Dodd-Frank Act and CFTC Rulemaking on Derivatives Clearing

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Jesse Overall
Supervised Research Project
Loss Mutualization, Central Clearing, and Derivatives Market Reform Under
the Dodd-Frank Act and CFTC Rulemaking: Historical, Legal,
and Policy Perspectives
Structure of paper:
§1: Clearing, Credit Risk, and Margin
(a) Comparison to Securities Clearing
(b) Derivatives clearing: Credit risk
(c) Margin
§2: Operation of Clearinghouses & Benefits of Central Clearing
(a) Loss Mutualization
(b) Central Clearing Prevents Building Up of Large Uncapitalized Exposures and Involves Less Disruptive
Margin Calls
1. Initial Margin Requirements Not Evadable: Fixing a Previously-Imperfect Market
2. More Orderly, Less Disruptive Margin Call Procedures
(c) Netting
(d) Transparency
§3: The CentralBenefit of Central Clearing: Comparing Loss Mutualization in Past Financial Crises with 2008
(a) Panic of 1907: The Loss Mutualization Role of a Private Bank Clearinghouse in a Bank Run
1. Development of Loss-Mutualizing Bank Clearinghouses Before 1907
(A) First Loss Mutualization Mechanism: Clearinghouse Loan Certificates
(1) Benefits of Clearinghouse Certificates for Depositors
(2) Benefits of Clearinghouse Certificates for Banks
(i) Improved Liquidity
(B) Second Loss Mutualization Mechanism: Clearinghouse Direct Guarantees of Member Banks
2. Benefits of Central Clearing in 1907: Clearinghouse Member Banks Able to Halt Runs and Restore
Depositor Confidence Early, While Uncleared Trust Companies Suffered the Worst Runs
3. Runs on Uncleared Trusts Eventually Halted By Formation of Loss Mutualizing Clearinghouse-like
Trust “Consortium”
4. Trusts That Were Clearinghouse Members in Chicago Suffered Less Runs,While Trusts that Were
Not Clearinghouse Members in New York Suffered Worse Runs
5. Differences Between Bank Clearinghouses in 1907 and Modern Derivatives Clearinghouses
(b) The Financial Crisis in 2008: ABSENCE of Loss Mutualization Due to Lack of OTC Swap Clearinghouse
1. Pre-Crisis Methods For Addressing Credit Risk: Dealing With Losses WITHOUT Mutualizing Them
(i) Special Purpose Vehicles (SPVs) and Derivatives Product Companies (DPCs)
(ii) Entering Swaps Only With Large and Well-Capitalized Financial Institutions as
Counterparties
2. Problems Caused by the Lack of Central Clearing: The AIG Case
(i) Why This Paper Does Not Discuss Lehman Brothers
(ii) AIG
(1) Narrative of AIG’s Downfall
(2) Effect of Government’s Preservation of AIGas a Going Concern on Incentives

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Facing Other Market Participants
§4: Will Dodd Frank reduce Systemic Risk?
(a) Dodd Frank’s Central Clearing Rules Would Not Have Applied to AIG’s Non-Standardized CDSs,But Both
Uncleared Margin Requirements and AIG’s Being Required To Register As A Swap Dealer Would Have
1. Because AIG’s CDSs were Non-Standardized, They Would Have Not Have Been Required To Be
Centrally Cleared
(A) Clearinghouses Lack the “Capacity and Operational Expertise” to Clear the CDSs AIGSold
Based on ABSs/MBSs/CDOs/CLOs
2. AIGWould Have Had to Register As A Swap Dealer,Imposing Minimum Capital Requirements
3. Uncleared Swap Collateral Requirements Would Have Applied to AIG
(b) The CFTC’s LSOC Collateral Segregation Requirements INCREASE, Rather Than Reduce, Systemic Risk
1. Different Margin Storage Models
2. CFTC Adopts LSOC Model
3. Adopting LSOC is a Mistake that Will Increase Systemic Risk
4. The CFTC Should Adopt the Legal Segregation With Recourse Model Instead
§5: Conclusion
Introduction
The central argument of this paper is that loss mutualization is the primary role of centralclearing during a financial crisis.
