Clearinghouse overconfidence

California Law Review

Volumn 101, Issue 6, 2013, Pages 1641-1704

  Roe, Mark J ^a  

^a HARVARD LAW SCHOOL   (United States)

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EID: 84893568976     PISSN: 00081221     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (156)

1. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §§ 723, 725(c), 763, 124 Stat. 1376, 1675-81, 1762-68, (2010) (to be codified in scattered sections of the U.S. Code). Clearing basics: When a trade clears, the two parties make their own deal, then give their trade over to the clearinghouse. The clearinghouse picks up the obligations to and from each side. Each party becomes obligated to the clearinghouse and no longer to the party with which it traded.
2. RENA S. MILLER, CONG. RESEARCH SERV., R41715, CONFLICTS OF INTEREST IN DERIVATIVES CLEARING 4 (2011), available at http://digitalcommons.ilr.cornell. edu/cgi/viewcontent.cgi?article=1832&context=key-workplace.
3. For close general analysis of systemic risk, see George G. Kaufman & Kenneth E. Scott, What Is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?, 7 INDEP. REV. 371 (2003).
4. E.g., Phil Mattingly & Silla Brush, JPMorgan's Losses Become Tool in Dodd-Frank Rules Debate, BLOOMBERG (May 22, 2013), www.bloomberg.com/news/print/ 2012-05-22/cftc-to-releaseclearing-proposal-for-index-swaps-gensler-says.html ("'Standard swaps between financial firms will move into central clearing, which will significantly lower the risks of the highly interconnected financial system,' Gensler said.").
5. See Ben S. Bernanke, Clearing and Settlement During the Crash, 3 REV. FIN. STUD. 133, 143-45 (1990). On the text's "within minutes": three minutes. See infra Part V.B., note 130 and accompanying text.
6. The metaphoric applicability of the Maginot Line error to the clearinghouse thesis I advance in this Article comes from its having been a costly fortification that an invading army side-stepped instead of hitting directly, and because its costliness short-changed better defensive measures. The Maginot Line was "a line of defensive fortifications built before World War II to protect the eastern border of France but easily outflanked by German invaders[.]" Maginot Line Definition, MERRIAM-WEBSTER.COM, http://www.merriam-webster.com/dictionary/maginot%20line. Its impressive engineering, and ultimate failure, made it a metaphor for "a defensive barrier or strategy that inspires a false sense of security." Id. While it would likely have been effective if attacked directly, it proved to be a strategic failure because it only moved the location of the attack without changing the fact and effectiveness of the invasion.
7. See also WILLIAM ALLCORN, THE MAGINOT LINE 1928-45, 4 (2003);
8. MARC ROMANYCH & MARTIN RUPP, MAGINOT LINE 1940: BATTLES ON THE FRENCH FRONTIER 5 (2010). Analogously, the systemic risk that the clearinghouse is targeted to contain will largely be diverted, will appear elsewhere, and will not be eliminated. But if policymakers are now satisfied that they have done the right thing, they will be less likely to attend to more efficacious strategies and will lack the resources to do so. The Maginot Line metaphor for other parts of Dodd-Frank has occurred to others.
9. E.g., Steven A. Ramirez, The Dodd-Frank Act as Maginot Line, 15 CHAPMAN L. REV. 109 (2011).
10. The official account is in OFFICE OF THE SPECIAL INSPECTOR GENERAL FOR THE TROUBLED ASSET RELIEF PROGRAM, SIGTARP 10-003, FACTORS AFFECTING EFFORTS TO LIMIT PAYMENTS TO AIG COUNTERPARTIES 3 (2009), available at http://www.sigtarp. gov/Audit%20Reports/Factors-Affecting-Efforts-to-Limit-Payments-to-AIG- Counterparties.pdf [hereinafter "SIGTARP AIG"];
11. see also Adam Davidson, How AIG Fell Apart, REUTERS (Sept. 18, 2008), http://www.reuters.com/article/2008/09/18/us-how-aig-fell-apart- idUSMAR85972720080918.
12. See AMERICAN INTERNATIONAL GROUP, ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 (FORM 10-K), at 122 (Feb. 28, 2008), available at http://www.ezodproxy.com/AIG/2008/AR2007/images/AIG-10K2007. pdf.
13. FIN. CRISIS INQUIRY COMM'N, PRELIMINARY STAFF REPORT: GOVERNMENTAL RESCUES OF "TOO-BIG-TO-FAIL" FINANCIAL INSTITUTIONS 25 (Aug. 31, 2010), available at http://fcic-static.law.stanford.edu/cdn-media/fcic-reports/ 2010-0831-Governmental-Rescues.pdf.
14. SIGTARP AIG, supra note 7; Rajna Gibson & Carsten Murawski, Margining in Derivatives Markets and the Stability of the Banking Sector, 37 J. BANKING & FIN. 1119 (2013);
15. Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 HARV. L. REV. 1151, 1185, 1188 n.99 (2010).
