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									                                               CHARTING                                   plicable not only to OTC derivatives,        had rested secure in the guarantee
Center for the Study of Financial Regulation

                                                                                          but also potentially to repurchase           provided by the AIG parent. Without
                                               A COURSE IN                                agreements (repos),3 and any other
                                                                                          “financial transactions” that use
                                                                                                                                       emergency financial assistance from
                                                                                                                                       the U.S. government, AIG would have
                                               CLEARING                                   designated financial utilities now or        collapsed. To prevent future “AIGs,”
                                               By Colleen Baker                           in the future. On the one hand, these        reforms in Dodd-Frank mandate that
                                                                                          reforms purport to be a critical com-        all standardized derivatives, includ-
                                               Memorable tales of financial collapse,     ponent in solving the AIG problem,           ing CDS, use a CCP. But not only is it
                                               such as that of Lehman Brothers            but this conclusion is uncertain. On         unclear that AIG’s CDS were “clear-
                                               (Lehman), Bear Stearns, and Ameri-         the other hand, these reforms lay the        ing eligible,”6 but it seems likely that
                                               can Financial Group (AIG), frequent-       groundwork for alleviating the prob-         its lax risk management practices
                                               ly drive narratives of financial market    lem of Lehman and Bear Stearns, but          also stemmed from the presence of a
                                               crises and future preventative regula-     fall short of this goal. Consequently, I     deep-pocketed parent guarantor. The
                                               tory solutions. Much U.S. financial        suggest4 that Title VIII’s financial util-   reason Title VIII’s financial utility re-
                                               regulation, such as the monumental         ity reforms both go too far in theory        forms go too far in theory is because
                                               and historic Dodd-Frank Wall Street        in addressing the “AIG problem,” but         they risk replicating this “guarantor
                                               Reform and Consumer Protection             not far enough in practice in address-       dynamic” by potentially creating an
                                               Act (Dodd-Frank), can be understood        ing the “Bear Stearns and Lehman             important moral hazard that risks
                                               from this perspective.                     problem.”                                    replacing one deep-pocketed guaran-
                                                    Aspects of such responses,                  Payment, clearing, and settlement      tor – the AIG parent – with another
                                               however, are sometimes puzzling. An        systems and the financial market             – the U.S. government.
                                               example is the reforms surrounding         utilities involved, such as central               In September 2008, without a
                                               certain financial market utilities in      counterparty clearinghouses (CCPs)           U.S. government rescue, Lehman
                                               Dodd-Frank’s Title VIII, “Payment,         provide the “plumbing” of financial          collapsed. The proximate cause of
                                               Clearing, and Settlement Supervision       markets. They represent an impor-            both Lehman and Bear Stearns’
                                               Act of 2010” (Title VIII). Financial       tant source of potential systemic            breakdowns has been termed a
                                               market utilities often play a vital        risk. A CCP “steps” into the middle          “run-on repo.”7 Heavy reliance upon
                                               role in a process known as “payment,       of a trade, becoming the buyer to            repo financing by borrowers such as
                                               clearing and settlement,” which oc-        the seller and the seller to the buyer.      Lehman or Bear Stearns can result in
                                               curs after a trade is made. Title VIII     While its market risk should be flat,        a serious funding shortage in a brief
                                               authorizes the Federal Reserve (Fed),      it is concern about counterparty             time. Lehman reportedly used ap-
                                               in consultation with the Treasury          credit risk that largely motivates CCP       proximately $200 billion in overnight
                                               Department, to extend discount and         use. CCPs are concentrated centers of        repos.8 Curiously, neither financial
                                               borrowing privileges in emergency          credit risk. They minimize counter-          regulatory reform discussions nor
                                               circumstances to financial market          party credit risk for market partici-        Dodd-Frank focused on repos. Title
                                               utilities designated1 by Dodd-Frank’s      pants, but in moments of extreme             VIII’s reforms provide the emergency
                                               new Financial Stability Oversight          economic distress, CCPs have both            authority to backstop a financial
                                               Council as “systemically important”        teetered upon and experienced col-           utility for repos. Congress should ad-
                                               or of “systemic importance;” i.e., to      lapse.5                                      dress repo market reform. Reforming
                                               provide an emergency credit and                                                         the repo markets could take various
                                               liquidity backstop. The Fed’s new          …that Title VIII’s financial utility         approaches,9 but should provide
                                               emergency authority is separate from       reforms both go too far in theory            additional regulatory transparency,
                                               its “13(3)” emergency powers.2             in addressing the “AIG problem,”             strengthened risk management and
                                                    What little attention so far has      but not far enough in practice in            collateral practices, and improved
                                               focused on Title VIII analyzes the         addressing the “Bear Stearns and             market structure.10
                                               Fed’s new authority in relation to         Lehman problem.”                                   In sum, although in theory,
                                               OTC derivatives, especially CDS. The                                                    the Fed’s new emergency author-
                                               actual scope of financial contracts            In September 2008, AIG faced             ity created in Title VIII to backstop
                                               for which this new authority is rele-      imminent financial collapse as its           systemically important financial
                                               vant, however, is quite vast: It applies   CDS counterparties demanded                  utilities should be removed because
                                               to any financial transactions using        collateral payments that it could            it introduces an important moral
                                               designated financial utilities. Title      not meet. Prior to the onset of the          hazard, in practice, this authority
                                               VIII’s financial utility reforms are ap-   financial crisis, these counterparties       is likely necessary because financial

