)(2)(B)(ii). This creates a minimum floor but does not specify mechanisms to ensure the legitimacy of risk-management procedures; moreover, this requirement is less stringent than LCH's current default fund calculation procedures.
38. See infra note 49.
39. See, e.g., LCH. Clearnet: A General Introduction to Risk Mitigation, LCH.CLEARNET 8, http://www.lchclearnet.com/Images/LCH%20Clearnet%20-%20how%20it%20mitigates%20risk_tcm6-44531.pdf (last visited Apr. 13, 2012) (noting that LCH.Clearnet's requirements include net capital and operational capability as well as rating and regulatory status in some markets).
40. LCH.Clearnet Ltd's Clearing Members, Membership Criteria and Clearing Member Monitoring (2011), LCH.CLEARNET 5-7, http://www.lchclearnet.com/images/lch%20clearnet%20ltd%20-%20members%20updated%20may%202011_tcm6-44532.pdf (last visited Apr. 13, 2012) (describing in detail the membership requirements).
41. Id. at 9.
42. LCH.Clearnet, supra note 27, at 10. Margin is the collateral posted by a clearing member to protect the clearinghouse in the case of default and generally consists of cash or securities.
43. See, e.g., Acceptable Collateral, LCH.CLEARNET, http://www.lchclearnet.com/risk_management/ltd/acceptable_collateral.asp (last visited Apr. 13, 2012).
44. See LCH.Clearnet Ltd-Initial Margin, LCH.CLEARNET 4-5, http://www.lchclearnet.com/Images/LCH%20Clearnet%20Ltd%20-%20Initial%20Margin_tcm6-44535.pdf (last visited Apr. 13, 2012).
45. LCH.Clearnet Limited's Default Protections, LCH.CLEARNET 5, http://www.lchclearnet.com/Images/LCH%20Clearnet%20Ltd%20-%20%20default%20protections%202010_tcm6-44534.pdf (last visited Apr. 13, 2012).
46. Id. at 7.
47. LCH.Clearnet Ltd's Default Fund, LCH.CLEARNET 2, http://www.lchclearnet.com/Images/LCH%20Clearnet%20Ltd%27s%20Default%20Fund%202011_tcm6-44536.pdf (last visited Apr. 13, 2012). LCH uses a stress-testing model that uses around sixty scenarios representing stressed conditions in the key contracts cleared by LCH. The scenarios are mostly based on historical events, such as Hurricane Katrina and the largest moves historically both up and down in specific contracts; however, the model also includes some theoretical scenarios.
48. Id. at 3-4.
49. Id. at 2.
50. In the case of member default, the order of funds used to cover the default is the following: the initial margin, the member's default fund contribution, LCH's own capital (up to £20 million), the remaining default fund, SwapClear contributions (in the case of a member of one specific product, SwapClear, which clears interest rates swaps, LCH has the right to request £50 million from each remaining SwapClear member on a nonvoluntary basis), and finally the remainder of LCH's capital. LCH.Clearnet Limited's Default Protections, supra note 32, at 7-19.
51. LCH.CLEARNET, DEFAULT MANAGEMENT OVERVIEW: EXCHANGE & COMMODITY DERIVATIVES MARKETS 3 (2010) (providing detailed information about the default management process but explicitly noting LCH's right to deviate from plans as needed during an actual default).
52. Id.
53. . Paul Cusenza & Randi Abernethy, Dodd-Frank and the Move to Clearing, INSIGHT, Sept. 2010, at 22, 23; Press Release, LCH.Clearnet, $9 Trillion Lehman OTC Interest Rate Swap Default Successfully Resolved (Oct. 8, 2008), available at http://www.lchclearnet.com/Images/2008-10-08%20SwapClear%20default_tcm6-46506.pdf.
54. Natasha de Terán, LCH.Clearnet Faces Biggest Clean-Up After Lehman Default, FIN. NEWS (Sept. 16, 2008, 2:04 PM GMT), http://www.efinancialnews.com/story/2008-09-16/lchclearnet-faces-biggest-clean-up-after-lehman-default-1.
55. Natasha de Terán, How the World's Largest Default Was Unravelled, FIN. NEWS (Oct. 13, 2008), http://www.efinancialnews.com/story/2008-10-13/how-the-largest-default-was-unravelled.