16. Anupam Chander & Randall Costa, Clearing Credit Default Swaps: A Case Study in Global Legal Convergence, 10 CHI. J. INT'L L. 639, 655 (2010) (footnote omitted).
17. Anton R. Valukas, 4 Report of the Examiner 1101, In re Lehman Brothers Holdings Inc., No. 08-3555 (Bankr. S.D.N.Y. 2010), available at http://jenner.com/lehman/VOLUME%204.pdf.
18. Press Release, U.S. Dep't of the Treasury, Treasury Announces Temporary Guarantee Program for Money Market Funds (Sept. 29 2008), available at http://www.treasury.gov/presscenter/press-releases/Pages/hp1161.aspx.
19. OFFICE OF THE SPECIAL INSPECTOR GEN. FOR THE TROUBLED ASSET RELIEF PROGRAM, SIGTARP 11-002, EXTRAORDINARY FINANCIAL ASSISTANCE PROVIDED TO CITIGROUP, INC. 4-32, 41-44 (2011), available at http://www.sigtarp.gov/ Audit%20Reports/ Extraordinary%20Financial%20Assistance%20Provided%20to%20Citigroup,%20Inc.pdf;
20. FIN. CRISIS INQUIRY COMM'N, FINAL REPORT OF THE NATIONAL COMMISSION ON THE CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS IN THE UNITED STATES 374, 375 (Jan. 2011);
21. Liz Moyer, Citi on Fire?, FORBES (Jan. 30, 2009, 12:00 PM), http://www.forbes.com/2009/01/13/banking-citigroup-pandit-biz-cx-lm- 0113citigroup.html.
22. FIN. CRISIS INQUIRY COMM'N, supra note 17, at 374-75; OFFICE OF THE SPECIAL INSPECTOR GEN. FOR THE TROUBLED ASSET RELIEF PROGRAM, SIGTARP 10-001, EMERGENCY CAPITAL INJECTIONS PROVIDED TO SUPPORT THE VIABILITY OF BANK OF AMERICA, OTHER MAJOR BANKS, AND THE U.S. FINANCIAL SYSTEM 1-2, 14-31 (2009), available at http://www.sigtarp.gov/Audit%20Reports/Emergency-Capital- Injections-Provided-to-Support-the-Viability-of-Bank-of-America.pdf;
23. Matthew Saltmarsh, Citi To Split Itself After Posting Massive Quarterly Loss, N.Y. TIMES (Jan. 16, 2009), http://www.nytimes.com/2009/01/16/business/ worldbusiness/16iht-16citi.19423678.html.
24. FIN. CRISIS INQUIRY COMM'N, supra note 17, at 24; FIN. CRISIS INQUIRY COMM'N, supra note 11, at 25; Janet Morrissey, Credit Default Swaps: The Next Crisis?, TIME (Mar. 17, 2008), available at http://www.time.com/time/business/ article/0,8599,1723152,00.html.
25. MARC LABONTE, CONG. RESEARCH SERV., RL34427, FINANCIAL TURMOIL: FEDERAL RESERVE POLICY RESPONSES 17 (2010), available at http://waxman.house.gov/sites/ waxman.house.gov/files/documents/UploadedFiles/Fed-Policy-Responses.pdf.
26. Ben S. Bernanke, Chairman, Fed. Reserve Bd., Address at the FDIC's Forum on Mortgage Lending for Low and Moderate Income Households (July 8, 2008), available at http://www.federalreserve.gov/newsevents/speech/bernanke20080708a. htm; FIN. CRISIS INQUIRY COMM'N, supra note 11.
27. G-20, Leaders' Statement: The Pittsburgh Summit 7 (2009), available at http://ec.europa.eu/commission-2010-2014/president/pdf/statement-20090826-en-2. pdf ("All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties . . . ."); cf. MILLER, supra note 2, at "Summary" (The Congressional Research Service concludes, "Clearinghouses . . . [can] prevent any firm from building up a large uncapitalized exposure, as happened in the case of . . . []AIG[].");
28. Yesha Yadav, The Problematic Case of Clearinghouses in Complex Markets, 101 GEO. L.J. 387, 388-89 (2013) (describing scramble for clearinghouse-type relationships to prevent Bear Stearns from failing).
29. MARKUS BRUNNERMEIER ET AL., THE FUNDAMENTAL PRINCIPLES OF FINANCIAL REGULATION 13-24 (2009); Kaufman & Scott, supra note 3.
30. Yee Cheng Loon & Zhaodong (Ken) Zhong, The Impact of Central Clearing on Counterparty Risk, Liquidity, and Trading: Evidence from the Credit Default Swap Market 1 (Nov. 15, 2012) (unpublished manuscript), available at http://ssrn.com/abstract=2176561.