                                          1    WINTER 2011 | ISSUE NO. 4
regulators are unlikely to allow a sys-                Had $200 Billion Overnight Repos Pre-Failure,

                                                                                                               Center for the Study of Financial Regulation
                                                       Bloomberg, Jan. 28, 2011.
temically significant financial utility,             9 Various approaches to repo market reform
such as a CCP, to fail. Assuming this                  have been suggested, some include the use of
                                                       financial utility-like entities. For example, see
is the case, the potential government                  the “repo banks” proposed by Gary B. Gorton
backstop or “liquidity option” avail-                  and Andrew Metrick in Regulating the Shadow
                                                       Banking System (Oct. 18, 2010), available at
able to designated financial utilities                 SSRN: http://ssrn.com/abstract=1676947,
in emergency situations should be ex-                  see also the “repo resolution fund” proposed
                                                       by Viral V. Acharya & T. Sabri Öncü, The Repur-
plicitly recognized and “purchased”                    chase Agreement (Repo) Market, in Regulating
by market participants. Ultimately,                    Wall Street (2010).
                                                     10             .
                                                                 J.P Morgan Chase and Bank of New
Title VIII’s financial utility reforms                 York Mellon, the two clearing banks in the tri-
highlight the need for additional                      party repo markets, essentially act as default
discussion about the provision of                      CCPs.
such public “options” or “backstops”
because the vast majority of all trad-
ing activity depends upon financial
utilities such as CCPs.

Colleen Baker is the associate professor of
Law at the University of Notre Dame. She
can be reached at cbaker5@nd.edu
1 These   designations will be made by Dodd-
  Frank’s newly created Financial Stability Over-
  sight Council. Such designations should be
  made later this year. See Silla Brush, Gensler
  Wants Decision Mid-Year on Derivatives Clear-
  inghouses, Bloomberg, Nov. 23, 2010.
2 Dodd-Frank amends the Fed’s 13(3) emergency
  powers in Title 11, Federal Reserve System
3 In a May 2010 white paper, the Federal
  Reserve Bank of New York solicited comments
  upon the use of a central counterparty clearing-
  house in the repo markets. See Tri-Party Repo
  Infrastructure Reform, available at http://www.
4 In a working paper, I expand upon the ideas
  in this piece, including an analysis of the
  expansive scope of the financial utility reforms
  in Title VIII, the Fed’s new emergency authority
  contained therein, potential implications of
  these reforms in the OTC derivative and repo
  markets, and several suggestions for “reform-
  ing the reforms.”
5 See Jeremy C. Kress, Credit Default Swaps,
  Clearinghouses, and Systemic Risk: Why Cen-
  tralized Counterparties Must Have Access to
  Central Bank Liquidity, 48 Harv. J. on Legis. 49
  (Winter 2011).
6 Professor Darrell Duffie notes that AIG’s prob-
  lematic CDS were not “standardized,” so a CCP
  “solution” would have been inapplicable. See
  Darrell Duffie, How Should We Regulate Deriva-
  tives Markets? (PEW Fin. Reform Project, Brief-
  ing Paper No. 5, 2009), available at http://
  Note that what percentage of the OTC de-
  rivative markets will ultimately be sufficiently
  standardized and, therefore, “clearing eligible”
  remains uncertain.
7 See Gary B. Gorton & Andrew Metrick,
  Securitized Banking and the Run on Repo
  (Yale ICF Working Paper No. 09-14, Nov. 9,
  2010), available at SSRN: http://ssrn.com/
8 As the name implies, “overnight” repos require
  lenders to daily reenter the transaction or
  “rollover” the debt. See Linda Sandler, Lehman


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