In sum, although in theory, the Fed’s new emergency authority created in Title VIII to backstop systemically important financial utilities should be removed because it introduces an important moral hazard, in practice, this authority is likely necessary because financial regulators are unlikely to allow a systemically significant financial utility, such as a CCP, to fail. Assuming this is the case, the potential government backstop or “liquidity option” available to designated financial utilities in emergency situations should be explicitly recognized and “purchased” by market participants. Ultimately, Title VIII’s financial utility reforms highlight the need for additional discussion about the provision of such public “options” or “backstops” because the vast majority of all trading activity depends upon financial utilities such as CCPs.
1. These designations will be made by Dodd-Frank’s newly created Financial Stability Oversight Council. Such designations should be made later this year. See Silla Brush, Gensler Wants Decision Mid-Year on Derivatives Clearinghouses, Bloomberg, Nov. 23, 2010.
2. Dodd-Frank amends the Fed’s 13(3) emergency powers in Title 11, Federal Reserve System Provisions.
3. In a May 2010 white paper, the Federal Reserve Bank of New York solicited comments upon the use of a central counterparty clearinghouse in the repo markets. See Tri-Party Repo Infrastructure Reform, available at http://www.newyorkfed.org/banking/nyfrb_triparty_whitepaper.pdf.
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 “reforming the reforms.”
5. See Jeremy C. Kress, Credit Default Swaps, Clearinghouses, and Systemic Risk: Why Centralized Counterparties Must Have Access to Central Bank Liquidity, 48 Harv. J. on Legis. 49 (Winter 2011).
6. Professor Darrell Duffie notes that AIG’s problematic CDS were not “standardized,” so a CCP “solution” would have been inapplicable. See Darrell Duffie, How Should We Regulate Derivatives Markets? (PEW Fin. Reform Project, Briefing Paper No. 5, 2009), available at http://www.pewfr.org/project_reports_detail?id=0017. Note that what percentage of the OTC derivative 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/abstract=1440752.
8. As the name implies, “overnight” repos require lenders to daily reenter the transaction or “rollover” the debt. See Linda Sandler, Lehman Had $200 Billion Overnight Repos Pre-Failure, Bloomberg, Jan. 28, 2011.
9. Various approaches to repo market reform have been suggested, some include the use of financial utility-like entities. For example, see the “repo banks” proposed by Gary B. Gorton and Andrew Metrick in Regulating the Shadow Banking System (Oct. 18, 2010), available at SSRN: http://ssrn.com/abstract=1676947, see also the “repo resolution fund” proposed by Viral V. Acharya & T. Sabri Öncü, The Repurchase Agreement (Repo) Market, in Regulating Wall Street (2010).
10. J.P. Morgan Chase and Bank of New York Mellon, the two clearing banks in the tri-party repo markets, essentially act as default CCPs.