In response to reports that the European Commission ("EC") is finalizing legislation on Central Counterparty ("CCP") recovery, University of Houston Finance Professor Craig Pirrong outlined the sources of "fundamental tension" that underlie the final resolution authority. Citing a statement in the EC's Executive Summary Sheet that the contemplated framework is likely to involve "a public authority taking extraordinary measures in the public interest, possibly overriding normal property rights and allocating losses to specific stakeholders" (emphasis supplied), Professor Pirrong concluded that the prospect of trampled rights "calls into question the prudence of creating and supersizing entities with such latent destructive potential."
Professor Pirrong argued that the resolution authority potentially will "impose large costs on members of CCPs, and even their customers, [which] raises the burden of being a member, or trading cleared products," and consequently, disincentivizes membership. He also asserted that "[t]he prospect of dealing with an arbitrary resolution mechanism will affect the behavior of participants in the clearing process even before a CCP fails, and one result could be to accelerate a crisis, as market participants look to cut their exposure to a teetering CCP, and do so in ways that push[] it over the edge." According to Professor Pirrong, the irony is that these measures to protect CCPs will lead to a "reduced supply of clearing services, and reduced supply of the credit, liquidity and capital that [such CCPs] need to function."
In addition, Professor Pirrong cautioned that with discretionary power comes "inefficient selective intervention" and the potential to influence costs. "[T]his makes it inevitable," he warned, that the body will be subjected to intense rent-seeking activity that will mean that its decisions will be driven as much by political factors as efficiency considerations, and perhaps more so: this is particularly true in Europe, where multiple states will push the interests of their firms and citizens."
Commentary / Bob Zwirb
In a speech delivered five years ago on "Clearinghouses, Financial Stability, and Financial Reform," then-Fed Chairman Ben Bernanke declared that "[i]f you put all your eggs in one basket, you better watch that basket." However, putting all of the risks of over-the-counter derivatives into a small number of CCP baskets will require a lot more from regulators than merely watching those baskets. In the aftermath of the financial crisis of 2008, clearinghouses have been charged with the task of curtailing risk in this new market – a task that they may not be able to fulfill, given the high values and long maturities of such instruments as compared to other cleared contracts. (Jo Braithwaite, Legal Perspectives on Client Clearing (LSE Legal Studies Working Paper No. 14/2015, 2015), quoted in Hester Peirce, Derivatives Clearinghouses: Clearing the Way to Failure, 64 Clev. St. L. Rev. 589, 605 n.71 (2016).)
One of the notable aspects of clearing member insolvency has been the ad hoc application and arbitrary nature of making customers whole, notwithstanding the CEA and the Bankruptcy Code's regulatory framework for dealing with such situations. By contrast, an insolvency involving a clearinghouse is several magnitudes greater. A glance at the regulatory framework for CCPs that is being contemplated by the EC inspires even less confidence that recovery and resolution following a CCP failure will be any less arbitrary.
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