Failure of the Clearinghouse: Dodd Frank Fatal Flaw?

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VIRGINIA LAW & BUSINESS REVIEW V OLUME 10 F ALL 2015 NUMBER 1

FAILURE OF THE CLEARINGHOUSE: DODD-FRANK’S FATAL FLAW?

Stephen J. Lubben†

INTRODUCTION ..................................................................................................... 127

I.

CLEARINGHOUSES AND THE FUTURES M ARKETS ....................................... 133

II. CLEARINGHOUSES AND DODD-FRANK ....................................................... 139

III. DODD-FRANK TITLE VIII ............................................................................ 145

IV. CLEARINGHOUSES IN DISTRESS .................................................................. 148

CONCLUSION .......................................................................................................... 160

INTRODUCTION

LEARINGHOUSES reduce risk by acting as a central hub for trades.Each party to a trade faces only the risk of the clearinghouse’s non-

performance, rather than the doubtlessly greater risk that the counterparty tothe trade will fail to perform.1

† Harvey Washington Wiley Chair in Corporate Governance & Business Ethics, Seton HallUniversity School of Law. I am extremely grateful for comments from Jennifer Hoyden,Colleen Baker, Anthony Casey, Anna Gelpern, Kathryn Judge, Richard Miller, SauleOmarova, Craig Pirrong, David Skeel, Mark Roe, Art Wilmarth, and others who asked toremain nameless. Adam Levitin provided extensive and extremely helpful comments onan earlier draft. I owe him special thanks.

1 See Kristin N. Johnson, Governing Financial Markets: Regulating Conflicts , 88 W ASH. L. R EV .185, 218 (2013); Jeffrey Manns, Insuring Against a Derivative Disaster: The Case for Decentralized

Risk Management , 98 IOWA L. R EV . 1575, 1606 (2013); see also 7 U.S.C. § 2(h)(2) (2012)(providing guidelines for the Commodity Futures Trading Commission’s review ofclearinghouse submissions). The clearinghouse is actually something more than a hub,

Copyright © 2015 Virginia Law & Business Review Association

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Virginia Law & Business Review 10:127 (2015) 128

For this reason, the Dodd-Frank Wall Street Reform and Consumer

Protection Act 2 now requires that most derivatives trade throughclearinghouses.3

The Dodd-Frank Act’s clearinghouse requirement is intended to reduce

systemic risk caused by domino effect failures: if one firm fails, it could resultin the failure of other firms to which it owes money, and so on. Yet theDodd-Frank Act’s clearinghouse requirement may be self-defeating.

The concentration of derivatives trades into a very small number ofclearinghouses or central counterparties (CCPs) arguably increases systemicrisk.4 As summarized by the International Swaps and Derivatives Association

(ISDA), the derivatives industry trade organization: The larger CCPs have become critical components of thefinancial markets infrastructure and are emerging as majorhubs concentrating the vast majority of global OTCderivatives transaction flows and risk positions. Great careneeds to be taken to ensure that CCPs are not the new “too

big to fail” institutions requiring public money to preventtheir failure.5

Clearinghouses are regulated,6 but given the vital place of clearinghousesin Dodd-Frank, it is surprising that Dodd-Frank makes no provision for thefailure of a clearinghouse.7

since it replaces a single contract between two parties with two contracts. That is, theclearinghouse replaces a direct contractual relationship, between the two parties havingtwo distinct relationships, with the clearinghouse. This is discussed more fully below.

2 Pub. L. No. 111-203, 124 Stat. 1376 (2010).3 See John C. Coffee, Jr., The Political Economy of Dodd-Frank: Why Financial Reform Tends to Be

Frustrated and Systemic Risk Perpetuated , 97 CORNELL L. R EV . 1019, 1063 (2012).4 See Eduard H. Cadmus, An Altered Derivatives Marketplace: Clearing Swaps Under Dodd-Frank,

17 FORDHAM J. CORP. & FIN. L. 189, 224 (2012); Felix B. Chang, The Systemic Risk Paradox:Banks and Clearinghouses Under Regulation , 2014 COLUM. BUS. L. R EV . 747, 775 (2014); Mark J. Roe, Clearinghouse Overconfidence , 101 C ALIF. L. R EV . 1641, 1692 (2013); David A. Skeel, Jr. & Thomas H. Jackson, Transaction Consistency and the New Finance in Bankruptcy , 112COLUM. L. R EV . 152, 196 (2012).

5 Scott O’Malia, Ensuring CCPs Are Not TBTF , DERIVATI V IEWS (Dec. 10, 2014),http://isda.derivativiews.org/2014/12/10/ensuring-ccps-are-not-tbtf/.

6 See Colleen Baker, The Federal Reserve as Last Resort , 46 U. MICH. J. L. R EFORM 69, 104(2012).

7 Chang, supra note 4, at 792. Indeed, it is arguable that the United States is not incompliance with its commitment to the G-20 on this point. See B ANK FOR INT’L

SETTLEMENTS & INT’L ORG. OF SEC. COMM’NS, R ECOVERY AND R ESOLUTION OFFINANCIAL M ARKET INFRASTRUCTURES: CONSULTATIVE R EPORT 1 (2012). Interestingly, asimilar document, but entitled “Recovery of Financial Market Infrastructures,” wasreleased in August 2013. “Resolution” was gone. The relationship between the two isexplained on page 4 of the latter document:


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10:127 (2015) Failure of the Clearinghouse 129

Clearinghouses are presently excluded from the Dodd-Frank Act’s new

Orderly Liquidation Authority (OLA).8 Yet the notion that a derivativesclearinghouse might file a regular bankruptcy petition is farcical, given thatCongress previously decided to exclude derivatives, and most securities

trades, from the most important parts of the Bankruptcy Code,9 and becausea clearinghouse would be required to liquidate in a chapter 7 bankruptcy. 10

Given the key role that clearinghouses will play in a post-Dodd-Frank world, this Article begins the hard discussion of what should happen if the worst were to happen.

The lack of insolvency mechanisms for clearinghouses is particularly

concerning given the unique way in which clearinghouses are apt to fail.Unlike most businesses, clearinghouses will never find themselves sufferingfrom ever-increasing degrees of financial distress. Instead, they will mostlikely fail as the result of one of their member’s failure, or as a result of a

In July 2012 the CPSS and IOSCO published a consultative report on recoveryand resolution of financial market infrastructures . That report covered both the needfor FMIs to have effective plans to recover from financial stresses and the needfor jurisdictions to have effective regimes for the resolution of an FMI incircumstances where recovery is no longer feasible. Many of the commentatorson that consultative report requested more guidance on what recovery tools would be appropriate for different types of FMI in different circumstances. This new report provides that guidance. Aspects of the consultation report concerningFMI resolution have been included in a new draft annex and will be included in anassessment methodology for the Key attributes. Many recovery tools will also be

relevant to an FMI under resolution, not least because a resolution authoritymay wish to enforce implementation of contractual loss allocation rules whereany such rules have not been implemented before entry into resolution.

B ANK FOR INT’L SETTLEMENTS & INT’L ORG. OF SEC. COMM’NS, R ECOVERY OFFINANCIAL M ARKET INFRASTRUCTURES: CONSULTATIVE R EPORT 4 (2013) (emphasisadded).

8 Some have argued that OLA applies to clearinghouses. E.g., Julia Lees Allen, Note,Derivatives Clearinghouses and Systemic Risk: A Bankruptcy and Dodd-Frank Analysis , 64 S TAN. L. R EV . 1079, 1100–02 (2012); see also PETER J. GREEN ET AL., MORRISON & FOERSTERLLP, A VOIDING ARMAGEDDON: R ESOLUTION R EGIMES FOR CENTRAL CLEARINGCOUNTERPARTIES 4 (2013) (“In terms of a resolution regime for CCPs, Title II of theDodd Frank Act has already provided the Federal Deposit Insurance Corporation (FDIC) with orderly liquidation authority over certain non-bank financial institutions, such asCCPs.”). But as discussed, infra , that assumption ignores the text and intent of Dodd-Frank.

9 See Stephen J. Lubben, Derivatives and Bankruptcy: The Flawed Case for Special Treatment , 12 U. P A. J. BUS. L. 61, 67 (2009); Mark J. Roe, The Derivatives Market’s Payment Priorities asFinancial Crisis Accelerator , 63 S TAN. L. R EV . 539, 547–48 (2011).

10 11 U.S.C. §§ 101(6), 109(d), 766(i) (2012). Subchapter IV of chapter 7 contains specialprovisions for “commodity broker liquidation.” 11 U.S.C. § 767.


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massive operational problem.11 In short, they will “jump to default,” just like

a credit default swap.12 As Congress recognized, all of this places special stress on the need for

risk management at the clearinghouses. 13 But what if a clearinghouse

nonetheless fails?Industry participants acknowledge that this eventuality, although arguably

unlikely, could happen.14 What happens next is unknown.15 In this paper I suggest two likely outcomes. Congress might be tempted

to adopt an ad hoc statutory solution. The fate of Fannie Mae and FreddieMac, the two mortgage companies who were placed in a conservatorship in

September 2008, just after Congress had created that possibility under theHousing and Economic Recovery Act of 2008,16 looms large here.17

But ad hoc solutions simply exacerbate uncertainty in times of financialdistress, and are subject to litigation risk too. And the sudden creation of aspecialized resolution process is really not anything more than a bailout, sinceany solution will require massive capital injections to save the clearinghouses.