31. Squam Lake Working Group on Financial Regulation, Credit Default Swaps, Clearinghouses, and Exchanges 3 (Council on Foreign Relations, Center for Geoeconomic Studies, Working Paper, 2009), available at http://www.cfr.org/ financial-crises/credit-default-swaps-clearinghouses-exchanges/p19756;
32. Adam J. Levitin, In Defense of Bailouts, 99 GEO. L.J. 435, 443-47 (2011);
33. Steven L. Schwarcz, Systemic Risk, 97 GEO. L.J. 193, 196-204 (2008).
34. E.g., Stephen G. Cecchetti et al., Central Counterparties for Over-the-Counter Derivatives, BIS Q. REV., Sept. 2009, at 45 ("[I]mprove market resilience by lowering counterparty risk");
35. Andrew G. Haldane, On Counterparty Risk, 5 J. RISK MGMT. FIN. INSTITUTIONS 224 (2012);
36. Alistair Milne, OTC Central Counterparty Clearing: Myths and Reality, 4 J. RISK MGMT FIN. INSTITUTIONS 335, 340 (2012) (clearinghouses will "coordinate[] management of open positions following the failure of a systemically important financial institution").
37. Squam Lake Working Group, supra note 28, at 3. Proponents do not say the clearinghouse can contain this systemic risk. Prominent analysts say this spiral triggered the financial crisis. Gary Gorton & Andrew Metrick, Securitized Banking and the Run on Repo, 104 J. FIN. ECON. 425 (2012);
38. Gaetano Antinolfi et al., Repos, Fire Sales, and Bankruptcy Policy (Federal Reserve Bank of Chicago, Working Paper, WP 2012-15), available at http://ssrn.com/abstract=2189583.
39. James Bullard et al., Systemic Risk and the Financial Crisis: A Primer, FED. RES. BANK ST. LOUIS REV., Sept./Oct. 2009, at 403, 408.
40. For rapid asset price deterioration as a major systemic risk, see generally CARMEN M. REINHART & KENNETH S. ROGOFF, THIS TIME IS DIFFERENT: EIGHT CENTURIES OF FINANCIAL FOLLY 142, 158-63, 216-20 (2009);
41. Andrei Shleifer & Robert Vishny, Fire Sales in Finance and Macroeconomics, 25 J. ECON. PERSP. 29 (2011).
42. See Jeffrey N. Gordon & Christopher Muller, Confronting Financial Crisis: Dodd-Frank's Dangers and the Case for a Systemic Emergency Fund, 28 YALE J. REG. 151, 160 (2011).
43. Timothy G. Massad, Infographic: Overall $182 Billion Committed to Stabilize AIG During the Financial Crisis Is Now Fully Recovered, U.S. DEP'T OF TREASURY (Sept. 11, 2012), http://www.treasury.gov/connect/blog/Pages/aig-182- billion.aspx.
44. Richard A. Miller, Editorial, FUTURES & DERIVATIVES L. REP., Apr. 2009, at 3;
45. see also Simon Boughey, After Bear Stearns Scare, Fed Pushes Banks to Form Central Clearing House for CDS Market, EUROWEEK, June 13, 2008, at 64; Stephen G. Cecchetti et al., supra note 29, at 45-46, 52; Chander & Costa, supra note 13, at 642.
46. See Darrell Duffie, The Failure Mechanics of Dealer Banks, 24 J. ECON. PERSP. 51, 67 (2010).
47. Yalman Onaran, Fed Aided Bear Stearns as Firm Faced Chapter 11, Bernanke Says, BLOOMBERG (Apr. 2, 2008), http://www.bloomberg.com/apps/news?pid= newsarchive&sid=a7coicThgaEE; Bernanke, supra note 23.
48. PETER NORMAN, THE RISK CONTROLLERS: CENTRAL COUNTERPARTY CLEARING IN GLOBALISED FINANCIAL MARKETS 222-25, 285-87, 291, 297 (2011); Chander & Costa, supra note 13, at 663.
49. See COUNTERPARTY RISK MANAGEMENT POLICY GROUP, CONTAINING SYSTEMIC RISK: THE ROAD TO REFORM 126 (2008), available at http://www.crmpolicygroup.org/docs/ CRMPG-III.pdf.
50. Jeremy Grant, Push to Underpin Clearing House Foundations, FT.COM (June 7, 2010), http://www.ft.com/cms/s/0/0d6dce68-725a-11df-9f82-00144feabdc0.html.
51. U.S. DEP'T OF THE TREASURY, FINANCIAL REGULATORY REFORM: A NEW FOUNDATION, available at http://www.treasury.gov/initiatives/Documents/ FinalReport-web.pdf;
52. Press Release, U.S. Dep't of the Treasury, Regulatory Reform of Over-the-Counter (OTC) Derivatives (May 13, 2009), available at http://www.treasury.gov/press-center/press-releases/Pages/tg129.aspx;
53. Press Release, U.S. Dep't of the Treasury, Treasury Outlines Framework for Regulatory Reform: Provides New Rules of the Road, Focuses First on Containing Systemic Risk (Mar. 26, 2009), available at http://www.treasury.gov/ press-center/press-releases/Pages/tg72.aspx.
54. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 723(a)(3), 124 Stat. 1376, 1675-76 (2010) (to be codified in scattered sections of the U.S. Code).
55. Id. (adding 7 U.S.C. § 2(h)(1)(D)(ii)(III), which states that in constructing clearinghouses, "the Commission shall take into account . . . [t]he effect on the mitigation of systemic risk").
56. Gary Gensler, How To Stop Another Derivatives Inferno, FT.COM (Feb. 24, 2010), http://www.ft.com/intl/cms/s/0/3b52b642-217c-11df-830e-00144feab49a. html#axzz1nmEBFEAt;
57. see also Gary Gensler, Chairman, Comm. Fut. Trading Comm'n, Remarks to the Council of Institutional Investors: Over-the-Counter Derivatives Reform (Apr. 13, 2010), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/ opagensler-38.
58. Jill E. Sommers, Comm'r, Comm. Fut. Trading Comm'n, Remarks to the Capital Markets Consortium: Clearinghouses as Mitigators of Systemic Risk (Sept. 30, 2010), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/ opasommers-10.
59. U.S. GOV'T ACCOUNTABILITY OFFICE, GAO-09-397T, SYSTEMIC RISK: REGULATORY OVERSIGHT AND RECENT INITIATIVES TO ADDRESS RISK POSED BY CREDIT DEFAULT SWAPS 21 (2009) (Statement of Orice M. Williams, Director, Financial Markets and Community Investment) (emphasis added), available at http://www.gao.gov/new. items/d09397t.pdf;
60. cf. Dwight Cass, Good Idea, Not in Practice, BREAKINGVIEWS.COM (Feb. 20, 2009) ("[The] financial stock meltdown put new impetus behind the drive for a central clearinghouse for credit default swaps.").
61. Testimony of Gary Gensler, Chairman, Commodity Futures Trading Commission, Before U.S. H. Comm. on Agric. (Feb. 29, 2012), available at http://agriculture.house.gov/sites/republicans.agriculture.house.gov/files/pdf/ hearings/Gensler120229.pdf.
62. William Dudley, How We Will Stop Derivatives Magnifying Future Crises, FT.COM (Apr. 15, 2012), http://www.ft.com/cms/s/0/b47b8f00-8555-11e1-a75a- 00144feab49a.html#axzz2OwyPP1Ap.
63. See Timothy F. Geithner, Pres. & CEO Fed. Reserve Bank of N.Y., Remarks at the Economic Club of New York: Reducing Systemic Risk in a Dynamic Financial System (June 9, 2008), available at http://www.bis.org/review/ r080612b.pdf.
64. Proposal for a Regulation of the European Parliament and of the Council on OTC Derivatives, Central Counterparties and Trade Repositories, at 14, COM (2010) 484/5, available at http://ec.europa.eu/internal-market/financial- markets/docs/derivatives/20100915-proposal-en.pdf;
65. Chander & Costa, supra note 13, at 676; Press Release, European Central Bank, The Eurosystem's Policy Line with Regard to Consolidation in Central Counterparty Clearing (Sept. 27, 2001), available at http://www.ecb.int/pub/pdf/other/centralcounterpartyclearingen.pdf.
66. FINANCIAL SERVICES AUTHORITY & HM TREASURY, REFORMING OTC DERIVATIVES MARKETS: A UK PERSPECTIVE, Dec. 2009, at 11 (U.K.);
67. Janis Sarra, Credit Derivatives Market Design: Creating Fairness and Sustainability, in THE EMBEDDED FIRM: CORPORATE GOVERNANCE, LABOR, AND FINANCE CAPITALISM 205, 217-18 (Cynthia Williams & Peer Zumbansen eds., 2012). An earlier set of British financial regulators had a more guarded view of clearinghouses' capacity to reduce systemic risk.
68. Bob Hills et al., Central Counterparty Clearing Houses and Financial Stability, FIN. STABILITY REV., June 1999, at 122, 126-27.
69. Joanne P. Braithwaite, Private Law and the Public Sector's Central Counterparty Prescription for the Derivatives Markets 8 (London School of Economics Legal Studies, Working Paper No. 2/2011, 2011), available at http://ssrn.com/abstract=1791740.
70. Proposal for a Regulation of the European Parliament, supra note 53; OECD Ad Hoc Expert Group on OTC Derivatives: Regulations and Implications for Sovereign Debt Management Practices, Regulatory Reform of OTC Derivatives and Its Implications for Sovereign Debt Management Practices (Organisation for Economic Co-Operation and Development, Working Paper on Sovereign Borrowing and Public Debt Management No. 1, 2011), available at http://www.oecd.org/finance/ public-debt/49931920.pdf.