56. Cusenza & Abernethy supra note 39, at 23.
57. Terán supra note 41.
58. Terán, supra note 40.
59. Press Release, LCH.Clearnet, supra note 39.
60. Cusenza & Abernethy, supra note 39, at 24.
61. Id.
62. Press Release, LCH.Clearnet, supra note 39.
63. See LCH.Clearnet Ltd's Default Fund, supra note 34, at 3-5 (describing the default fund, the stress-testing of the fund, and the necessary proportionate contributions of clearing members to the fund). The adequacy of the default fund maintained by LCH is carefully monitored and stress tested: the testing analyzes the worst-case loss of the member with the largest exposure, or alternatively, the combined losses of the two members with the second and third largest exposures. The worst-case loss includes the losses of any affiliates of the member as well as an assumed knock-on impact where the five lowest-credit-scored members of LCH.Clearnet also default as a consequence. If the worst-case loss is above or equal to ninety percent of the default fund, the risk committee determines whether member-specific action or an increase in the size of the default fund is required.
64. Id. at 5.
65. During its lifetime, LCH has handled five defaults, with Lehman constituting the largest default. LCH.Clearnet's Default History, LCH.CLEARNET 2-9, http://www.lchclearnet.com/Images/LCH%20Clearnet%20Ltd%20-%20%20default%20history%202010_tcm6-44530.pdf (last visited Apr. 13, 2012) (describing in detail the five defaults managed by LCH).
66. Analysts at Barclays Capital recently expressed concern as to whether clearing-houses will maintain the strict collateral requirements necessary to prevent systemic risk given that they are for-profit enterprises.
67. RAJIV SETIA ET AL., BARCLAYS CAPITAL, DERIVATIVES REFORM: EVOLUTION, NOT REVOLUTION 1, 5 (2010), available at http://www.scribd.com/doc/33749996/Barclays-Interest-Rate-Strategy-20100630 ("While CCPs are run for profit, under the new bill, they now serve a vital public purpose. In fact, in some respects, this function is reminiscent of the [government sponsored entities'] role in the mortgage markets. If CCPs compete for clearing business by lowering margin requirements, it could weaken the financial infrastructure."). Moreover, a recent CFTC draft proposal lowered the capital threshold for a clearinghouse to $50 million, which will encourage new entrants to the business.
68. Manmohan Singh, Making OTC Derivatives Safe-A Fresh Look 5 (Int'l Monetary Fund, Working Paper No. 11/66, 2011), available at http://www.imf.org/external/pubs/cat/longres.aspx?sk=24726. The degree of risk associated with the changing landscape for derivatives clearinghouses depends on whether new entrants and existing clearinghouses maintain the strict standards necessary to effectively manage potential defaults.
69. LCH.Clearnet is headquartered in the United Kingdom; however, two other leading clearinghouses are based in the United States. First, ICE runs a clearinghouse for futures and a clearing house for North American credit default swaps. Clearing, ICE, https://www.theice.com/clear_overview.jhtml (last visited Apr. 13, 2012). Second, CME Group clears credit derivatives and interest rate swaps.
70. See Clearing, CME GROUP, http://www.cmegroup.com/clearing/index.html (last visited Apr. 13, 2012). Each of these clearinghouses includes the largest United States commercial banks in its membership, illustrating the central role each institution plays in the financial markets.
71. See Clearing Firms, CME GROUP, http://www.cmegroup.com/tools-information/clearing-firms.html (last visited Apr. 13, 2012) (listing participating clearing firms)
72. Participant List, ICE, https://www.theice.com/publicdocs/ice_trust/ICE_Trust_Participant_List.pdf (last visited Apr. 13, 2012) (listing participating institutions).
73. LCH.CLEARNET LIMITED, GENERAL REGULATIONS OF THE CLEARING HOUSE 85-86 (2012), available at http://www.lchclearnet.com/Images/General%20regulations_tcm6-43737.pdf.
74. "In the money" refers to those clearing members who will have the right to collect money after netting all of their trades. By contrast, those members who owe money to the clearinghouse after netting are "out of the money."
75. See 11 U.S.C. § 362(a) (2006) (describing application of the automatic stay upon filing of the bankruptcy petition).
76. See id. § 547(b)(4) (describing preferences that must be returned to the estate after filing of the bankruptcy petition).
77. See id. § 548(a)(1) (describing fraudulent conveyance liability for mismatched consideration).
78. See id. § 365(e) (prohibiting creditors from terminating contract because of bankrupt's insolvency or filing of a bankruptcy petition).
79. See id. § 362(b)(17), (27)
80. id. § 560.
81. See id. § 546(g), (j).
82. See id.
83. See id. § 555 (permitting termination and liquidation of securities contracts)
84. id. § 556 (permitting termination and liquidation of commodities or forward contracts)
85. id. §§ 559-561 (permitting termination and liquidation of repos, swaps, and master netting agreements).
