Law Professor Suggests an Ex Ante Formula for Nationalizing Clearinghouses

In a paper titled “Failure of the Clearinghouse: Dodd-Frank’s Fatal Flaw?” Professor Stephen Lubben of Seton Hall University discusses “what should happen if the worst should happen,” with regard to Dodd-Frank’s lack of risk management provisions in the event of a clearinghouse failure.

First, Mr. Lubben suggests that while bailouts of individual institutions may end, bailouts of clearinghouses might become inevitable in a “post Dodd-Frank world.” He argued that the reason bailouts are now “foreseeable” is because Dodd-Frank makes their failure “too disruptive to be politically tolerated.”

Mr. Lubben further remarked that stakeholders in the clearinghouse would have a strong incentive to avoid failure if the government implemented ex ante procedures, or “structured bailouts.” This would involve the government stating that clearinghouses that ultimately fail would be nationalized, and that there would be specific consequences to investors as well as an expectation of member participation in the recapitalization of the clearinghouse.

However, Mr. Lubben advised that these consequences must include “clearly outlined delineated outcomes” for the stakeholders best suited to avoid problems at the clearinghouse.

Lofchie Comment: The reality that the government-created clearinghouses are the ultimate “too big to fail” is becoming more and more obvious. Having created this problem, the government is likely to find attractive the notion that its solution can be pushed on to private market participants; i.e., the clearinghouse members, as the Professor suggests. It is not obvious that this is really doable: the clearinghouses are just too big. If clearing firms really take account of the scale of the risk to which they are potentially subject, they may opt out of becoming clearing members. This would then leave an ever shrinking pool of sell-side firms willing to become clearing members, and those firms would be asked to absorb ever more risk from trades entered into by others. Further, since the clearing members don’t own the clearinghouse, or fully control it, it could be an imprudent risk to take. Bottom line, it just doesn’t sound attractive to be a clearinghouse member and bear this risk.