71. Leaders Statement, G20, The Pittsburgh Summit 13 (Sept. 24-25, 2009), available at www.g20.org/load/780988012 ("[S]tandardized OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. . . . Non-centrally cleared contracts should be subject to higher capital requirements."). The EU has authorized the European Securities and Markets Authority to force traders to clear certain derivatives through clearinghouses.
72. Jim Brunsden, EU Reached Accord on Clearing Law for Over-the-Counter Derivatives, BLOOMBERG (Feb. 9, 2012), www.bloomberg.com/news/2012-02-09/eu- reaches-deal-on-clearing-law-for-over-the-counter-derivatives.html.
73. E.g., Hendrik Bessembinder & William Maxwell, Markets: Transparency and the Corporate Bond Market, 22 J. ECON. PERSP. 217 (2008);
74. Richard C. Green et al., Financial Intermediation and the Costs of Trading in an Opaque Market, 20 REV. FIN. STUD. 275 (2007).
75. Lester G. Telser & Harlow N. Higinbotham, Organized Futures Markets: Costs and Benefits, 85 J. POL. ECON. 969 (1977);
76. Lester G. Telser, Why There Are Organized Futures Markets, 24 J.L. & ECON. 1 (1981).
77. Says the CFTC's chair, "Central clearing . . . democratizes the market by eliminating the need for market participants to individually determine counterparty credit risk, as now clearinghouses stand between buyers and sellers." Silla Brush, Dodd-Frank Swap-Clearing Rule Gets CFTC Final Approval, BLOOMBERG (Nov. 29, 2012, 12:01 AM), http://www.bloomberg.com/news/ 2012-11-28/cftc-said-to-have-votes-to-complete-swap-clearing-requirement.html.
78. Robert R. Bliss & Robert S. Steigerwald, Derivatives Clearing and Settlement: A Comparison of Central Counterparties and Alternative Structures, ECON. PERSP., Fourth Quarter 2006, at 22, 26.
79. Craig Pirrong, The Clearinghouse Cure, 31 REGULATION 44, 48, 51 (2008);
80. see also Bruno Biais et al., Incentive Compatible Centralized Clearing, BANQUE DE FRANCE FIN. STABILITY REV., Apr. 2013, at 161.
81. JON GREGORY, COUNTERPARTY CREDIT RISK: THE NEW CHALLENGE FOR GLOBAL FINANCIAL MARKETS 377 (2010).
82. CME GROUP, INC., ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 (FORM 10-K), at 33 (Mar. 1, 2013), available at http://www.sec.gov/Archives/edgar/data/1156375/000115637513000007/ cme-2012123110k.htm.
83. Half of that amount, aggregating CME's contributed capital, members' guarantees, and clearinghouse assessment strength, backs up the clearinghouse operations. CME GROUP, INC., CME CLEARING FINANCIAL SAFEGUARDS 19 (2012), available at http://www.cmegroup.com/clearing/files/financialsafeguards.pdf.
84. 11 U.S.C. § 362 (Title 11 of the United States Code is hereinafter referred to as the "Bankruptcy Code").
85. Bankruptcy Code § 1129(b).
86. Bankruptcy Code § 362(a)(17).
87. Ralph Atkins, Crunch Feared if Collateral Rules Enforced: New Clearing Regulations Could Suck in $10tn of Safe Assets, FT.COM (Feb. 5, 2013), www.ft.com/intl/cms/s/0/e7737740-6f85-11e2-b906-00144feab49a.html (the $2 trillion number comes from an IMF researcher; the $10 trillion estimate comes from ISDA).
88. Bankruptcy Code § 553.
89. James Angell McLaughlin, Amendment of the Bankruptcy Act, 40 HARV. L. REV. 583, 600-04 (1927).
90. BARRY E. ADLER ET AL., BANKRUPTCY 387-88 (4th ed. 2007);
91. MARGARET HOWARD & PETER A. ALCES, CASES AND MATERIALS ON BANKRUPTCY 550-56 (2d ed. 2001) (excerpting Elcona Homes, discussed infra in text accompanying note 82);
92. ROBERT L. JORDAN ET AL., BANKRUPTCY 442 (5th ed. 1999) ("[I]n bankruptcy, [setoff] produces results that fly in the face of the equality-ofdistribution rule that we saw as the backbone of preference law.");
93. ELIZABETH WARREN & JAY LAWRENCE WESTBROOK, THE LAW OF DEBTORS AND CREDITORS: TEXT, CASES, AND PROBLEMS 444 (6th ed. 2009).
94. COLLIER ON BANKRUPTCY ¶ 553.02 (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2011) (footnote omitted).
95. CHARLES JORDAN TABB, THE LAW OF BANKRUPTCY 166 (1997);
96. accord DAVID L. BUCHBINDER, A PRACTICAL GUIDE TO BANKRUPTCY 190 (1990).
97. John C. McCoid, II, Setoff: Why Bankruptcy Priority?, 75 VA. L. REV. 15, 32-39 (1989); McLaughlin, supra note 75, at 600-04.