This paper examines the Panic of 1907 and the financial crisis of 2008, and finds that – across time and space – markets
that were centrally cleared functioned better than markets without central clearing. During both crises, non-centrally-
cleared markets required ad hoc bailouts by the government (2008) and by other industry participants (1907). Had loss
mutualization mechanisms– such as private clearinghouses – existed in these uncleared markets ex ante, this paper argues
they could have eliminated or reduced the need for bailouts on both occasions. Because loss mutualization is the
fundamental purpose of central clearing, attempts to achieve other goals through regulation – such as customer protection
– may conflict with central clearing’s fundamental purpose, and should therefore be avoided.
§1: Clearing, credit risk, and margin
In financial markets, clearing is the process by which the obligations called for by the parties’ contract are actually
carried out, fulfilled, and ultimately discharged. The components of the clearing process vary based on the characteristics
of the financial instruments involved, but at the broadest level the function of clearing –physical fulfillment and discharge
of each party’s contractual obligations – is the same. A brief comparison of the clearing process of two financial
instruments – derivatives and securities – illustrates both the varying steps,and the identical function, that clearing plays
in both markets.
(a) Comparison: Securities clearing
In securities markets,“clearing” refers to all steps taken after the trade is made in preparation for eventual settlement.
“Settlement” involves one party’s transfer of possession and legal ownership of a security to another party in exchange for
cash,pursuant to the parties’ contract. Because a security (or the certificate evidencing ownership of title to a specified
quantity of securities) is a physical object, clearing of securities involves procedures and market intermediaries necessary
to transfer ownership of a physical object, including a custodian to hold the security, transfer agents,and re-assigning

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“record” ownership of the security from the seller to the buyer in a centralsecurities depository.1
In securities trades,the
elapsed length of time between the parties’ entering a contract, and the contract’s final settlement, is unintentional and
grows out of operational exigencies only; it is not part of the economic bargain made by the parties. If they could clear
and settle the trade instantaneously, the parties would;2
it is only the limits of available technology or other operational
constraints that prevents them from settling securities trades instantaneously. In any event, the vast majority of securities
trades are settled within 3 days of being entered into.3
While in securities clearing the risk of counterparty non-performance is a problem – e.g.,the buyer may not have enough
cash to pay the full purchase price of the security – the fact that the contract is only open for 3 days means that
counterparty non-performance risk does not have to be borne for long. The early development and almost universal
availability of centralclearing also minimizes the amount of counterparty credit risk a party faces in a securities trade.
The main purpose of securities clearing is merely to “standardize and simplify operational processes”4
– to make things
run more smoothly and more efficiently. Because the mitigation of systemically significant risks5
is not a primary function
of securities clearing, the existence or non-existence of clearing of securities arguably does not have systemic risk
implications.
(b) Derivatives clearing: credit risk
In derivatives markets,the function of clearing at the broadest level – the fulfillment and discharge of contractual
obligations – is the same as in securities, but the nature of derivative contracts gives derivatives clearing much greater
implications for systemic risk than securities clearing.6
As a matter of procedure, most derivatives trades – particularly
swaps – involve an exchange of cash flows based on market movements in the underlying reference asset only, and do not
contemplate the transfer of either legal title to or physical possession of any particular physical object, unlike a securities
trade, where the goal is to transfer a physical object (the security, evidenced by a certificate) from one party to the other.7
Most fundamentally, however, the difference between securities clearing and derivatives clearing is that clearing of
derivatives takes place over the course of a long period of time. In a derivatives contract the primary feature of the parties’
economic bargain is a significant time lapse between the time the parties enter the contract, and the time the contract is
finally settled. The statutory definition of the original derivative instrument – a futures contract – makes this time lapse
feature the touchstone of CFTC jurisdiction: a futures contract over which the CFTC has exclusive jurisdiction is defined
as a “contract of sale of a commodity for future delivery,”8
that is, a contract involving delivery in the future of a
commodity whose price, quantity and grade are determined now, at present.
As noted above, under any contract – whether for derivatives or securities – there is some degree of risk that parties will
not perform their contractual obligations. Thus, credit risk is not unique to derivatives contracts. However,what is unique
is the sheer length of time that a party to a derivatives trade is exposed to the risk of its counterparty’s non-performance.
1 Robert Bliss and RobertSteigerwald, Derivatives Clearing and Settlement: A comparison of central counterparties and alternative
structures, 30 Fed. Res. Bank of Chi. Econ. Persp.22, 23 (4Q 2006).
