Dodd-Frank's Swap Clearing Requirements and Systemic Risk

Abstract

Credit Default Swaps (CDS) have been widely criticized for exacerbating losses during the recent financial crisis. Accordingly, a reorganization of the CDS market is a primary goal of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act seeks to mitigate systemic risk by moving more trades onto central clearinghouses. In this Comment, I argue that the various provisions of the Dodd-Frank Act related to central clearing might actually undermine the law's objectives. I focus on the penal rules governing uncleared CDS. These regulations are meant to account for the supposedly greater risk of uncleared trades and to encourage the use of clearinghouses. In actuality, the bifurcated treatment of cleared versus uncleared CDS creates incentives for banks to clear as many types of CDS as possible, including instruments with features that render them unsuitable for central clearing. As an alternative policy, I recommend that regulators require banks to move all CDS dealing activities to separately capitalized affiliates. Regulators should recognize that CDS, cleared or uncleared, generate significant systemic risk. By eliminating the implied government backstop, banks will internalize the full social costs of CDS trading. Insofar as clearinghouses effectively reduce counterparty risk for certain transactions, participants will be motivated to clear, rather than simply shifting activities to the trading venue with the most advantageous regulatory treatment.