98. See, e.g., D.E. Murray, Banks Versus Creditors of Their Customers: Set-Offs Against Customers' Accounts, 82 COM. L.J. 449, 464 (1977);
99. Note, Setoff in Bankruptcy: Is the Creditor Preferred or Secured?, 50 U. COLO. L. REV. 511 (1979).
100. Bankruptcy bars preferential eve-ofbankruptcy payments that favor some creditors over others. Such payments are recalled during the bankruptcy proceeding, to be shared proportionately among all unsecured creditors, not just the favored one. Bankruptcy Code § 547.
101. In re Elcona Homes Corp., 863 F.2d 483, 485 (7th Cir. 1988). Posner says that any rationale for setoff comes from the setoff beneficiary being like a secured creditor, with the debt to the creditor acting like the security. Id. at 485.
102. See, e.g., Citizens Bank of Md. v. Strumpf, 516 U.S. 16, 18 (1995) ("The right of setoff . . . allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding 'the absurdity of making A pay B when B owes A.'")
103. (quoting Studley v. Boylston Nat'l Bank, 229 U.S. 523, 528 (1913)).
104. Franco Modigliani & Merton H. Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, 48 AM. ECON. REV. 261 (1958).
105. For syntheses of the post-M-M thinking, see RICHARD A. BREALEY ET AL., PRINCIPLES OF CORPORATE FINANCE 440-67 (10th ed. 2013);
106. IVO WELCH, CORPORATE FINANCE 590 (2d ed. 2013).
107. Such M-M-type thinking has improved our understanding of other bankruptcy issues. Thus, secured debt has been understood to transfer risk, not necessarily reduce it, with the transfers moving to tort creditors, Alan Schwartz, Security Interests and Bankruptcy Priorities: A Review of Current Theories, 10 J. LEGAL STUD. 1, 3, 7-8, 11 n.28 (1981)
108. to non-adjusting contract creditors, Lucian Arye Bebchuk & Jesse M. Fried, The Uneasy Case for the Priority of Secured Claims in Bankruptcy, 105 YALE L.J. 857 (1996). Similarly, strong priorities for derivatives contracts in bankruptcy have been shown to transfer the risk of derivatives' failures to the bankrupt's other creditors, not necessarily eliminating the risk of these new instruments.
109. Franklin R. Edwards & Edward R. Morrison, Derivatives and the Bankruptcy Code: Why the Special Treatment?, 22 YALE J. ON REG. 91, 101 (2005);
110. Mark J. Roe, The Derivatives Market's Payments Priorities as Financial Crisis Accelerator, 63 STAN. L. REV. 539 (2011);
111. see generally Stephen J. Lubben, Repeal the Safe Harbors, 18 AM. BANKR. INST. L. REV. 319 (2010);
112. Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, 75 U. CIN. L. REV. 1019, 1036 (2007);
113. Michael Simkovic, Secret Liens and the Financial Crisis of 2008, 83 AM. BANKR. L.J. 253 (2009).
114. Franklin R. Edwards, Hedge Funds and the Collapse of Long-Term Capital Management, 13 J. ECON. PERSP. 189, 199 (1999).
115. MF GLOBAL HOLDINGS LTD., ANNUAL REPORT (FORM 10-K), at 84 (Mar. 31, 2011), available at http://www.sec.gov/Archives/edgar/data/1401106/ 000119312511145663/d10k.htm#tx172225-27.
116. Nick Brown, MF Global Trustee Sees $1.6 Billion Claims Gap, REUTERS (Feb. 10, 2012), http://www.reuters.com/article/2012/02/10/us-mf-global- trustee-gap-idUSTRE8191QF20120210.
117. See Jeremy C. Kress, Credit Default Swaps, Clearinghouses, and Systemic Risk: Why Centralized Counterparties Must Have Access to Central Bank Liquidity, 48 HARV. J. ON LEGIS. 49 (2011) (criticizing Dodd-Frank's limitation on Fed loans to clearinghouses).
118. Jeremy C. Stein, Securitization, Shadow Banking and Financial Fragility, DAEDALUS, Fall 2010, at 41, 49-50.
119. Cf. REINIER KRAAKMAN ET AL., THE ANATOMY OF CORPORATE LAW 10 (2d ed. 2009);
120. Henry Hansmann & Reinier Kraakman, The Essential Role of Organizational Law, 110 YALE L.J. 387, 402 (2000) (arguing that those trading with a partnership must know the net worth of each partner to assess the partnership well).
121. Craig Pirrong, The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing of Default Risks Through a Central Counterparty 25-30 (University of Houston, Department of Finance, Working Paper, 2009), available at www.ssrn.com/abstract=1340660.
122. OFFICE OF THE COMPTROLLER OF THE CURRENCY, OCC'S QUARTERLY REPORT ON BANK TRADING AND DERIVATIVES ACTIVITIES FIRST QUARTER 2012, at 26 tbl.2, available at http://www.occ.gov/topics/capital-markets/financial-markets/trading/ derivatives/dq112.pdf.