Again, consider the mortgage companies, and the U.S. Treasury’s outsizedpreferred share holdings therein.18

11 In theory, a clearinghouse could also fail because of investment losses: clearinghousesinvest the collateral they hold and this could trigger insolvency, though that would have toinvolve investment decisions so poor as to amount to an operational problem.

12 Adam J. Levitin, Response: The Tenuous Case for Derivatives Clearinghouses , 101 GEO. L.J. 445,455 n.35 (2013) (“‘Jump-to-default’ is the phenomenon in which protection sellers’ CDS-payout liability occurs suddenly through triggers such as payment defaults or bankruptcy

filings, rather than incrementally. The effect is to make the liquidity demands on CDS-protection sellers more volatile.”).

13 See 7 U.S.C. § 7a–1(c)(2)(D) (2012).14 INT’L S WAPS & DERIVATIVES ASS’N, PRINCIPLES FOR CCP R ECOVERY 7 (2014) [hereinafter

ISDA], available athttp://www2.isda.org/attachment/NzExMw==/Principles%20for%20CCP%20Recovery%20FINAL.pdf (“Although it should be extremely unlikely, the DMP [defaultmanagement process] could fail. In this case, regardless of the amount of loss-absorbingresources utilized (or that remain available), the clearing service is likely to be deemed nolonger viable.”).

15 See id.16 Pub. L. No. 110-289, 122 Stat. 2654 (2008).17 See Michael S. Barr, The Financial Crisis and the Path of Reform , 29 Y ALE J. ON R EG. 91, 111

(2012). To be sure, Fannie and Freddie did not “jump to default.” Instead, theirproblems built up more gradually. But the creation of a special insolvency proceeding just

for them is the point of similarity.18 See FED. HOUS. FIN. AGENCY , TREASURY AND FEDERAL R ESERVE PURCHASE PROGRAMS

FOR GSE AND MORTGAGE-R ELATED SECURITIES 2 (2014), available athttp://www.fhfa.gov/DataTools/Downloads/Documents/Market-Data/TSYFEDPP_NOV2014r.pdf.


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So then there will be a temptation to engage in direct bailout, despite

Dodd-Frank’s claim to have ended bailouts.19 Bailouts of individual financialinstitutions may end, but bailouts of clearinghouses might become morecommon in a post-Dodd-Frank world.20 Given that most clearinghouses are

themselves publicly traded companies, with strong connections to all themajor banks, there are good reasons to wonder if we will not simply bebailing out the same group of banks indirectly in the next financial crisis.

Academics decry bailouts because of the “moral hazard” they create.Clearinghouses will run their businesses with less caution if they know thatthe government will save them from losses. From a broader perspective,

taxpayers might rightly wonder why they should save investors from lossesthose investors willingly undertook—recall again that all major derivativesclearinghouses are now publicly held firms.21

On the other hand, the very aim of Dodd-Frank is to placeclearinghouses at the heart of the nation’s financial system.22 And it is notcredible to think that any government will allow its entire banking system to

collapse if something could be done to prevent that. 23 Central bankinglending that overcomes “mere” illiquidity is generally innocuous, but in timesof crisis it will be difficult to separate illiquidity from insolvency.

What to do?I propose that the government should nationalize the clearinghouses

upon failure, and that the intention to do so should be made clear ex ante .

That is, the government should expressly state that clearinghouses thatultimately fail will be nationalized, with specific consequences to investors,

and an expectation of member participation in the recapitalization of the

19 See Sean J. Griffith, Governing Systemic Risk: Towards a Governance Structure for DerivativesClearinghouses , 61 EMORY L.J. 1153, 1201 (2012); see also Dodd-Frank Wall Street Reformand Consumer Protection Act of 2010 § 214, 12 U.S.C. § 5394 (2012) (providing that“[t]axpayers shall bear no losses from the exercise of any authority” under OLA).

20 In a recent paper, Adam Levitin argues that structuring bailouts this way will be morepolitically palatable. Adam J. Levitin, Prioritization and Mutualization: Clearinghouses and theRedundancy of the Bankruptcy Safe Harbors , 10 BROOK . J. CORP. FIN. & COM. L. (forthcoming2015) (manuscript at 25), available athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=2610469.

21 Cf. John Patrick Hunt, Credit Ratings in Insurance Regulation: The Missing Piece of FinancialReform, 68 W ASH. & LEE L. R EV . 1667, 1692 (2011) (describing the moral hazardassociated with so-called “rule bailouts”).

22 Whether this was wise is of course subject to debate. See Craig Pirrong, The Economicsof Clearing in Derivatives Markets: Netting, Asymmetric Information, and the Sharing ofDefault Risks Through a Central Counterparty 4–5 (Jan. 8, 2009) (unpublishedmanuscript), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1340660.

23 See Adam J. Levitin, In Defense of Bailouts , 99 GEO. L.J. 435, 439 (2011).


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clearinghouse, once that becomes systemically viable. This should provide

stakeholders in the clearinghouses with strong incentives to oversee theclearinghouse’s management and avoid such a fate.24

In essence, what I propose is a system of precommitment or “structured

bailouts.”25 Bailouts of clearinghouses seem inevitable. We must specify what would happen today, both to discourage an avoidable situation, and tofacilitate an organized response, in the event of an essential bailout.

In a world of limited liability, this may not be enough to get theincentives “just right.” But it is better than the status quo.

* * *

This Article makes three basic claims. First, bailouts of clearinghousesare now foreseeable, because the important, central place of clearinghousesafter Dodd-Frank makes their failure too disruptive to be politically tolerated.Second, the United States needs to enact a clear, ex ante procedure to deal with the failure of a clearinghouse and address the consequences of a bailout. Third, those consequences must include clearly delineated outcomes for the

stakeholders best situated to avoid problems at the clearinghouse.In short, both shareholders and members must incur real costs if a

clearinghouse fails. Hence, upon failure, clearinghouses must be nationalizedand memberships cancelled.26

The Article commences with a discussion of the structure and nature ofclearinghouses. Part II then sketches the central role of clearinghouses in

Dodd-Frank’s regulation of derivatives, while Part III turns to the new, post-financial crisis regulation of clearinghouses.

Part IV then considers the clearinghouse in financial distress. My focus ison the clearing of derivatives trades, although much of what I have to sayapplies to clearinghouses generally. I note that the only Dodd-Frankprovision remotely addressing the failure of systemically important

clearinghouses is the section that allows clearinghouses to access the FederalReserve’s discount window.27 That presupposes that the clearinghouse willhave assets to discount.28

24 See Sarah Pei Woo, Regulatory Bankruptcy: How Bank Regulation Causes Fire Sales , 99 GEO. L.J. 1615, 1626 (2011).

25 Alternatively, this could be seen as an instance of “containment.” See Anna Gelpern,Financial Crisis Containment , 41 CONN. L. R EV . 1051, 1057 (2009).

26 In essence, both types of equity in the clearinghouse—memberships and formal equity—

must be forfeited in exchange for the bailout.27 12 U.S.C. § 5465(b) (2012).28 Or maybe not. See Christian Chamorro-Courtland, The Trillion Dollar Question: Can a

Central Bank Bail Out a Central Counterparty Clearing House Which Is "Too Big to Fail"? , 6BROOK . J. CORP. FIN. & COM. L. 433, 464 (2012) (“Notwithstanding the Fed’s power,


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Nonetheless, this provision might provide the basis for a Federal Reserve

bailout of important clearinghouses. Alternatively, the Treasury will facestrong pressure to bail out the clearinghouse, since failure to do so might wellproduce a broader systemic collapse. None of this is very consistent with

Congress’ stated desire to end bailouts of the financial system.29 I conclude with a sketch of a proposal to nationalize systemically

important clearinghouses upon failure. Clearinghouses are too important tofail, but failure should have real consequences for investors and the membersof the clearinghouse. Anything less provides little more than no-costgovernment insurance, something to which taxpayers and voters should

rightly object. At this point, the academic literature on the bankruptcy of clearinghouses

is almost non-existent.30 As recent events have shown, it is never too early toconsider the impossible.

This Article also surfaces the important question of whether suchimportant financial system infrastructure should remain with publicly traded

firms. There is an obvious conflict of interest between the public role thesefirms play and the normal duties their boards owe to their shareholders.

I. CLEARINGHOUSES AND THE FUTURES M ARKETS

Transactions in futures have long been cleared and settled through a

clearinghouse. 31 A future, which is a specialized kind of forward, is astandardized contract to purchase or sell an underlying asset in the future at a

specified price and date.32

The seller of the futures contract (the short party)

[Dodd-Frank] Title VIII is ambiguous for several reasons. First, it does not specify whether the CCP must provide good collateral in exchange for access to the discount window.”).

29 As provided in the preamble to Dodd-Frank, the law’s stated goal is “[t]o promote thefinancial stability of the United States by improving accountability and transparency in thefinancial system, to end ‘too big to fail,’ to protect the American taxpayer by endingbailouts . . . .” Pub. L. No. 111-203, pmbl., 124 Stat. 1376, 1376 (2010).

30 The exception being a single student note. See Allen, supra note 8.31 One historian notes “the first U.S. clearinghouse to ‘set off’ multiple transactions at once

appeared in Chicago in 1884. The first clearinghouse in produce was actually adopted inLiverpool in cotton in 1876.” Jonathan Ira Levy, Contemplating Delivery: Futures Trading and

the Problem of Commodity Exchange in the United States, 1875–1905 , 111 AM. HIST. R EV . 307,314 n.29 (2006). Clearinghouses for banknotes developed a few decades earlier. See GaryGorton, Clearinghouses and the Origin of Central Banking in the United States , 45 J. ECON. HIST. 277, 278 (1985).