2 Id., 23-4.
3 Hal Scott and Anna Gelpern, INTERNATIONAL FINANCE: POLICY, TRANSACTIONS, AND REGULATION, 20th ed., 701 (2014).
4 Jon Gregory, CENTRAL COUNTERPARTIES: MANDATORY CENTRAL CLEARING AND INITIAL MARGIN REQUIREMENTS FOR OTC
DERIVATIVES, 9 (2014).
5 Of course,mitigatingcounterparty credit risk is themain motivation behind central clearing;but for securities,counterpar ty credit
risk is lessof a concern due to the extremely shorttime between the time a contractis entered and the time it is finally settled.
6 Bliss and Steigerwald,23
7 Futures settled by actual delivery arean exception, and resemble securities clearingin thatthe transfer of a physical objec tis the
goal of the transaction,butphysical settlement of futures is exceedingly rare. Also,forward contracts arepredominantly – although
need not exclusively be– settled by actual delivery,though they are not derivatives.
8 7 USC §2(a)(1)(A) (emphasis added)

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In contrast to the 3-day open period of securities trades,most futures contracts remain open for severalmonths or a few
years,9
and swap contracts can remain open for decades (up to 30 years or more).10
Of course, a counterparty’s financial
condition can obviously change over the course of years or decades; the most creditworthy counterparty at the contract
formation stage may not be creditworthy at all (or have gone bankrupt and disappeared) by the time the contract is
ultimately settled ten or twenty years later.
Because the protracted time period derivatives trades are open gives rise to significantly greater counterparty credit risk
than in securities trades, derivatives clearing developed mechanisms over time to reduce credit risk. Instead of merely
making things run faster and more smoothly (which is the function of securities clearing), derivatives clearing plays the
primary role in mitigating counterparty credit risk across the system as a whole.
(c) Margin
How can derivatives parties be sure their counterparties will honor their obligations, particularly if those obligations
become very large in amount, or extend many years into the future? Margin is the solution: a performance bond –
requiring the posting of collateral up front – which secures the future payment in full of the party’s contractual
obligations. Its origins lie in it being a market-based (rather than governmentally-imposed) solution to the problem of
currently-unsecured, unfunded promises by derivatives counterparties to pay each other potentially large amounts of
money in time periods ranging from years to decades into the future. Because long-term credit risk is not a prominent
feature of securities trades settled within 3 days of being made, securities clearing has no equivalent to the concept of
derivatives margin.
There are two margin systems: an organized system found on exchanges, and an unorganized system – in which all terms
are a product of bargaining between the parties – that prevails in the off-exchange OTC11
market. Margin on a futures
exchange takes two forms – initial, and variation. Initial margin is calculated by the clearinghouse at the contract’s
beginning in terms of the amount of potential losses that a counterparty might incur over the contract’s life. For purposes
of setting initial margin, the length of time it will take to liquidate the contract is a proxy for the contract’s life;
standardized exchange-traded futures are estimated to take only 1 day to liquidate, physical commodity swaps
(agriculture, energy, and metals) require 2 days, and other swaps projected to require 5 days or more to liquidate.12
Variation margin constitutes the actual losses incurred over a specified period of time.13
In a process called “marking-to-
market”, which usually occurs every day or even multiple times a day,14
the market movements on the underlying
reference asset are applied to the initial margin. The counterparty for whom the market movement was favorable receives
a transfer of the losing counterparty’s margin; the losing counterparty will have to make a corresponding addition to their
previously-posted margin, to top it back up to the required level. This additional amount is called variation margin. To
satisfy futures margin requires cash or liquid securities. In contrast to the organized initial and variation margin system
found on futures exchanges,the disorganized ad hoc system that prevails in the OTC market might involve initial margin,
9 See, e.g., CME Group, Globex Crude Oil Future contract, expiration date December 2020 (5 year tenor), available onlineat
<http://www.cmegroup.com/trading/energy/crude-oil/light-sweet crude_quotes_timeSales_globex_futures.html#pageNumber=1>
10 See, e.g., CME Group, Globex 30 Year USD DeliverableInterestRate Swap Future contract, variableexpiration dates,available
onlineat
< http://www.cmegroup.com/trading/interest-rates/deliverable-swaps/30-year-deliverable-interest-rate-swap-
futures_contract_specifications.html>
11 “OTC” means Over-The-Counter (off-exchange).
12 See CFTC Reg. §39.13(g)(2)(ii),17 CFR 39.13(g)(2)(ii).
13 Rena Miller,Kathleen Ruane, The Dodd Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives, Congressional
Research Service Report 41398 (Nov. 6, 2012), at 3.
