Cornell Law Review Volume 99 Issue 4

Clearinghouses as Liquidity Partitioning

To reduce the risk of another financial crisis, the Dodd-Frank Act
requires that trading in certain derivatives be backed by clearinghouses. Critics
mount two main objections: a clearinghouse shifts risk instead of reducing
it; and a clearinghouse could fail, requiring a bailout. This Article’s
observation that clearinghouses engage in liquidity partitioning answers
both. Liquidity partitioning means that when one of its member firms becomes
bankrupt, a clearinghouse keeps a portion of the firm’s most liquid
assets, and a matching portion of its short-term debt, out of the bankruptcy
estate. The clearinghouse then applies the first toward immediate repayment
of the second. Economic value is created because creditors within the
clearinghouse are paid much more quickly, and other creditors are paid no
less quickly, than they would be otherwise. The rapid cash payouts for
clearinghouse members reduce illiquidity and uncertainty in the financial
sector, the main causes of contagion in a crisis. And because the clearinghouse
holds only liquid assets, it avoids the maturity mismatch between
short-term liabilities and long-term assets that characterizes the balance sheets
of many financial institutions. A clearinghouse therefore is much less likely
than its members to fail during a crisis. To ensure that clearinghouses remain
stable and systemically valuable, rulemakers should require clearing of
a wide variety of derivatives contracts, but should limit clearinghouse membership
to dealer firms.

 

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