86. Existing scholarship provides an in-depth discussion of the rationales for and critiques of these provisions.
87. See Kimberly Anne Summe, Lessons Learned from the Lehman Bankruptcy, in ENDING GOVERNMENT BAILOUTS AS WE KNOW THEM 59, 69-72 (Kenneth E. Scott et al. eds., 2010) (summarizing the rationales behind protecting qualified financial contracts from the automatic stay)
88. see also Roe supra note 5 (contending that the safe harbor provisions for derivatives counterparties reduce prebankruptcy incentives to monitor and adjust investments to better account for counterparty risk since derivatives counterparties will do well in any resulting bankruptcy)
89. David Skeel & Thomas Jackson, Transaction Consistency and the New Finance in Bankruptcy (Inst. for Law & Econ., Research Paper No. 11-06, 2011), available at http://ssrn.com/abstract=1773631 (proposing reforms to current derivatives and repo treatment under the Bankruptcy Code).
90. See, e.g., LCH.CLEARNET LIMITED, supra note 53, at 86.
91. Dodd-Frank does include provisions regarding segregation requirements; however, it remains unclear how these requirements will actually operate.
92. See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 724, 124 Stat. 1376, 1682-85 (2010) (codified as amended in scattered sections of 7 and 11 U.S.C.). Additionally, in an International Monetary Fund working paper Manmohan Singh argues that a clearinghouse may face a pure liquidity crisis if it suffers from a massive outflow of otherwise solvent clearing members because it would have to realize its investment portfolio at low prices.
93. Singh supra note 51, at 9. If all clearing members were trying to liquidate collateral simultaneously, a problem arises if the clearinghouse has tied up the collateral in repo transactions and either cannot get it back or does not want to pay cash to the members.
94. Id.
95. See Peter Marchette, The Bankruptcy Court's Ruling in the Lehman-Metavante Matter: Has the Ticking Time Bomb of Enron v. TXU Exploded or Been Defused? 7 (N.Y. Law Sch. Legal Studies, Research Paper No. 29, 2010), available at http://ssrn.com/ abstract=1568425.
96. Id. at 8.
97. Id.
98. Some clearinghouses do not require strict segregation of member collateral because of the increased costs associated with segregation. Section 724 of Dodd-Frank requires that property of a swaps customer received to margin a swap "shall not be commingled with the funds of the futures commission merchant or be used to margin, secure, or guarantee any trades or contracts of any swaps customer or person other than the person for whom the same are held."
99. Dodd-Frank Wall Street Reform and Consumer Protection Act § 724, 7 U.S.C. § 6d (2006 & Supp. IV 2010). Nevertheless, futures commission merchants (FCMs) may hold the collateral pledged to a clearinghouse, and the framework for collateral segregation upon the default of an FCM is still to be determined by the CFTC. The critical issue is whether or not the collateral of a nondefaulting member held by the FCM could be used to pay the clearinghouse upon the FCM's default. (If the futures customer suffers sufficient losses such that the customer's debit balance exceeds the FCM's available capital, the FCM may be unable to make required payments to the clearinghouse with respect to the FCM's customer account without using nondefaulting customers' collateral.) The proposed rules include four models with differing levels of protection for customer collateral, ranging from complete segregation to the use of an omnibus account through which the clearinghouse has recourse to all collateral in the event of a FCM failure, including collateral from nondefaulting customers.
100. See Protection of Cleared Swaps Customers Before and After Commodity Broker Bankruptcies, 75 Fed. Reg. 75,162, 75,163-64 (proposed Dec. 2, 2010) (to be codified at 17 C.F.R. pt. 190).
101. See Marchette K, supra note 66, at 8. While the Bankruptcy Code does not define "executory contract," the most common definition used is that of Vern Countryman: "a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other."
102. See Vern Countryman, Executory Contracts in Bankruptcy (pt. 1), 57 MINN. L. REV. 439, 460 (1973).
103. For a general explanation of executory contracts and options available to the debtor with respect to these contracts, see Skeel & Jackson supra note 63, at 20-21.
104. Section 365(a) permits the bankruptcy estate to assume any executory contract as long as it cures any previous default. 11 U.S.C. § 365(a) (2006). Likewise, the estate may assign a contract and thus relieve itself of all obligations.
105. Id. § 365(k).
106. In re Lehman Brothers Holdings, Inc., No. 08-13555 (Bankr. S.D.N.Y. Dec. 16, 2008).
107. See infra Part II.B.3.
108. A working group at the Hoover Institution proposed an amendment to the Bankruptcy Code creating a Chapter 14, which would contain a number of substantive and procedural changes designed especially for the complexity and potential systemic consequences of the failure of the nation's largest financial institutions.