14 Protection of Cleared Swaps Customer Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions, CFTC
Final Rule,77 F.R. 6336,6337 (Feb. 7, 2012).

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both initial and variation margin, or no margin at all. Acceptable OTC collateral varies based on whatever is negotiated by
the parties.
§2: Operation of Clearinghouse and Benefits of Central Clearing
Derivatives clearing can take place two ways: bilaterally, or centrally. In bilateral clearing, the parties directly clear and
settle each other’s trades – no entity is interposed between them. The parties themselves bear the risk of counterparty non-
performance for the life of the contract,which they mitigate by negotiating contractual protections (such as margin
systems) or by limiting potential counterparties to large, creditworthy financial institutions. By contrast, the primary
feature of central clearing is the interposition of an entity – the clearinghouse – between the two parties to a contract. The
interposition is accomplished by means of novation, in which the parties’ single original contract with each other is
discharged and replaced by two contracts, one between the buyer and the clearinghouse, and the other between the seller
and the clearinghouse.15
The clearinghouse will collect payments from the losing counterparty and pass them through to
the winning one. This substitution of the clearinghouse for a party’s original counterparty replaces each party’s previous
exposure, which was to the credit risk of the other counterparty, with exposure to the credit risk of the clearinghouse only.
The first use of novation was in late nineteenth century, when both French (caisse de liquidation) and German
(liquidationskaisse) commodities exchanges made their clearinghouses a counterparty to every futures transaction,
thereby guaranteeing that the winning counterparty would be made whole and removing counterparty credit risk from
transactions. In the US, the Minneapolis Grain Exchange was the first – in 1891 – to introduce novation.16
The clearinghouse then guarantees each of its novated counterparties that the clearinghouse will ensure that the party
receives all payments due it under the contract, eliminating credit risk. Since a clearinghouse can mobilize the collective
resources of its members, it has superior financial resources compared to the individual counterparty it is replacing, and it
can use these to satisfy the obligations arising from any defaulting individual’s contract. Each clearing member is eligible
to enter contracts directly (on a principal-to-principal basis) with the clearinghouse, and – in the event of default of
another clearing member caused by a defaulting customer’s17
position liability – will be the source of funds that the
clearinghouse uses to cure the default and make the defaulting customer’s counterparty whole.
A non-clearing-member firm cannot contract directly with the clearinghouse, but instead must proceed through a clearing
member. In the novation scheme discussed above, it was stated that a clearinghouse interposes itself between the two
counterparties to the trade. In a centrally cleared contract, this is not technically accurate because, if neither of the two
counterparties are themselves clearing members, then there is an extra layer of intermediaries separating the counterparties
from the clearinghouse. These intermediaries are,of course, clearing members. The principals (the counterparties) have to
clear their contracts through an agent (the clearing members), and the agents (clearing members) are the ones who actually
enter bilateral contracts with the clearinghouse, on behalf of their respective principals.
Clearing member firms will be a small subset of the total number of firms participating in the derivatives market. This is a
function of a clearinghouse’s clearing member eligibility requirements (and restrictions). Each clearing member has
traditionally been required to be a large, stable, creditworthy, and well-capitalized financial institution, because – in case
of default of another clearing member – all non-defaulting clearing members must be capable of contributing enough of
their own proprietary resources to cure the default. The traditional view is that entity size is a good proxy for having
15 Chicago MercantileExchange (CME) Group, Overview of CME Clearing, lastaccessed 3/22/15, availableonlineat
http://www.cmegroup.com/clearing/overview.html
16 Randall Kroszner, Can the Financial Markets Privately Regulate Risk? The Development of Derivatives Clearinghouses and Recent
Over-The-Counter Innovations, 31 J. of Money, Credit & BankingNo. 3, Part2, 596,602 (Aug. 1999)
17 A “customer” is defined as any person who uses any of a number of enumerated market intermediaries as its agent in transacting
in derivatives markets. CFTC Reg. §1.3(k), 17 CFR 1.3(k).

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sufficient resources:“the greater a [clearing] member’s capital, the greater the loss… he can withstand.”18
However,
traditional tight membership requirements have been rolled back somewhat by the Dodd-Frank Act,which requires that
all firms with over $50 million in assets be permitted to become clearing members if they wish,19
a threshold some
industry members consider too low,20
in the name of promoting fair and open access to clearing for all firms.