32 S TEPHEN J. LUBBEN, CORPORATE FINANCE 317 (2014).


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incurs a liability to the futures market, and the buyer (the long party) acquires

an asset from the market.33 Historically the futures markets were devoted to agricultural and other

similar commodities, and thus were centered in Chicago, the agricultural hub

of the United States.34 Beginning in the 1970s, however, the futures marketsexpanded to include contracts based on stock indexes and other securities.Nonetheless, the basic model remained the same.

The clearinghouse in all cases becomes a central party to each trade,joining the parties and assuming the obligation of each party so that there isno counterparty risk between the original buyer and seller. 35 In short, once a

futures trade is cleared—that is, matched and confirmed—the clearinghousebecomes a party to both legs of a trade.36

Either of the original parties can leave the trade without the consent oftheir original counterparty, because the original contract is replaced by twocontracts, each with the clearinghouse.37 The two halves of the trade nolonger have any necessary connection, and each party now holds one of many

fungible contracts with the clearinghouse.Given this setup, the clearinghouse would not be long for this world if it

did not take steps to prevent being left “holding the bag.”38 And in the more

33 Lester G. Telser & Harlow N. Higginbotham, Organized Futures Markets: Costs and Benefits ,85 J. POL. ECON. 969, 970 (1977).

34 See Randall S. Kroszner, Can the Financial Markets Privately Regulate Risk?: The Development ofDerivatives Clearinghouses and Recent Over-the-Counter Innovations , 31 J. MONEY , CREDIT &

B ANKING 596, 598–604 (1999). For a concise overview of this history, see PHILIPMCBRIDE JOHNSON ET AL., DERIVATIVES R EGULATION: 2015 CUMULATIVE SUPPLEMENT §1.19[1] (2015).

35 For empirical evidence of the reduction in counterparty risk in the swaps context, see YeeCheng Loon & Zhaodong Ken Zhong, The Impact of Central Clearing on Counterparty Risk,Liquidity, and Trading: Evidence From the Credit Default Swap Market , 112 J. FIN. ECON. 91, 92(2014).

36 B ANK FOR INT’L SETTLEMENTS, COMM. ON P AYMENT & SETTLEMENT S YS. & INT’L ORG. OF SEC. COMM’NS, PRINCIPLES FOR FINANCIAL M ARKET INFRASTRUCTURES 9 (2012)[hereinafter CPSS-IOSCO PRINCIPLES ].

37 Contracts are terminated by purchasing an equal, offsetting position from theclearinghouse. Robert R. Bliss & Robert S. Steigerwald, Derivatives Clearing and Settlement:

A Comparison of Central Counterparties and Alternative Structures , ECON. PERSPECTIVES, Nov.2006, at 22, 26, available at http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2006/ep

_ 4qtr2006_part2_bliss_steigerwald.pdf. The authors argue that this increases liquidity inthe market, since positions are not subject to lengthy renegotiation.

38 See Jeremy C. Kress, Credit Default Swaps, Clearinghouses, and Systemic Risk: Why CentralizedCounterparties Must Have Access to Central Bank Liquidity , 48 H ARV . J. ON LEGIS. 49, 62(2011).


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than century-long history of clearinghouses, several routine tools have been

developed to reduce the risk to the clearinghouse.On the front end, the clearinghouse has membership requirements.39

Every clearing model currently in use permits access to the clearinghouse only

by or through members of the clearinghouse. That is, the clearinghouselimits membership to certain financial institutions that meet set requirements,and everyone else who wants to trade on the clearinghouse must do sothrough a member. These membership requirements are typicallysubstantially higher than the requirements for membership in an underlyingtrading market.40

The clearinghouse screens its members, and the members then screentheir customers. 41 Ideally. But at the very least, the members will beresponsible for any performance lapses of its customers, so the clearinghouseis protected from most routine problems.

Next, members have to post margin (collateral) to vouch for theirperformance on trades conducted through a clearinghouse.42

For example, imagine a member broker-dealer’s trading desk 43 takes along position in four hundred S&P 500 futures contracts. For simplicity,assume the index is at 1,000, so that this position represents $100 million inexposure to the S&P 500 index,44 and the member will typically have to post5% margin to open this position, or $5 million. This “initial margin” willtypically take the form of Treasury or other high-quality securities.45

39 Bliss & Steigerwald, supra note 37, at 25.40 2 PHILIP MCBRIDE JOHNSON & THOMAS LEE H AZEN, DERIVATIVES R EGULATION §

3.09[5] (2004).41 See Customer Clearing Documentation, Timing of Acceptance for Clearing, and Clearing

Member Risk Management, 77 C.F.R. 21,278, 21,278 (Apr. 9, 2012) (to be codified at 17C.F.R. pts. 1, 23, 37, 38, 39).

42 David S. Bates & Roger Craine, Valuing the Futures Market Clearinghouse’s Default ExposureDuring the Crash of 1987 , 31 J. MONEY , CREDIT & B ANKING 248, 248 (1999) (“The marginsystem is the clearinghouse’s first line of defense against default risk.”).

43 Ignore the future effects of the Volker Rule for purposes of the example. Broker-members are referred to as “futures commission merchants,” or “FCMs” in the CFTC world. See 17 C.F.R. § 255.6 (2014). But I continue to use “broker,” “dealer,” or“member” for readability in the text.

44 Each contract represents $250 multiplied by the index value.45 CME accepts Treasuries, agencies, certain sovereign debt, gold, select S&P 500 shares,

letters of credit, and of course, cash. The clearinghouse has various concentration anddiversification limits with regard to the margin, and cash that is not in USD is sometimessubject to a “haircut” (reduction in crediting value). Brokers might accept margin that would be unacceptable to the clearinghouse, and thus provide their customers with aservice by transforming the margin into an acceptable form. Laura Dicioccio & Christian


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Moreover, trades are subject to daily settlement payments, called

“variation margin,” so that the margin account remains at 5% in all cases, andthe clearinghouse never faces more than one day’s trading exposure. If, forexample, the index goes down by 200 points one day, at the end of that day

the broker will have to provide the clearinghouse with $20 million. 46 If the broker fails to provide these funds, the position will be taken over

by the clearinghouse, and the clearinghouse will attempt to recoup lossesfrom the member.47 Note that before this default, the clearinghouse had anet market exposure of zero: the long and short positions in the S&P 500index cancelled out.48 Its only exposure was to the credit risk of its members.

After the default, the clearinghouse takes on the long position—that is,until the clearinghouse is able to remedy the situation, it holds a directionalbet in the market.49 In times of financial stress, there may be few clearingmembers who are capable of executing a covering transaction that will relievethe clearinghouse of its predicament, and those members will have strongincentives to price the transaction assertively, since the clearinghouse must act

quickly.Because the clearinghouse only holds $5 million in initial margin in this

example, the clearinghouse faces a $15 million loss if the broker-dealer cannotor will not pay. Nonetheless, the counterparty to the trade, who is short theS&P 500 index, will receive its full $20 million of “variation margin” from theclearinghouse. From its perspective, the fate of its original counterparty

ceased to matter the moment its trade was accepted by the clearinghouse.If the dealer fails to pay, the clearinghouse will turn to its next risk

reduction feature, the default fund. Each member of the clearinghouse isrequired to contribute to a general fund that protects the clearinghouse fromdefault. Contributions are based on the size of the members’ positions and

Johnson, A Primer on Clearing OTC Derivatives: A Buyside Blueprint fo r Implementation , 33 No.6 FUTURES & DERIVATIVES L. R EP. 9, 12 (2013).

46 $50,000 loss per contract ! 400 contracts.47 CME GROUP, NYMEX R ULEBOOK R. 802.A.1 (2009). Specifically, in the period

following a default, the clearinghouse will attempt to return to a matched book byentering into offsetting transactions or by holding an auction of the defaulter’s positions.Id. R. 802.A.2.

48 See Anupam Chander & Randall Costa, Clearing Credit Default Swaps: A Case Study in GlobalLegal Convergence , 10 CHI. J. INT’L L. 639, 676–77 (2010).

49 CPSS-IOSCO PRINCIPLES, supra note 36, at 42 (“[D]uring the period in which a CCP

neutralises or closes out a position following the default of a participant, the market valueof the position or asset being cleared may change, which could increase the CCP’s creditexposure, potentially significantly. A CCP can also face potential future exposure due tothe potential for collateral (initial margin) to decline significantly in value over the close-out period.”).