109. See WORKING GRP. ON ECON. POLICY, HOOVER INST., BANKRUPTCY CODE CHAPTER 14: A PROPOSAL (2011), available at http://www.hoover.org/taskforces/economic-policy/resolution-project/publications. In particular, the paper proposed a three-day window after the filling of a bankruptcy petition during which termination of derivatives contracts would be prohibited.
110. Id. at 23.
111. The three-day window could help avoid the problematic incentive structure described in this Part, providing the estate with time to evaluate the best available next steps before derivatives counterparties could exit trades; moreover, the proposal provides more time than the Dodd-Frank liquidation authority provisions that create a one-day window before allowing termination and liquidation.
112. See infra Part II.B.2. Nevertheless, the larger window before termination would not address the concerns discussed in Part II.B.3 regarding the ability of other clearinghouses to suddenly absorb an insolvent clearinghouse's trades or the need for normal market conditions.
113. See infra Part II.B.3.
114. Dodd-Frank Wall Street Reform and Consumer Protection Act § 204(a), 12 U.S.C. § 5384(a) (Supp. IV 2010).
115. Ben S. Bernanke, Chairman, Bd. of Governors of the Fed. Reserve Sys., Speech at the Independent Community Bankers of America National Convention (Mar. 20, 2010) (transcript available at http://www.federalreserve.gov/newsevents/speech/bernanke20100320a.htm).
116. See Dodd-Frank Wall Street Reform and Consumer Protection Act § 204(a), 12 U.S.C. § 5384(a) ("The authority provided in this subchapter shall be exercised in the manner that best fulfills such purpose, so that-(1) creditors and shareholders will bear the losses of the financial company; (2) management responsible for the condition of the financial company will not be retained; and (3) [the FDIC] and other appropriate agencies will take all steps necessary and appropriate to assure that all parties, including management, directors, and third parties, having responsibility for the condition of the financial company bear losses consistent with their responsibility, including actions for damages, restitution, and recoupment of compensation and other gains not compatible with such responsibility.").
117. See id. §102(a)(4)(B), 12 U.S.C. § 5311(a)(4)(b).
118. See id. § 804(a)(1), 12 U.S.C. § 5463(a)(1).
119. Authority to Designate Financial Market Utilities as Systemically Important, 76 Fed. Reg. 17,047, 17,048 (proposed Mar. 28, 2011) (to be codified at 12 C.F.R. pt. 1320).
120. Id. at 17,053-54.
121. It remains to be seen how other clearinghouses would be classified based on these criteria.
122. See KIMBERLY SUMME, AN EXAMINATION OF LEHMAN BROTHERS' DERIVATIVES PORTFOLIO POST-BANKRUPTCY AND WHETHER DODD-FRANK WOULD HAVE MADE ANY DIFFERENCE 18-19 (2011), available at http://www.hoover.org/taskforces/economic-policy/resolution-project/publications.
123. See Dodd-Frank Wall Street Consumer Protection Act § 202(a), 12 U.S.C. § 5382(a).
124. See id. § 201(a)(8), 12 U.S.C. § 5381(a)(8).
125. See id. § 203(a), 12 U.S.C. § 5383(a).
126. The definition of "default" or "danger of default" includes the initiation of bankruptcy proceedings or a likelihood that they will promptly be commenced.
127. Id. § 203(c)(4), 12 U.S.C. § 5383(c)(4).
128. Id. § 203(b), 12 U.S.C. § 5383(b).
129. See id. § 202(a)(1)(A), 12 U.S.C. § 5382(a)(1)(A). If the directors and officers do not consent, the Secretary must file a sealed petition with the United States District Court for the District of Columbia for an order authorizing the Secretary to appoint the FDIC as receiver; a highly deferential standard is applied and effectively presumes the validity of the Secretary's determinations.
130. See id.
131. See id. § 210(a)(1), 12 U.S.C. § 5390(a)(1).
132. See id. § 210 (c)(8), 12 U.S.C. § 5390(c)(8). The "qualified financial contracts" receiving special treatment include repurchase agreements, securities contracts, forward contracts, commodity contracts, and swap agreements.
