Viewpoint - Disincentivizing clearing: It’s déjà vu all over again 

15 September 2023


In the wake of Silicon Valley Bank’s failure, U.S. regulators announced in July a 65-page proposal to raise capital on systemically-important banks. The move would ostensibly finalize crisis-era capital reforms developed by international regulators to strengthen banks’ ability to withstand financial shocks. Contained in the proposal, however, are changes that go beyond these standards to raise the amount of capital required for the clearing of over-the-counter (OTC) derivatives.

This is a dangerous move that disincentivizes hedging among businesses, runs counter to reforms aimed at preventing government bailouts, and increases costs for consumers and businesses.

As head of the US Commodity Futures Trading Commission (CFTC) during the 2008 financial crisis, I had a front-row seat to the volatility and uncertainty of that time. Mortgage markets seized up and stock markets plunged. Many pointed to complex OTC derivatives as a leading cause of the near collapse of the financial system.

At that time, I wrote in the opinion pages of the Wall Street Journal that we needed to move more of these OTC derivatives onto regulated clearinghouses. The exchange-traded derivatives industry, which clears all trades through central counterparties, worked extraordinarily well during the crisis. I argued that this model could benefit OTC derivatives markets by reducing the counterparty risk that proved so fatal during the 2008 financial crisis. The G20 nations agreed, and recommended clearing OTC derivatives with the futures industry as a model of reform.

The reasoning remains just as true today as it was then. Regulated central clearing provides "ex ante" contingency plans and controls that compartmentalize functions and socialize risk. Clearinghouses, intermediaries, and end-users serve as important checks on one another, each with their own responsibilities in managing the risk of these trades. Importantly, every trade is supported by its own private capital in the form of margin and default fund contributions, lowering the risk of a taxpayer bailout.

Unfortunately, the recent proposal by prudential regulators does not acknowledge these risk reduction benefits. If the proposal stands, it may cause some banks to question the viability of customer clearing as a business model. Although Dodd-Frank created a "clearing mandate" for many of these products, there is no obligation on banks to provide intermediary services to the marketplace.

Exacerbating the issue is the limited number of banks that provide clearing services for over-the-counter swaps. When post-crisis reforms came into force in 2014, there were 22 firms that provided OTC clearing. Today there are only 12 clearing banks with 7 of these firms making up 94% of the market.

The last thing we should do is disincentivize something that makes the marketplace safer. This proposal would leave banks with the unenviable choice of either getting out of the business altogether or raising prices that would cause customers like agri-businesses, energy companies and financial firms to stop hedging. These costs would then be passed on to consumers in the form of higher prices for food, gas and mortgages. 

Ironically, one of the cited reasons for the failure of Silicon Valley Bank was the fact it stopped using derivatives to hedge interest rate risk in an effort to save money. If this recent proposal was to go through, many more banks may similarly forgo hedging and subject themselves to the same interest rate volatility that drove SVB under, putting taxpayer dollars at risk. As Yogi Berra would say, “It’s déjà vu all over again.”  

If regulators need further swaying, they should reread their own Leaders Statement from the Pittsburgh Summit of the G20 nations from 2009, which in the wake of the financial crisis recommended, "All standardized OTC derivative contracts…be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end 2012 at the latest." 

Ten years ago, policymakers recognized the need to incentivize clearing. And since then, we’ve seen the real risk mitigating benefits it provides. Nearly 90% of interest rate swaps are now cleared at US registered clearinghouses, according to CFTC data.

Bank regulators should be reminded about why our leaders made these structural changes in the first place. Our financial system is literally counting on it. 

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