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an evaluation of the risk of those positions. Thus, in this example, the

clearinghouse would first seek to recoup losses from the defaulting member’scontribution to the fund, and next from the fund generally.50

This is sometimes the basis of claims that clearinghouses mutualize losses

among members. 51 But that is not quite correct, or at least it isoversimplified. As Craig Pirrong explains:

Clearinghouses use margins to limit the amount of riskthat is mutualized. Only losses on defaulted positions inexcess of margin posted by the defaulter are mutualized. The higher the margin cover, the lower the level of risk

sharing.In practice, CCPs utilize a “defaulter pays” model in

which margin covers losses on defaulted positions withextremely high probability, e.g., 99.7 percent of the time. Ina defaulter pays model, the amount of risk mutualization is very low. CCPs are not, therefore, primarily an insurance

mechanism. They insure only tail risks (which has importantimplications for systemic risk and wrong way risk).52

According to CME’s53 own literature, its fund is designed to withstandthe default of its largest single member. Contributions to the default fund areset at the following:

the greater of $500,000 or the results of a formula under

which 95 percent of the total requirement is based on theClearing Member’s proportionate contribution to aggregate

risk performance bond requirements over the prior threemonths and the remaining 5 percent is based on the clearingmember’s contribution to risk-weighted transaction activityover the prior three months.54

In the example explored herein, involving the failure of a single, relativelysmall trade, that would likely be the end of the matter. In more significant

50 Richard Squire, Clearinghouses as Liquidity Partitioning , 99 CORNELL L. R EV . 857, 871 (2014).51 Id. See also Sean J. Griffith, Substituted Compliance and Systemic Risk: How to Make a Global

Market in Derivatives Regulation , 98 MINN. L. R EV . 1291, 1316 (2014); Roe, supra note 4, at1674–75; Houman B. Shadab, Credit Risk Transfer Governance: The Good, the Bad, and theSavvy , 42 SETON H ALL L. R EV . 1009, 1044 (2012).

52 Craig Pirrong, Moral Hazard, Defaulter Pays, and the Relative Costs of Cleared and Uncleared

Derivatives Trades , S TREETWISE PROFESSOR (Oct. 28, 2013, 3:38 PM),http://streetwiseprofessor.com/?p=7757.

53 Chicago Mercantile Exchange Group (CME).54 CME GROUP, CME CLEARING: FINANCIAL S AFEGUARDS 23 (2012), available at

http://www.cmegroup.com/market-regulation/files/14-254_App1D.pdf.


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situations, in theory the clearinghouse would next turn to its members’ capital

contribution commitments.55 That is, if the problem were severe enough to deplete the fund, the

clearinghouse has some ability to replenish the fund through capital

contributions.56 Typically these capital contributions would at least allow theclearinghouse to recreate its default fund—although the ability to do so issubject to some degree of counterparty risk, in that a member might struggleto meet its obligations, especially in times of financial stress.57

Since most clearinghouses are now publicly traded, the clearinghouse alsohas its own capital to fall back upon. For example, existing shareholders

could be heavily diluted by a new equity offering, or subordinated by the saleof preferred shares. Undistributed shareholder surplus could also be used tofund some degree of losses.

In the example above, a member was directly trading with theclearinghouse. Most often, it is a member’s customer who will be trading with the clearinghouse, but in general the process works the same. In the

United States, the addition of the customer to the transaction means that themember acts as an agent and guarantor for the customer. The membercollects margin from the customer and passes it on to the clearinghouse, while providing the clearinghouse with an additional source of recovery if thecustomer fails to perform on a trade.

In the futures market, customer margin must be segregated from a

broker’s own house account margin, but the broker can commingle all of itscustomers’ collateral in a single, omnibus account at the clearinghouse.58

Under this model, the clearinghouse does not know individual customer’spositions, and there is some risk that a defaulting customer, who causesfinancial distress to his broker, will also impose losses on fellow customers.59

55 As discussed, infra , there are good reasons to doubt the utility of these provisions in timesof systemic stress.

56 CME GROUP, supra note 47, R. 802.F (“In the event it shall become necessary to apply allor part of the Base Guaranty Fund contributions to meet obligations to the ClearingHouse pursuant to this Rule 802, clearing members shall restore their contribution to theBase Guaranty Fund to the previously required level prior to the close of business on thenext banking day.”).

57 This issue is discussed in its broader context in Part IV.58 Customers Before and After Commodity Broker Bankruptcies, 75 Fed. Reg. 75,162,

75,162–63 (Dec. 2, 2010) (to be codified at 17 C.F.R. pt. 190). See also Andrea M.

Corcoran & Susan C. Ervin, Maintenance of Market Strategies in Futures Broker Insolvencies:Futures Position Transfers from Troubled Firms , 44 W ASH. & LEE L. R EV . 849, 866 (1987);Grede v. FCStone, LLC, 746 F.3d 244, 247–48 (7th Cir. 2014).

59 James V. Jordan & George Emir Morgan, Default Risk in Futures Markets: The Customer- Broker Relationship, 45 J. FIN. 909, 910 (1990). See also Protection of Cleared Swaps


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The clearinghouse cuts its own risk of default, in situations where a

member defaults, by maintaining revolving credit lines at major financialinstitutions. Indeed, as the foregoing example illustrates, the clearinghouse’sown solvency is closely tied to its liquidity. It must be able to perform on the

non-defaulted leg of a trade, or the benefits of central clearing are lost.In addition to maintaining a credit line at a major financial institution, the

clearinghouse’s margin is also held by one or more custodian banks. Giventhat the financial institutions that are apt to provide the credit lines andcustodian services to the clearinghouse are also apt to be members of theclearinghouse, certain member defaults could be more painful than others.

II. CLEARINGHOUSES AND DODD-FRANK

It is this basic model that Dodd-Frank extends to the broader derivativesmarket, most notably the over-the-counter (OTC) part of the market. 60

OTC derivatives are commonly termed “swaps” although, strictly

speaking, swaps are only those contracts that are exempt from theCommodity Exchange Act under section 2(g) thereof.61 More precisely, anOTC derivative can refer to any trade that (before Dodd-Frank) was notexecuted through a regulated exchange, and that was exempt from mostprovisions of the federal securities and commodities laws.

A small number of very large broker-dealers “make the market” in OTC

derivatives globally. That is, these big brokers-dealers are parties to the vastbulk of OTC contracts outstanding, typically with a customer-counterparty

taking the other side of a trade. The key difference between futures and swaps is that, until recently,swaps involved a direct contractual relationship between the parties to a trade,and thus exposed the parties to risk of nonperformance that varied with each

counterparty. These contracts benefited from reduced cost and theoreticallygreater tailoring to the needs of the parties, although the frequent use ofstandardized documents provided by ISDA might call the latter benefits intoquestion.

Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker

Bankruptcy Provisions, 77 Fed. Reg. 6336, 6336, 6338–39 (Feb. 7, 2012) (to be codified at17 C.F.R. pts. 22, 190).

60 See Gabriel D. Rosenberg & Jai R. Massari, Regulation Through Substitution as Policy Tool: SwapFuturization Under Dodd-Frank, 2013 COLUM. BUS. L. R EV . 667, 689–92 (2013).

61 See generally Commodity Exchange Act § 2(g), 7 U.S.C. § 2(g) (2012).


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Much of the reduced cost of OTC trades may reflect the failure to

adequately manage the risks associated with them.62 But central clearing isnot free. For example, it is anticipated that fees associated with cleared swaps will include a clearing member fee, a clearinghouse fee, and an execution fee if

the instrument is traded on a swap execution facility. Uncleared swaps arenot subject to such fees.63

For example, a bank might want to reduce its exposure to GeneralMotors by buying a credit default swap from a dealer.64 Under the contract,the dealer promises to pay the bank if GM defaults. But if the dealer isLehman Brothers, the bank faces “counterparty risk,” the risk that its

counterparty will fail to live up to its obligations.Clearinghouses solve this problem by interjecting themselves in the

middle.65 In the example, the clearinghouse would continue to perform,leaving the bank largely unconcerned about Lehman’s financial woes.

The Dodd-Frank Act requires that standardized swaps clear through aregistered clearinghouse, if a clearinghouse accepts the contract for clearing.66

If a counterparty wishes to enter into a trade involving such a swap, it musteither be cleared or the counterparty must point to a relevant exemption, suchas the exemption for non-financial “end users” who are hedging. 67

Certain types of swaps, like foreign exchange swaps, are also subject to a wholesale exemption from the clearing requirements of Dodd-Frank. 68

62 Jean Tirole, Illiquidity and All Its Friends , 49 J. ECON. LIT. 287, 309 (2011) (“[I]t has becomeclear that contracts in OTC markets often have been motivated more by the prospect offees and by underpriced capital requirements than by first-order hedging benefits.”).

63 Matthew Leising, Saving World from Swaps Blowup Seen Raising Trade Costs 92-Fold ,BLOOMBERG, Apr. 10, 2014, available at http://www.bloomberg.com/news/2014-04-10/saving-world-from-swaps-blowup-seen-raising-trade-costs-92-fold.html.

64 Stephen J. Lubben, Credit Derivatives and the Future of Chapter 11, 81 AM. B ANKR . L.J. 405,411 (2007).

65 See Tirole, supra note 62, at 307–08.66 Dodd-Frank Wall Street Reform & Consumer Protection Act, Pub. L. No. 111-203, §

724(a), 124 Stat. 1376, 1682 (2010).67 Commodity Exchange Act § 2(h)(7)–(8), 7 U.S.C. § 2(h)(7)–(8) (2012); End-User

Exception to the Clearing Requirement for Swaps, 77 Fed. Reg. 42,560, 42,560 (July 19,2012) (to be codified at 17 C.F.R. pts. 39, 50). See also Ed Nosal, Clearing Over-the-CounterDerivatives , ECON. PERSPECTIVES, Oct. 2011, at 137, 145, available at http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2011/4q tr2011_part1_nosal.pdf (arguing against the end-user exemption) (“Nonfinancialcorporate end-users represent a relatively large share of the OTC market, 10 percent to 15

percent. If these firms receive a correlated shock that weakens their ability to perform,they may transmit this adverse shock to the balance sheets of the dealers.”).

68 On November 16, 2012, the U.S. Department of the Treasury announced that the centralclearing and exchange trading requirements would not apply to FX swaps and forwards.Press Release, U.S. Dept. of the Treasury, Fact Sheet: Final Determination on Foreign


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Options and futures on physical commodities are also technically exempt

from clearing under Dodd-Frank, but as noted in the prior section, thesetrades were already subject to clearing long before Dodd-Frank was enacted.