133. Id.
134. See id. § 210(c)(8)(A), 12 U.S.C. § 5390(c)(8)(A).
135. See id. § 210(c)(8)(C), 12 U.S.C. § 5390(c)(8)(C).
136. See id. § 210(c)(10)(B), 12 U.S.C. § 5390(c)(10)(B). Dodd-Frank prohibits the protected party from terminating, liquidating, or netting out its position solely by reason of the appointment of the FDIC as receiver, or by reason of the financial condition of the company in receivership, until 5:00 PM eastern time on the business day following the date of appointment. Likewise, Dodd-Frank precludes the protected party from exercising any contractual rights after it receives notice that its qualified financial contract has been transferred to another financial institution, including a bridge financial company.
137. Id.
138. The bridge financial company created is meant to be temporary and to serve as a bridge to a permanent transaction with a private acquirer; it need not be funded with capital or surplus (though the aggregate amount of liabilities assumed by a bridge company may not exceed the aggregate amount of assets that are transferred to it).
139. See id. § 210(h), 12 U.S.C. § 5390(h). Dodd-Frank provides that the bridge financial company shall terminate at the end of the two-year period following the date on which it was granted a charter; however, the FDIC may extend the status of the bridge financial company for no more than three additional one-year periods.
140. See id. § 210(h)(12), 12 U.S.C. § 5390(h)(12).
141. The other option available to the FDIC would be to terminate and liquidate all of the clearinghouse's trades after transferring them; however, in reality this is not an option because it would foster high levels of systemic risk. Dodd-Frank provides that the FDIC must disaffirm or repudiate all financial contracts with a counterparty or none of them.
142. See id. § 210(c)(11)(A), 12 U.S.C. § 5390(c)(11)(A). Repudiating the trades would create the largest amount of risk and consequently create significant instability in the financial markets: all of the clearing members would no longer have desired hedges, and many would immediately, suddenly, and unexpectedly experience significant losses. Terminating the trades would create precisely the type of systemic risk that a clearinghouse was created to avoid: it would permit the default of one or more clearing members to spread throughout the financial system. As a result, terminating and liquidating all of the insolvent clearinghouse's trades simply would not be feasible.
143. See id. § 210(c)(9), 12 U.S.C. § 5390(c)(9). This rule reflects concerns about the FDIC "cherry-picking" the trades: terminating the out-of-the-money trades and affirming the in-the-money trades. Avoiding cherry-picking by the bankruptcy estate is one rationale often offered in support of the Bankruptcy Code's safe harbor provisions.
144. See David Mengle, The Importance of Close-Out Netting, ISDA RESEARCH NOTES, Nov. 2010, at 4-5, available at http://www2.isda.org/attachment/MTY4MQ==/Netting-ISDAResearchNotes-1-2010.pdf.
145. One concern with the auction process would be finding acquirers for the out-of-the-money portfolios. However, this problem could perhaps be addressed through strategic packaging of the portfolios: in-the-money positions could be bundled with out-of-the-money positions to ensure all trades would be transferred to another clearinghouse.
146. See Interest Rate Swaps, LCH.CLEARNET, http://www.lchclearnet.com/swaps/swapclear_for_clearing_members (last visited Apr. 13, 2012). Similarly, ICE Trust specializes in clearing credit default swaps.
147. See ICE Clear Credit: Credit Default Swap Clearing, ICE, https://www.theice.com/clear_credit.jhtml (last visited Apr. 13, 2012)
148. STANDARD & POOR'S ARE EXCHANGES AND CLEARINGHOUSES "TOO BIG TO FAIL"? 5-6 (2010), available at http://www.standardandpoors.com/ratings/articles/en/us/?articleType=PDF&assetID=1245236164429 (noting the monolithic and monopolistic nature of clearinghouses in the United States that specialize in a particular product, and the unlikelihood that the positions would be transferable to another clearinghouse).
149. See Duffie et al., supra note 4, at 6.
150. One potential solution to this problem would be successful implementation of international interoperability agreements among clearinghouses. Interoperability, or linking of clearinghouses, allows a financial participant to concentrate its portfolio at a chosen clearinghouse regardless of the clearinghouse that its counterparty chooses. Consequently, interoperability permits one clearinghouse to hold or access collateral from another clearinghouse such that in the case of a clearinghouse's insolvency, the losses of the clearinghouse linked to the insolvent clearinghouse may be covered.
151. See Singh supra note 51, at 7. However, the main difficulty with these agreements is that cross-border margin access is subordinate to national bankruptcy laws such that it is unlikely a clearinghouse in one country would be permitted to access collateral posted by a clearinghouse registered in another country. As a result, LCH-the only clearinghouse to successfully implement linking thus far- has not been able to compete for clients in the United States.
152. Id.
153. Nevertheless, interoperability of derivatives clearinghouses could be one solution to the significant problem of the current system's inability to manage a derivatives clearinghouse's insolvency.