123. Viral V. Acharya & T. Sabri Oncu, A Proposal for the Resolution of Systemically Important Assets and Liabilities: The Case of the Repo Market, INT'L J. CENT. BANKING, Jan. 2013, at 293, 294;
124. accord TOBIAS ADRIAN & ADAM B. ASHCRAFT, FED. RES. BANK OF N.Y. STAFF REP. NO. 559, SHADOW BANKING: A REVIEW OF THE LITERATURE, 22, 27 (2012), available at http://www.newyorkfed.org/research/staff-reports/sr580.pdf.
125. Patrick E. McCabe, The Cross Section of Money Market Fund Risks and the Financial Crises 1 (Fed. Res. Bd., Fin. & Econ. Disc. Series No. 2010-51, 2010).
126. PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS, MONEY MARKET FUND REFORM OPTIONS 12 (2010), available at http://www.treasury.gov/press-center/press- releases/Documents/10.21%20PWG%20Report%20Final.pdf.
127. INVESTMENT COMPANY INSTITUTE, 2011 INVESTMENT COMPANY FACT BOOK 164, 171 (2011).
128. Tobias Adrian and Hyun Song Shin, two Federal Reserve economists, describe the large and growing interbank dependencies arising from non-derivative-based, non-clearable securitization. TOBIAS ADRIAN & HYUN SONG SHIN, FED. RES. BANK N.Y. STAFF REP. NO. 382, THE SHADOW BANKING SYSTEM: IMPLICATIONS FOR FINANCIAL REGULATIONS 11 (2009).
129. See Richard Squire, Clearinghouses and the Rapid Resolution of Bankrupt Financial Firms, 99 CORNELL L. REV. - (forthcoming 2014).
130. Darrell Duffie & Haoxiang Zhu, Does a Central Clearing Counterparty Reduce Counterparty Risk?, 1 REV. ASSET PRICING STUD. 74, 76 (2011) ("Suppose that Dealer A is exposed to Dealer B by $100 million on [credit default swaps], while at the same time Dealer B is exposed to Dealer A by $150 million on interest-rate swaps. The bilateral exposure is the net, $50 million. The introduction of central clearing dedicated to [credit default swaps] eliminates the bilateral netting benefits and increases the exposure between these two dealers, before collateral, from $50 million to $150 million.") Efforts to link clearinghouses can increase setoff, but linkage also increases too-big-to-fail interconnectedness. And many derivatives are too complex to clear. If a noticeable volume is unclearable, the separation of the clearable from the unclearable would reduce the anticipated liquidity, not increase it.
131. See Andrew J. Olejnick, Lehman Brothers' ADR Procedures for Resolving Its Derivative Contracts in Bankruptcy, BANKR. STRATEGIST, June 2012, available at http://jenner.com/system/assets/publications/9813/original/081061201-Jenner.pdf? 1339099814;
132. Nick Brown, Court OKs Lehman Settlements to Free Up $15 Billion for Customers, REUTERS (Apr. 16, 2013), http://www.reuters.com/article/2013/04/ 16/us-lehman-settlements-idUSBRE93F11720130416. Lehman's cleared obligations settled out quickly. That could signal a general clearinghouse capacity to settle out fast. But the obligations cleared were the easy ones, which may well also have settled out quickly bilaterally. Clearinghouses are now being asked to clear more complex obligations. To be sure here, if the obligation to the member is identical to that from the member, then setoff would presumably be quick. In the running examples in this paper's figures, we have debts with firm numbers attached to them. But in the real world, there will be obligations that can, and often will, be contested. The extensive litigation over Lehman's open obligations should not make one optimistic about quick settlement of mutual obligations for setoff.
133. Cf. R.H. Coase, The Problem of Social Cost, 3 J. L. & ECON. 1 (1960).
134. Analysts of the crisis state, "[A] large part of the financial sector [was] funded with fragile, short-term debt and [was] hit by a common shock to its long-term assets . . . . This occurred in the fall and winter of 2008-2009 . . . ." Viral V. Acharya & Matthew Richardson, Implications of the Dodd-Frank Act, 4 ANN. REV. FIN. ECON. 1, 2 (2012). The financial crisis erupted because the entire system had overinvested in the wrong kind of liabilities, not because a single institutional failure could not be contained.
135. Ben S. Bernanke, Chairman, Fed. Reserve Sys., Remarks at the 2011 Financial Markets Conference: Clearing Houses, Financial Stability, and Financial Reform 10 (Apr. 4, 2011), available at http://www.federalreserve.gov/ newsevents/speech/bernanke20110404a.pdf.
136. Matthias Arnsdorf, Quantification of Central Counterparty Risk, 5 J. RISK MGMT. FIN. INST. 273, 274 (2012) (emphasis added).
137. Sean J. Griffith, Governing Systemic Risk: Towards a Governance Structure for Derivatives Clearinghouses, 61 EMORY L.J. 1153 (2012).