In 2013, clearing began for trades in index-based CDS and interest rate

swaps.69 According to ISDA, as of late 2014 “more than two-thirds ofoutstanding interest rate derivatives have been centrally cleared.” 70 TheCFTC expects to extend the clearing requirement to other trades in the nearfuture.71

The clearinghouses themselves are divided between “derivatives clearingorganizations” (DCOs), regulated by the CFTC, and “securities clearing

agencies” (SCAs), regulated by the SEC.72 But in general, the regulation ofthe clearinghouse, for now, appears to be quite similar.

The market is also heavily concentrated, as commentators have noted: The global market structure of the provision of clearing

services is monopolistic within a number of risk or productclasses. Global clearing of OTC-interest rate products

occurs almost exclusively through the SwapClear subsidiaryof the U.K., CCP LCH.Clearnet. And, global clearing ofOTC-CDS is dominated by the CCP InterContinentalExchange’s (ICE) U.S. and U.K. subsidiaries, ICE ClearCredit and ICE Clear Europe.

Exchange Swaps and Forwards (Nov. 16, 2012), available athttp://www.treasury.gov/press-center/press-releases/Pages/tg1773.aspx.

69 See Clearing Requirement Determination Under Section 2(h) of the CEA, 77 Fed. Reg.74,284, 74,335–36 (Dec. 13, 2012) (to be codified at 17 C.F.R. pts. 39, 50) (adopting finalrules specifying mandatory clearing requirements for four classes of interest rate swapsand two classes of credit default swaps).

70 ISDA, supra note 14, at 1.71 The CEA provides the CFTC with exclusive jurisdiction over, among other things, U.S.

commodity futures trading, swaps trading (other than security-based swaps and mixedswaps), futures exchanges, clearinghouses that clear U.S. futures contracts, swaps,commodity options and FCMs. The CEA and CFTC rules require all FCMs to registerand become a member of the National Futures Association (“NFA”), and they also maybe members of one or more designated contract markets (i.e., futures exchanges) andaffiliated clearinghouses. The SEC has jurisdiction over security-based swaps, and theagencies share jurisdiction over mixed swaps. Dodd-Frank Act § 712(a)(8).

For present purposes, the most important class of trades that will be subject to SECjurisdiction will be single-name CDS contracts. While the SEC has not published all of its

rules in this area, in general the treatment will be quite similar, and thus I focus on theCFTC in the text.

72 The division corresponds to the types of swaps cleared by the clearinghouse. See supra notes 69–71 and accompanying text. Most major swap clearinghouses will likely beclassified as both a DCO and an SCA by the CFTC and the SEC, respectively.


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The market power of these major CCPs creates

necessary conditions for them to be globally systemicfinancial institutions. Since the lion’s share of these CCPs’risk exposures is to the largest global banks, this also makes

them especially effective shock transmitters. The post-crisiscommitment of the G20 countries to mandate clearing of allstandardized OTC-D trades will, in the absence of a changeto the market structure of global clearing services, serve toexacerbate the global systemic importance of these CCPs.73

Broadly speaking, in the United States, interest rate swaps are cleared

through LCH.Clearnet and CME Group, and credit default swaps are clearedthrough ICE (Intercontinental Exchange) and CME Group.74 That is, theUnited States market uses the two major global clearinghouses, supplementedby CME.

Swaps that are approved for clearing must be traded on a registeredexchange that has been approved by the applicable regulator, unless no

registered exchange accepts the swap for trading.75 In practice, it is commonto subdivide the exchanges into designated contract markets (DCMs), whichinclude the pre-Dodd-Frank futures exchanges, and swap execution facilities(SEFs), electronic platforms on which some degree of interest rate swaptrading was already taking place before Dodd-Frank.76

Margining of cleared swap trades under Dodd-Frank is handled

somewhat differently than in the futures world. Namely, under a recentlyenacted CFTC rule, brokers and clearinghouses are allowed to commingle all

of a broker’s customers’ collateral in one account.77

But the broker isrequired to provide the clearinghouse with information about the identity ofeach of its customers and the amount of cleared swap collateral held at theclearinghouse and attributable to each customer, on a daily basis. 78

73 Li Lin & Jay Surti, Capital Requirements for Over-the-Counter Derivatives Central Counterparties 5(Int’l Monetary Fund, Working Paper No. 13/3, 2013), available at http://www.imf.org/external/pubs/ft/wp/2013/wp1303.pdf.

74 Uncleared swaps will continue to be traded on a bilateral basis with a swap counterpartyunder an ISDA Master Agreement between the parties. See Kress, supra note 38, at 71(describing the “end user” exemption).

75 7 U.S.C. § 2(h)(8) (2012). Under the Commodities Exchange Act, exchanges are referredto as “boards of trade.”

76 Bloomberg L.P. v. Commodity Futures Trading Comm’n, 949 F. Supp. 2d 91, 98 (D.D.C.2013).

77 17 C.F.R. § 22.2(e)(3)(i) (2015).78 17 C.F.R. § 22.11(e) (2015). See also CPSS-IOSCO PRINCIPLES, supra note 36, at 2

(“Principle 14: Segregation and Portability: A CCP should have rules and procedures that


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This is referred to as the Legally Segregated Operationally Commingled,

or “LSOC,” model.79 It will protect a non-defaulting customer from thedefault of its fellow customers,80 although the customer still faces risk fromoperational problems of the broker or the clearinghouse.81

In addition, CFTC rules require swap clearinghouses to collect frommembers the initial margin amounts that the clearinghouse would require ofeach individual customer within the account if each individual customer werea clearing member.82 Thus, members are not allowed to setoff customers forpurposes of initial margin—each customer must be independently margined.

The Dodd-Frank Act also rejects the close relationship that historically

has existed between futures clearinghouses and specific futures markets. The Act requires a clearinghouse to accept transactions without regard to theplatform on which they were executed.83

And the CFTC has adopted open access rules that require entities withnet capital of $50 million or greater to be given access to clearinghouses asmembers for swap clearing purposes.84 Before the financial crisis, ICE Clear

Credit, the world’s largest credit default swap clearinghouse, had required $5billion of net capital to become a member.85 ICE Clear Credit LLC itselfreports equity of just under $92 million.86

At the clearinghouse level, CME has chosen to establish separate defaultfunds for interest rate and credit default swaps, respectively. Thus, upon adefault, the type of underlying trade becomes relevant.87 For example, if a

CME member defaulted on CDS trades to an extent that exceeds availablemargin, the clearinghouse would then turn to its CDS fund, which is

enable the segregation and portability of positions of a participant’s customers and thecollateral provided to the CCP with respect to those positions.”).

79 See Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, 77 Fed. Reg. at 6339.

80 See 17 C.F.R. § 22.2(d)(1) (2015).81 Protection of Cleared Swaps Contracts and Collateral; Conforming Amendments to the

Commodity Broker Bankruptcy Provisions, 76 Fed. Reg. 33,818, 33,826 n.72 (June 9,2011) (to be codified at 17 C.F.R. pts. 22, 190).

82 17 C.F.R. § 39.13(g)(8)(i) (2015).83 See 7 U.S.C. § 2(h)(1)(B) (2012).84 17 C.F.R § 39.12(a)(2)(iii) (2015).85 Silla Brush & Matthew Leising, CFTC Approves Rule Expanding Access to Swaps

Clearinghouses , BLOOMBERG BUS. (Oct. 18, 2011),http://www.bloomberg.com/news/2011-10-18/cftc-may-complete-rule-broadening-

access-to-swaps-clearinghouses.html.86 ICE CLEAR CREDIT LLC, FINANCIAL S TATEMENTS 3 (2013), available at

https://www.theice.com/publicdocs/regulatory_filings/ICC_FinancialStatement.pdf.87 It is not clear that these divisions would be respected if the clearinghouse were placed into

a resolution process like bankruptcy or OLA.


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comprised of $650 billion in member fund contributions and $50 billion of

CME’s own capital.88 This fund is designed to cover “the largest theoreticalaggregate losses caused by the default of any two CDS Clearing Members.” 89

Should the unmargined loss exceed the fund, CME would then proceed

to assess its CDS members.90 Under its rules, the total assessment will beequal to the largest theoretical aggregate losses caused by the default of anytwo CDS Clearing Members, but this time excluding the two members that were the subject of the creation of the original default fund. Thus, if weassume the default fund was created to protect against the default of the twolargest dealers, the assessment will generate a new fund that will be somewhat

smaller, protecting against the default of dealers three and four. What would happen next? CME cryptically explains: “Should the

applicable financial safeguard package be exhausted, beyond maximumassessment powers, the terms of Rule 818 Close-Out Netting would apply.”91

Presumably this is a reference to CME Rule 818.C, which provides for acloseout and setoff of positions following a bankruptcy or insolvency of the

exchange.92 Its connection to a default of the clearinghouse, as distinct fromthe exchange, is somewhat unclear, but apparently CME intends for allmembers, and their customers, to face a realization event at this point. Theimplications of that for the broader issue of systemic risk are addressed inPart IV.

88 For current numbers, see CME GROUP, CME CLEARING’S FINANCIAL S AFEGUARDSS YSTEM (2015), available at http://www.cmegroup.com/clearing/cme-clearing-overview/safeguards.html.

