It was comforting to see that the House Agriculture Committee worries a lot about CCP resolvability, with our report on this hearing laying out key concerns. What isn’t so comforting is that the solution seems to rest not in making CCPs themselves more resolvable, but rather in getting the Fed to back them up with access to the discount window. Marrying the Agriculture Committee’s interest in CCP backstops with the Financial Services panel’s aversion to systemic regulation could leave the U.S. with the worst of both worlds: huge CCPs without anything close to the market discipline and regulatory limits needed to contain the structural challenges of for-profit companies dependent on a few very big-bank customers.
CCPs did not take on their critical systemic role until the G20 in 2009 told nations to convert OTC-derivatives markets into centrally-cleared ones. Prior to the financial crisis, CCPs had large roles, but only in selected sectors and generally outside the ambit of prudential financial regulation and resolution. In 2010, the Dodd-Frank Act demanded U.S. adherence to the G20 mandate, but in true U.S. style did so by creating a patchwork of competing regulatory authorities with varying duties under a still uncertain resolution framework. As a result, CCPs today are only as strong as their large bank members – which are a lot more resilient – but they are only that strong if shocks come to them through traditional liquidity challenges. As the House Ag Committee noted in a series of rightly-worried questions, CCPs can be taken out by operational risks such as cyber-attack like anyone else. Indeed, their for-profit structure and lack of clear prudential authority makes them sitting ducks absent a lot of selfless information-security and contingency-funding enhancements.
Resolution is no more clear-cut than prudential regulation. A new report from the Brookings Center on Regulation and Markets argues for changes to the Bankruptcy Code to deal with the differences between CCPs and other large financial-services companies, going beyond changes now approved by the House. As this paper points out, OLA may also be required for CCPs even if the Code is changed. In fact, I think that OLA would almost certainly be the only way to handle a CCP under stress because of the lightning-speed decisions that would need to be made, the complexities of understanding cross-border clearing in arcane financial instruments, and the intricacies of membership versus ownership waterfalls ahead of insolvency.
So, what to do? Trust in OLA as a first resort? Regulate CCPs so that the Bankruptcy Code is more likely to work, ensuring that OLA is a backstop? Or, use the Fed as lender of last resort for CCPs much as several Fed officials have urged for the repo and its similarly systemic market.
Testimony at the hearing from a senior Federal Reserve Bank of Chicago staffer in fact urges that CCP meltdowns be prevented by resort to the Federal Reserve. CCPs would thus not only have broader access to the Fed for account services than now permitted, but also get the right to call on the Federal Reserve for emergency liquidity support. This statement represents only the staffer’s views, but should be understood as the perspective of much, if not all, of the policy-makers at the central bank. In short, the Fed is saying: we can’t really regulate CCPs so we need to stand with and behind them.
This isn’t to say that the Fed wouldn’t like to see CCPs made more resilient through stress testing and even the kind of liquidity-risk tools the EU is busily building. However, likely and I think rightly despairing that these can be implemented effectively in the U.S., the Fed is doing what it knows how to do – stand behind large financial-services companies to keep systemic risk under wraps.
One way said to offset the taxpayer risk of CCP discount-window access is to require that CCPs collateralize draws with high-quality liquid assets. This is of course also required of banks, but it isn’t considered nearly enough for banks – especially big ones. Why is a light-touch backstop acceptable for CCPs and not for the biggest banks?
The answer is that it isn’t and shouldn’t be. If CCPs get the implicit guarantee of Fed access without the explicit price of stringent regulation and resolution protocols, then we’ll have done the GSE “hybrid” thing all over again, only bigger. Private shareholders will have all the CCP fun until they don’t. Then, taxpayers pick up the tab either indirectly through the Fed or far more directly through another round of costly bail-outs. I can understand why CCPs like this a lot. I’m not so sure about the Fed.