News: Harvard Law School | The Dodd-Frank Act’s Maginot Line: Clearinghouse Construction

09 May 2013 | Ben Larah

Earlier today, Mark J Roe published an abstract to his paper on clearing houses on the Harvard Law Blog (a link to which is here. The full paper can be downloaded here).

It is an eloquent, thought-provoking paper which reviews the financial crisis, describes the functionality of a CCP, and introduces some well-known criticisms of central clearing (e.g. that they're the new "too big to fail", that they'll result in collateral scarcity during times of crisis, that they merely transfer risk rather than eliminating it, etc.).

In addition to pointing out the shortcomings of CCPs, Roe suggests risk-mitigating alternatives to CCPs, such as expanded ISDA set-off structures and private institutions for netting.

One significant concern I have with the paper is that it doesn't give the CCPs due credit for the orderly post-default settlement of Lehman's $9trn IRS portfolio in 2008 (see here). Instead, the footnote on p.33 brushes off this achievement by saying  "...the obligations cleared were the easy ones, which may well also have settled out bilaterally quickly". They may have settled quickly had they been bilateral, but how could we ever determine this?

My criticism aside, I do recommend reading the article, if you have the spare time to read through 45 pages. It would be interesting to hear people's feedback on the paper in the "comments".

Ben L.


I noticed in particular that hes picked up onHarvard Professor Roes draft paper proposing that OTC clearing is no silver bullet for systemic risk which Ben Larah posted about recently here.

There's a lot in this excellent paper and it's hard to sum up in a few words my reactions.Firstly Roe seems to downplay the importance of margin (both VM and IM) in containing the risk on the netted portfolio at source - focusing instead on risks as if they were uncollateralized in most of the paper. Secondly his key insight is that by netting risk in default, are effectively transfered to uncleared portfolios or other direct creditors of a failing member. This makes perfect sense but it seems harsh to blame the CCP construct for this. More logical would be a discussion of how to provide similar netting benefits outside of clearing also (given not everything can be cleared realistically). To be fair he does support this point by advocating that regulators attention should broaden away from CCPs as the sole silver bullet on OTC derivatives systemic risk. They have started by pushing bilateral margin and capital. However, there is a lot more that they and market innovation can do including in particular enabling bilateral risk reduction trades. The point in particular here related to CCPs is that mandating their use to some extent may inhibit the bilateral reduction of systemic risk because a trade they want to do to mutually offset risk must clear. This point in particular should be a regulatory priority to fix. Also they should focus on enabling multi-lateral utilities emerging for netting outside of clearing and compression (risk reduction compression can actually reduce counterparty risk for once which I think would appeal to Professor Roe).I suppose that if all OTC risk was reduced through compression or offset by IM and netted either in a CCP or a multi-lateral netting utility that this would largely shift the default risks away from derivatives altogether to loans, open FX forwards, etc. using his risk transfer argument. And banks capital ratios would either start to look more healthy or they could return cash to investors in their issuances. Frankly if this were achieved I think it would be time to put the flag up the pole nonetheless and regulators focus would then shift to how to deal with systemic risks in the cash markets...