89 CME GROUP, CME R ULEBOOK R. 8H07.1(i)(a) (2015), available at https://www.cmegroup.com/rulebook/CME/I/8H/8H.pdf. See also CPSS-IOSCO PRINCIPLES, supra note 36, at 1 (“Principle 4: [A] CCP that is involved in activities with amore-complex risk profile or that is systemically important in multiple jurisdictions shouldmaintain additional financial resources sufficient to cover a wide range of potential stressscenarios that should include, but not be limited to, the default of the two participants andtheir affiliates that would potentially cause the largest aggregate credit exposure to theCCP in extreme but plausible market conditions.”).

90 Membership can be had in some or all of the three basic categories (futures and other

traditional products, CDS, and interest rate swaps).91 CME GROUP , supra note 54, at 16.92 In this case, “Exchange” is defined as Chicago Mercantile Exchange Inc. CME GROUP,

DEFINITIONS (2015), available at http://www.cmegroup.com/rulebook/files/CME_Definitions.pdf.


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III. DODD-FRANK TITLE VIII

As evident from the prior example, clearinghouses are highly dependenton their ability to properly set margin levels. At CME, if margin is

insufficient in its CDS clearing operation, it can survive, at most, two majormember defaults before it will need to extract funds from its remainingmembers. Even assuming that is possible, the assessment process can onlyabsorb, at most, two more defaults before the process grinds to a halt. 93

In short, a clearinghouse is particularly vulnerable to systemic crisis, andthus there is a strong need for prudential regulation that might prevent such a

scenario.Congress, for all its faults, was not totally oblivious in this regard, and

hence it enacted the Payment, Clearing, and Settlement Supervision Act of2010 (Dodd-Frank title VIII).94

This introduces the term “financial market utility” (FMU) for thosemultilateral systems that transfer, clear, or settle payments, securities, or other

financial transactions among financial institutions. Dodd-Frank does notapply to every single payment or clearance system that fits the definition of anFMU; it only applies to “systemically important” FMUs.95

In the context of FMUs, Dodd-Frank title VIII defines “systemicallyimportant” and “systemic importance” by the following description: “asituation where the failure of or a disruption to the functioning of a financial

market utility . . . could create, or increase, the risk of significant liquidity orcredit problems spreading among financial institutions or markets and thereby

threaten the stability of the financial system of the United States.” Accordingly, on July 18, 2012, the Financial Stability Oversight Councildesignated eight FMUs as systemically important under title VIII of Dodd-Frank.96 Five of the designated FMUs are clearinghouses:

• Chicago Mercantile Exchange, Inc.• Fixed Income Clearing Corporation

93 Admittedly, the CDS “waterfall” is smaller than some others at CME. The largestseparate waterfall, the base waterfall (covering all futures, and swaps other than interestrate swaps and CDS), has an assessment power of 275% of the prefunded contribution ofeach member for one default, and 550% of the prefunded contribution of each memberfor two or more defaults within a “cooling off” period.

94 Dodd-Frank Act § 802, 12 U.S.C. § 5461 (2012).

95 Baker, supra note 6, at 107.96 Dodd-Frank Act § 803, 12 U.S.C. § 5462(9) (2012). See also Press Release, Sec. & Exch.

Comm’n, Financial Stability Oversight Council Makes First Designations in Effort toProtect Against Future Financial Crises (July 18, 2012), available athttp://www.treasury.gov/press-center/press-releases/Pages/tg1645.aspx.


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• ICE Clear Credit LLC

•

National Securities Clearing Corporation• The Options Clearing CorporationFMUs that have been designated are then subject to enhanced regulation

by a federal supervisory agency, which can be the SEC, the CFTC, the Boardof Governors of the Federal Reserve System, or another financial-institutionsupervisor.97 For a designated FMU that is regulated by both the SEC, as aclearing agency (CA), and by the CFTC, as a derivatives clearing organization(DCO), only one of these agencies will be the “supervisory agency” underDodd-Frank. The Act directs the SEC and CFTC to determine which agency

is the “supervisory agency” for each clearing agency; if the agencies are unableto agree, FSOC decides the issue.98

Both the SEC and the CFTC are directed to promote additionalprudential requirements for systemically important clearing agencies.99 Underthis authority, the agencies may enforce the Act with respect to a systemicallyimportant clearinghouse using the tools provided in section 8(b)–(n) of the

Federal Deposit Insurance Act. 100 This will permit the agencies to useadministrative cease-and-desist proceedings and bar individual systemicallyimportant clearinghouse officers and employees from continuing in theirroles, in instances where the CFTC or SEC has reasonable cause to believethe systemically important clearinghouse is about to engage in a practice thatis unsafe or unsound, or violates any applicable law or regulation.101

If the Fed determines that the agencies’ prudential requirements areinsufficient, it may recommend new risk management standards for SEC or

CFTC adoption.102

If the agencies disagree with the recommendation,FSOC—by a two-thirds vote—may require them to adopt the new standardsrecommended by the Fed. In short, the Fed backstops the agencies’traditional regulation of the clearinghouses.103

The Act authorizes the Fed to participate in the examinations ofdesignated FMUs for which the Fed is not the supervisory agency.104 And it

97 12 U.S.C. § 5462(8) (2012).98 12 U.S.C. § 5462(8)(B).99 Dodd-Frank Act § 805, 12 U.S.C. § 5464(a)(2) (2012). See also Enhanced Risk

Management Standards for Systemically Important Derivatives Clearing Organizations, 78Fed. Reg. 49,663, 49,665–66 (Aug. 15, 2013) (to be codified at 17 C.F.R. pt. 39).

100 12 U.S.C. § 5466(c) (2012); see also 12 U.S.C. § 1818(b)–(n) (2012).

101 Enhanced Risk Management Standards for Systemically Important Derivatives ClearingOrganizations, 78 Fed. Reg. at 49,674; see also 12 U.S.C. § 1818(b)(1) (2012).

102 12 U.S.C. § 5464(a)(2)(B).103 See Dodd-Frank § 811, 12 U.S.C. § 5470 (2012).104 12 U.S.C. § 5466(a), (d).


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grants the regulators the power to make any rules necessary to properly carry

out their duties, a very broad grant of rulemaking authority.105 Section 806 authorizes the Fed to provide systemically important FMUs

with Federal Reserve Bank services that are traditionally only available to

depository institutions.106 This will allow designated utilities to have the sameaccounts at Federal Reserve Banks as those provided to depositoryinstitutions.107 Having an account at the Fed might reduce a clearinghouse’sdependence on other important pieces of financial infrastructure, and itobviously avoids the problem of the clearinghouse’s cash becoming involvedin the insolvency process that results from a key member’s failure.

Under this section, the Fed may authorize a Federal Reserve Bank toprovide a designated utility with discount and borrowing privileges, pursuantto section 10B of the Federal Reserve Act. 108 But such authorization ispermitted only in unusual or exigent circumstances, and only upon majority vote of the Fed, after consultation with the Secretary of the Treasury.109 Accordingly, the utility would have to show that it is unable to secure

adequate credit accommodations from other banking institutions, arequirement somewhat akin to the Bankruptcy Code’s provisions for chapter11 “DIP loans.”110

The procedural mechanics of lending under this provision remain to bedeveloped, but since the statute expressly refers to section 10B, it would seemthat the Federal Reserve Banks, when authorized, may extend secured credit

to clearinghouses.111 Given the context in which this lending might be used,it might often be appropriate to treat advances under this provision as

secondary credit, which would then be priced at a premium to the discountrate.112 In light of the post-Dodd-Frank limitations on the Federal Reserve’s

105 12 U.S.C. § 5469 (2012).106 12 U.S.C. § 5465(a) (2012).107 A recent rule recognizes that the possible extension of Federal Reserve accounts and

services to designated FMUs presents credit, settlement and other risks to the FederalReserve Banks. Financial Market Utilities, 78 Fed. Reg. 76,973, 76, 975–78 (Dec. 20,2013) (to be codified at 12 C.F.R. pt. 234).

108 12 U.S.C. § 347b (2012).109 12 U.S.C. § 5465(b).110 11 U.S.C. § 364(c)–(d) (2012). More directly, it also tracks the 1991 version of section

13(3) of the Federal Reserve Act. See 12 U.S.C. § 343 (2012).111 See 12 C.F.R. § 201.3(a) (2010). See also Kathryn Judge, Three Discount Windows , 99

CORNELL L. R EV . 795, 809–10 (2014).112 12 C.F.R. § 201.4(b) (2007). For a description of “secondary credit” and the current

interest rates, see FED. R ESERVE DISCOUNT W INDOW , DISCOUNT W INDOW BOOK (2015),available at www.frbdiscountwindow.org/discountwindowbook.cfm?hdrID=14&dtlID=43.


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13(3) emergency lending powers, this provision might have important

implications, as discussed in Part IV below. This part of Dodd-Frank also provides that clearinghouses must provide

their lead supervisory agency with 60 days’ advance notice of a proposed

change that could materially affect the nature or level of risks presented bythe utility.113 If the agency objects within 60 days, the utility may notimplement the change. However, a designated utility may implement changeson an emergency basis, in order for the utility to provide its services in a safeand sound manner.

In short, Dodd-Frank provides an important basis for ex ante prudential

regulation of clearinghouses, combined with rulemaking and lending powersthat might be especially important in addressing financial distress at theclearinghouse. The next section considers these issues in the broader contextof the collapse of a systemically important FMU.