138. DAVID SKEEL, THE NEW FINANCIAL DEAL: UNDERSTANDING THE DODD-FRANK ACT AND ITS (UNINTENDED) CONSEQUENCES 70-71 (2011);
139. Iman Anabtawi & Steven L. Schwarcz, Regulating Systemic Risk: Towards an Analytical Framework, 86 NOTRE DAME L. REV. 1349, 1395 (2011);
140. Roe, supra note 88 at 587; Angela Monaghan, Bank of England's Paul Tucker Calls for Reform of Clearing Houses, TELEGRAPH (Oct. 25, 2011), http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/8846780/ Bank-of-Englands-Paul-Tucker-calls-for-reform-of-clearinghouses.html (Deputy Governor of Bank of England points to "mayhem" if a major clearinghouse collapsed);
141. Manmohan Singh, Making OTC Derivatives SafeA Fresh Look 10-13 (Int'l Monetary Fund, Working Paper 11/66, 2011), available at www.ssrn.com/paper= 1795845; Bernanke, supra note 118, at 2 ("[T]he flip side of the centralization of clearing . . . in clearinghouses is the concentration of . . . risk in a small number of organizations . . . with potentially important systemic implications.").
142. See also Julia Lees Allen, Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd- Frank Analysis, 64 STAN. L. REV. 1079 (2012).
143. E.g., Gary Gensler, Clearinghouses Are the Answer, WALL ST. J. (Apr 12, 2010), http://online.wsj.com/article/ SB10001424052748704671904575194463642611160.html; NORMAN, supra note 40, at 12.
144. NORMAN, supra note 40, at 358; cf. Michael Mackenzie, Call for "Bulletproof" Clearing Houses, FT.COM (Mar. 22, 2012), http://www.ft.com/intl/cms/s/0/eacb29cc-7451-11e1-9e4d-00144feab49a.html (Federal Reserve Bank of New York president says post-crisis derivatives clearinghouses must be, and can be, bulletproof).
145. Viral V. Acharya et al., Regulating OTC Derivatives, in REGULATING WALL STREET: THE DODD-FRANK ACT AND THE NEW ARCHITECTURE OF GLOBAL FINANCE 367 (Viral Acharya et al., eds. 2010); see also NORMAN, supra note 40, at 138.
146. BASEL COMM. BANKING SUPERVISION, MARGIN REQUIREMENTS FOR NONCENTRALLY- CLEARED DERIVATIVES (2012), available at http://media.futuresmag.com/futuresmag/ article/2012/07/06/Basel.pdf.
147. Pirrong, supra note 62; see also Gerard Hertig, Trading and Clearing Reforms in the EU: A Story of Interest Groups with Magnified Voice, 5 ZEITSCHRIFT FUR BANKRECHT UND BANKWIRTSCHAFT 329, 337 (2011);
148. René M. Stulz, Credit Default Swaps and the Credit Crisis, 24 J. ECON. PERSP. 73, 89 (2010);
149. Chris Kenyon & Andrew Green, Will Central Counterparties Become the New Rating Agencies? 1 (November 27, 2012) (unpublished manuscript), available at http://ssrn.com/abstract=2181291.
150. But the consensus regulatory wisdom is that the centralized clearinghouse will monitor better. Randall S. Kroszner & Philip E. Strahan, Financial Regulatory Reform: Challenges Ahead, 101 AM. ECON. REV: PAPERS & PROC. 242, 244 (2011).
151. Franklin R. Edwards, The Clearing Association in Futures Markets: Guarantor and Regulator, in THE INDUSTRIAL ORGANIZATION OF FUTURES MARKETS 225, 232 (Ronald W. Anderson ed., 1984) (emphasis added);
152. cf. Bruno Biais et al., Clearing, Counterparty Risk, and Aggregate Risk, 60 IMF ECON. REV. 193 (2012); Yadav, supra note 24, at 400 (clearinghouse underinvestment in due diligence).
153. Nicholas Vause, Counterparty Risk and Contract Volumes in the Credit Default Swap Market, BIS Q. REV., Dec. 2010, at 64.
154. See Robert R. Bliss & George G. Kaufman, Derivatives and Systemic Risk: Netting Collateral and Closeout, 2 J. FIN. STABILITY 55 (2006).
155. Peter F. Coogan, Public Notice Under the Uniform Commercial Code and Other Recent Chattel Security Laws, Including "Notice Filing," 47 IOWA L. REV. 289, 289 (1962). Michael Simkovic quotes Coogan and notes how nonpublic, de facto liens weakened financial structures prior to the recent crisis. Simkovic, supra note 88 at 255.
156. In principle, Dodd-Frank bars federal authorities from directly bailing out the clearinghouse. Dodd-Frank Wall Street Reform and Consumer Protection Act § 716, 15 U.S.C. § 8305. One could presume that the bar would be ignored, evaded, or repealed in a crisis.