IV. CLEARINGHOUSES IN DISTRESS

As publicly traded companies answerable to shareholders, clearinghouses,like all financial institutions, have incentives to undercapitalize.114 Indeed,industry participants have recently noted that clearinghouses are relativelythinly capitalized in comparison with their SIFI counterparts. 115 Members who may have effective control over the clearinghouse also have incentives to

push for reduced margin and default fund contribution requirements.116 Inshort, despite the best efforts of regulators, a clearinghouse might be

fragile.117

113 12 U.S.C. § 5465(e) (2012). The Fed recently adopted Regulation HH to implement theseprovisions. Regulation HH § 234.5 defines and describes changes that the Fed considersto be material and thus subject to its review. 12 C.F.R. § 234.5(b) (2014).

114 See Michael Simkovic, Competition and Crisis in Mortgage Securitization , 88 IND. L.J. 213, 216(2013).

115 Lukas Becker & Cecile Sourbes, UniCredit’s Mustier ‘Frightened’ by CCP Capital Levels , R ISKM AGAZINE (Apr. 9, 2014), http://www.risk.net/risk-magazine/news/2338899/unicredits-mustier-frightened-by-ccp-capital-levels(“UniCredit’s head of corporate and investment banking is “frightened” by the low capitallevels at central counterparties (CCPs) such as Eurex and LCH.Clearnet and has suggestedthat users should either provide unlimited contingent funding for CCPs or that clearing

should not be run for profit at all.”).116 See Michael Greenberger, Diversifying Clearinghouse Ownership in Order to Safeguard Free and

Open Access to the Derivatives Clearing Market , 18 FORDHAM J. CORP. & FIN. L. 245, 251(2013).

117 Johnson, supra note 1, at 227.


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Clearinghouses have external insurance mechanisms to protect against

failure. These take the form of either capital contribution obligations ofmembers, or formal insurance policies.118 Both link the clearinghouse toother SIFIs, and thus present a potential transmission mechanism for

financial distress.Moreover, both expose the clearinghouse to counterparty risk, which

could arise either from a direct default by the counterparty, or a defaulttriggered by regulatory pressures at the counterparty. For example, if a majorbroker-dealer would be rendered insolvent by its performance on aclearinghouse capital call, would its regulator allow the payment? If the

clearinghouse is in one jurisdiction, but the financial institution is in another,these concerns become even more extreme.119

Because the clearinghouse maintains a net zero position in the market itclears and, given market concentration, likely has an ability to price its servicesabove its costs, clearinghouses are unlikely to experience financial distress asthe result of a slow erosion of their business. Instead, the two most likely

causes of financial distress in the clearinghouse are the failure of one or moremembers120 or a major operational failure.121

Given events of still-recent memory, it would be easy enough to imaginethat two, three, or four large broker-dealers might fail simultaneously, or inrapid succession. If the clearinghouse faced losses in excess of the defaultfund and its ability to recapitalize the same, what would happen next? 122

The SEC recently proposed a rule that would force the clearing agenciesit regulates to answer that question.123 The difficulty with such planning, at

118 Matthew Leising, Catastrophe Prevention Drives Insurance Pitch to Clearinghouse , BLOOMBERGBUS. (Mar. 11, 2014), http://www.bloomberg.com/news/2014-03-11/catastrophe-prevention-drives-insurance-pitch-to-clearinghouses.html.

119 See Stephen J. Lubben & Sarah Pei Woo, Reconceptualizing Lehman , 49 TEX . INT’L L.J. 297,322–23 (2014).

120 Colleen Baker, The Federal Reserve’s Supporting Role Behind Dodd-Frank’s Clearinghouse Reforms ,3 H ARV . BUS. L. R EV . ONLINE 177, 180 (2013), http://www.hblr.org/?p=3283.

121 Cf. Huberto M. Ennis & David A. Price, Discount Window Lending: Policy Trade-Offs and the1985 BoNY Computer Failure , FED. R ESERVE B ANK OF R ICHMOND (2015), available at https://www.richmondfed.org/publications/research/economic_brief/2015/pdf/eb_15-05.pdf. In general, the full default waterfall is not available to cover such losses; rather,the clearinghouse must rely on its own capital. But other than the reduction of assets toavoid insolvency, the basic problem remains the same.

122 See CPSS-IOSCO PRINCIPLES, supra note 36, at 35 (“A CCP should determine and test

regularly the sufficiency of its financial resources to cover its current and potential futureexposures by rigorous backtesting and stress testing.”).

123 SEC. & EXCH. COMM’N, PROPOSED R ULE: S TANDARDS FOR COVERED CLEARING AGENCIES 142 (proposed (May 27, 2014)) (to be codified at 17 C.F.R. pt. 240) (17Ad-22(e)(13)), available at http://www.sec.gov/rules/proposed/2014/34-71699.pdf.


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present, is that there is no obvious legal mechanism for resolving a

clearinghouse in financial distress, 124 and many of the stated plans seemmostly designed to highlight the “too big to fail status” of the clearinghouses.

The most obvious tool for addressing a distressed clearinghouse is the

new orderly liquidation authority under the Dodd-Frank Act. Indeed, manyhave assumed that OLA applies to clearinghouses.125 But a close reading ofDodd-Frank indicates otherwise.

OLA applies to “covered financial companies,” which are defined as“financial companies” that have been the subject of a decision to invokeOLA, under the intricate process provided, but not including insured

banks.126 Financial companies are in turn comprised of the following:1. Bank holding companies2. A nonbank financial company supervised by the Board ofGovernors3. [A]ny company that is predominantly engaged in activitiesthat the Board of Governors has determined are financial in

nature or incidental thereto for purposes of section 1843(k)of [title 12].127

Clearinghouses are not bank holding companies, and are also notincluded on the list of financial activities kept under section 4(k) of theFederal Reserve Act. 128 If the provision was intended to incorporateRegulation Y—the current source of the list of financial activities—then

clearinghouses are expressly outside of OLA.

124 This is in contrast to the United Kingdom, where the Bank of England recently obtainedsuch authority as part of the recent revision to Britain’s regulatory scheme. E. Murphy &S. Senior, Changes to the Bank of England , 53 B ANK OF ENG. Q. BULL., no.1, 2013, at 23, 25.

125 See Allen, supra note 8, at 1101.126 12 U.S.C. § 5381(8) (2012).127 12 U.S.C. § 5381(11). Section 1843(k) of title 12 is more commonly referred to as section

4(k) of the Federal Reserve Act.128 See 12 C.F.R. § 225.85(a)(1)–(2) (2005). Presumably the Fed could amend the list, but as

discussed herein, there might be little point in putting a clearinghouse into OLA, anddoing so would arguably conflict with the apparent intent of Dodd-Frank. Moreover,adding a clearinghouse to the list would at least open the door to the possible ownershipof a clearinghouse by a financial holding company, although the Fed has other tools toprevent that from happening. Cf. 15 U.S.C. § 8323(a) (2012) (conferring on the CFTC the

power to adopt “limits on the control of, or the voting rights with respect to, anyderivatives clearing organization that clears swaps, or swap execution facility or board oftrade designated as a contract market that posts swaps or makes swaps available fortrading, by a bank holding company . . . with total consolidated assets of $50,000,000,000or more”).


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It could be argued, however, that this is not an express reference to

Regulation Y, but rather to a more abstract determination by the Fed undersection 4(k) of the Federal Reserve Act. The statute is ambiguous in thisregard, but if this latter interpretation were adopted, then a clearinghouse

certainly, in the abstract, seems to engage in activities that are “financial innature.”

But putting a clearinghouse into OLA would place the FDIC in charge ofthe clearinghouse, despite the FDIC’s complete lack of involvement in theregulation of clearinghouses under Dodd-Frank.129 And the CFTC is givenno role in triggering an OLA proceeding—indeed, it goes unmentioned in

OLA entirely—despite its central role in regulating clearinghouses, and inregulating the OTC market more generally.130 Both indicate that Congressnever intended OLA to apply to clearinghouses regulated under Dodd-Frank.

Thus, we turn to the question of whether a clearinghouse is a “nonbankfinancial company supervised by the Board of Governors.”

That seemingly straightforward phrase is defined in title II, but the

definition sends us to title I.131 Once in title I, we are told that “the term‘nonbank financial company supervised by the Board of Governors’ means anonbank financial company that the Council has determined under section5323 of this title shall be supervised by the Board of Governors.”132

That presents two obvious problems. First, clearinghouses have beendesignated systemically important under section 5462 rather than under

section 5323.133 Thus, to be eligible for OLA, the clearinghouse would haveto have been designated under title I, and not under title VIII, of Dodd-

Frank.Second, designating a clearinghouse under title I would undermine the very structure of title VIII, inasmuch as title VIII is deliberately meant toleave the SEC and the CFTC in charge of overseeing the clearinghouses, with

the Fed acting as a rampart. 134 The Fed does not habitually overseeclearinghouses, and changing that reality would require FSOC to ignore theobvious intent of title VIII.

129 See Stephen J. Lubben, Resolution, Orderly and Otherwise: B of A in OLA, 81 U. CIN. L. R EV .485, 508 (2012).

130 In every other instance, title II gives the financial institution’s main regulator a vote on whether to put the inst itution into OLA. E.g., 12 U.S.C. § 5383(a)(1)(A)–(C) (2012).

131 12 U.S.C. § 5381(15).

132 12 U.S.C. § 5311(a)(4)(D) (2012).133 Compare 12 U.S.C. § 5462 (2012), with 12 U.S.C. § 5323 (2012).134 See 12 U.S.C.§ 5464(a)(2) (2012); see also BD. OF GOVERNORS OF THE FED. R ESERVE S YS.

ET AL., R ISK M ANAGEMENT SUPERVISION OF DESIGNATED CLEARING ENTITIES 3–5(2011), available at http://www.sec.gov/news/studies/2011/813study.pdf.


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That leaves the generally applicable provisions of the Bankruptcy Code.

There is no legal reason to bar a clearinghouse from bankruptcy court.135 Butthe so-called safe harbors provide a practical impediment to the use of theBankruptcy Code.136

These provisions exempt derivatives and securities trades, and theirassociated margin, from three key provisions of the Bankruptcy Code—theautomatic stay, the assumption and rejection power, and the variousavoidance powers.137 And without securities and derivatives contracts inplace, there will be little left to reorganize at a clearinghouse—assuming“reorganize” is the right term for a proceeding that could only happen under

chapter 7 of the Bankruptcy Code.138 Instead of a formal insolvency proceeding, most clearinghouse rules state

that, upon exhaustion of the default fund and any assessment rights, allcontracts will be closed and member positions netted. Given theconcentration of certain trades in one or two clearinghouses, the suddentermination of more than half of the index CDS trades, to take one example,

could not help but have systemic effects.139 In Europe, clearinghouses often also provide for reduction of variation

margin payments when the default fund has been fully tapped. For example,LCH.Clearnet, a key clearinghouse for interest rate swaps, provides for variation margin payments to be cut by the higher of £100 million or theamount of the member’s default fund contribution.140

In essence, the haircutting of margin is simply a capital contribution thateliminates the counterparty, nonpayment risk to the clearinghouse. This

135 See 11 U.S.C. § 109(a)–(c) (2012). 136 In re Quebecor World (USA) Inc., 453 B.R. 201, 204 (Bankr. S.D.N.Y. 2011), aff’d , 480

B.R. 468 (S.D.N.Y. 2012), aff’d , 719 F.3d 94 (2d Cir. 2013).137 Stephen J. Lubben, The Bankruptcy Code Without Safe Harbors , 84 AM. B ANKR . L.J. 123, 129

(2010).138 Under the terms of section 109(d), the clearinghouse would not be allowed into chapter

11. See 11 U.S.C. §§ 101(6), 109(d), 766(i) (2012). Subchapter IV of chapter 7 containsspecial provisions for “commodity broker liquidation,” which would pick upclearinghouses. See 11 U.S.C. § 767 (2012).

139 S TANDARD & POOR ’S, ARE EXCHANGES AND CLEARINGHOUSES “TOO BIG TO F AIL”? 5–6(2010), available athttp://www.standardandpoors.com/ratings/articles/en/us/?articleType=PDF&assetID=1245236164429 (noting the monolithic nature of clearinghouses in the United States

that specialize in a particular product and the unlikelihood that the positions would betransferable to another clearinghouse).

140 LCH.CLEARNET, LIMITED DEFAULT R ULES 95 (2014), available at http://www.lchclearnet.com/Images/lch%20default%20fund%20rules%20-%2030.12.13_tcm6-43735.pdf.


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seems like an attempt to save the clearinghouse at the expense of its members

and their customers.In situations where this power would be invoked, the effect of these

additional losses on members, and likely their customers, would make a bad

situation worse. Although in the absence of a resolution mechanism forclearinghouses, at least such an approach moves the financial distress to anarea where regulators (in theory) have tools to address it.

It is plain that the consequences of a clearinghouse insolvency would besevere, and thus quite unattractive to policymakers. As one commentatorsummarizes:

The failure of a CCP could be very disruptive. In theabsence of an appropriate resolution regime, the CCP wouldhave to stop trading and enter liquidation. [Members] wouldnot receive payments due from the CCP and might not beable to access their margin and any remaining default fundcontributions for some time. There could be uncertainty

over the status of open cleared contracts. The finaldetermination of losses could take a considerable period oftime. And trading would be disrupted in the markets thatthe CCP clears . . . .141

Thus, there will be a strong temptation to conduct a bailout, keep theclearinghouse operating, and avoid these disruptions.142

First, Dodd-Frank’s discount window provision might provide a statutorymeans of injecting the Fed’s money into a failing clearinghouse. Indeed,

Colleen Baker has argued that Dodd-Frank’s special clearinghouse provisionsmight become the basis for a wholesale purchase of a clearinghouse’s entirederivatives portfolio, as in the rescue of AIG.143

That would seem to be the outer edge of what might be reasonably

accomplished under the Act, but even a more modest use of the discount window power could facilitate something that might rightly be called a bailoutof a clearinghouse. For example, it could well be imagined that theclearinghouse’s own assets would suffer from depressed values during times

141 David Elliot, B ANK OF ENG., CENTRAL COUNTERPARTY LOSS-ALLOCATION R ULES 6(2013), available at http://www.bankofengland.co.uk/financialstability/Documents/fpc/fspapers/fs_paper20.pdf.

142 E.g., Peter Conti-Brown, Elective Shareholder Liability , 64 S TAN. L. R EV . 409, 424 (2012) (“Inthe event of pure financial terror, where, as in the fall of 2008, panic sweeps through alarge number of financial institutions, bailouts are likely the only mechanism available togovernments and regulators that could possibly work to stem the tide of failures.”).

143 Baker, supra note 6, at 114–15.


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of financial crisis. If the local Federal Reserve Bank were to nonetheless

allow borrowing against the assets’ “true” value, that might provide themargin of funding the clearinghouse needs to avoid failure. 144 In such acircumstance, the Fed would effectively convert illiquid, low-value assets into

liquid, high-value assets.145 Some might argue that such lending is not a bailout, but instead is just a

classic Bagehot-inspired lender-of-last-resort mechanism. 146 Thatpresupposes the answer to two concerns: first, that the Fed will charge apenalty rate, and second, that the “in crisis” asset value reflects liquidityproblems, and not simply a revaluation of the assets.147

Bagehot’s dictum provides that central banks should lend freely tosolvent institutions—but only against good collateral, and at interest rates thatare high enough to dissuade overuse of the government purse.148 In therecent financial crisis, the government generally recouped its principal, but itremains unclear if above-market interest rates were actually charged.149

Moreover, only with the benefit of hindsight, and after the effects of the

government’s actions muddied the analysis, can it be argued that lendingduring the crisis was secured. If, for example, the value of mortgage-backedsecurities had not returned to pre-crisis levels, it seems quite clear that thegovernment would have been undersecured in many cases.150

In short, it is undoubtedly true that “liquidity lending, if fullycollateralized and short-term, is neither a central bank subsidy nor a

bailout.”151 But it is often impossible to know if the lending is fully securedor if an appropriate interest rate is being charged.

144 See Thomas C. Baxter, Jr. & Joseph H. Sommer, Liquidity Crises , 34 INT’L L AW . 87, 95(2000).

145 See Manmohan Singh, The Changing Collateral Space 5–6 (Int’l Monetary Fund, WorkingPaper, 2013), available at http://www.imf.org/external/pubs/cat/longres.aspx?sk=40280.0.

146 See, e.g., Randall D. Guynn, Are Bailouts Inevitable? , 29 Y ALE J. ON R EG. 121, 126 (2012).147 Brian F. Madigan, Director, Div. of Monetary Affairs, Bagehot’s Dictum in Practice:

Formulating and Implementing Policies to Combat the Financial Crisis, Speech at theFederal Reserve Bank of Kansas City’s Annual Economic Symposium in Jackson Hole, Wyoming 12 (Aug. 21, 2009), available athttp://www.federalreserve.gov/newsevents/speech/madigan20090821a.htm.

148 W ALTER B AGEHOT, LOMBARD S TREET: A DESCRIPTION OF THE MONEY M ARKET 51–52,187–89 (9th ed. 1888).

149 See Steven R. Blau, The Federal Reserve and European Central Bank as Lenders-of-Last-Resort:Different Needles in Their Compasses , 21 N.Y. INT’L L. R EV . 39, 50 (2008).

150 See Adam J. Levitin, The Politics of Financial Regulation and the Regulation of Financial Politics: AReview Essay , 127 H ARV . L. R EV . 1991, 1997–98 (2014).

151 Baxter & Sommer, supra note 144, at 100.


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And the Fed might not have intended, subjectively, to give a bailout, but

it could end up bailing out the clearinghouses nonetheless. Indeed, thediscount window might be used to recapitalize the clearinghouse. Much willdepend on what the Board of Governors makes of its instructions under

Dodd-Frank, when placed in the broader context of Dodd-Frank’s generaldisdain for anything that looks like a bailout.152

In the absence of a bailout through the discount window, Congress mightbe tempted to create a special “one off” insolvency proceeding forclearinghouses. Here, Congress’ approach to the GSEs might beinstructive.153

In 2008, the GSEs’ financial condition had weakened, and there wereconcerns over their ability to meet their obligations on $1.2 trillion in bondsthey had issued and $3.7 trillion in MBSs that they had guaranteed.154 Inresponse, Congress passed the Housing and Economic Recovery Act and theSafety and Soundness Act, which created a special conservatorship processfor the GSEs.155

Shortly thereafter, the boards of both GSEs assented to the order of theFederal Housing Finance Agency appointing the Agency as conservator ofFannie Mae and Freddie Mac. 156 Under the conservatorship, the U.S. Treasury has purchased massive quantities of preferred shares—more than$200 billion to date—to keep the GSEs operational.157 Under revised terms

152 See Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No.111-203, pmbl., 124 Stat. 1376 (2010)