All clearinghouses – whether for futures or swaps –can draw on the following resources during a default of a clearing
member firm: (1) Margin of the defaulting customer and the defaulting clearing member; (2) the defaulting clearing
member’s guaranty fund deposits; (3) all other clearing members’ guaranty fund deposits; (4) the clearinghouse’s own
proprietary capital; (5) as a last resort,21
special assessments of all clearing member firms; and (6) default insurance.22
Clearinghouses that exclusively clear futures also have access to an additional source of funds: the margin collateral
provided by all non-defaulting futures customers of the defaulting clearing member, which is held in an “omnibus
account.” An omnibus account is so named because the funds of all customers deposited therein – not just funds
belonging to the defaulting customer – can be used by the clearing member to satisfy any defaulting customer’s margin
obligations. A clearing member’s use of the collateral of non-defaulting customers to cure another customer’s default is
not available for swaps.23
In both futures and swaps,a clearing member who accepts customer money to meet margin
payments on those customers’ contracts must register with the CFTC as a Futures Commission Merchant (FCM).24
There are four main benefits of central clearing: loss mutualization, discouragement of large uncapitalized exposures,
netting, and improved transparency.
(a) Loss mutualization
Loss mutualization is the primary benefit25
of central clearing,26
and is embodied in the CFTC’s regulatory definition of a
clearinghouse (a “Designated Clearing Organization” or “DCO”) as being an entity or association which “provides…
arrangements that mutualize or transfer among the participants in the derivatives clearing organization the credit risk
arising from [derivatives] agreements.”27
As mentioned above, the fundamental purpose of centralclearing is to apply the
resources of many entities to cure the default of a single entity. Because every derivatives contract is zero sum – one
counterparty’s gain can only come at the expense of another party’s loss – one of the contracting parties will inevitably
bear most or all of the burden of adverse market movements. This concentrates the burden of loss on a single entity: the
losing counterparty. If the losing counterparty cannot meet the burdens imposed by those adverse market movements, then
it defaults, and – if the contract is centrally cleared – the clearinghouse will take over the defaulted counterparty’s
obligations.
18 Franklin Edwards, The Clearing Association in Futures Markets: Guarantor and Regulator, 3 The Journal of Futures Markets 369,
384 (Winter 1983).
19 See CFTC Reg. §39.12(a)(2)(iii),17 CFR 39.11(a)(2)(iii).
20 See Derivatives Clearing Organization General Provisions and Core Principles, CFTC Final Rule, 76 Fed.Reg. 69334,69355 (Nov. 8,
2011)(“SIFMA commented that the appropriateminimumcapital requirement would be $300 million,whileISDAcommented… a $1
billion requirement would be appropriate”).
21 Id, at69348 (“given the contingent nature of assessments,they should be relied on only as a lastresort”).
22 See CFTC Reg. §39.11(b)(1), 17 CFR 39.11(b)(1) .
23 This will bediscussed in greater detail below. See infra §4(b).
24 CFTC Reg. §1.3(p)(1), 17 CFR 1.3(p)(1).
25 See §3 infra.
26 Over The Counter Derivatives: Modernizing Oversight to Increase Transparency and Reduce Risks, 111th Cong., S. Hrg. 111-248,
Appendix at 52 (Jun 22, 2009) (CFTC Chairman Gary Gensler prepared statement)(“Clearing reduces risk by facilitatingthenetting of
transactions and by mutualizingcreditrisks”),availableonlineat http://www.gpo.gov/fdsys/pkg/CHRG-111shrg54589/pdf/CHRG-
111shrg54589.pdf
27 CFTC Reg. §1.3(d)(3), 17 CFR §1.3(d)(3).

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Following default by the customer – and emptying of the customer’s margin contributions – the clearinghouse will then
mutualize the burden of the loss by dispersing it among a large number of other market participants, forcing each one to
bear a pro rata share of the burden, but not concentrating the entire burden on any single member (as the entire burden
was originally concentrated upon the original customer-counterparty, who defaulted because of it).28
The main mechanism
for loss mutualization is the “guaranty fund”: a pool of capital to which – like insurance premiums – each clearing
member is required to contribute periodically. The so-called loss “waterfall” starts with the proprietary margin and
guaranty fund contributions of the defaulted customer’s FCM, which is in first-loss position. Traditionally, the second
source of funds – assuming the derivative contract was a futures contract – would be the margin payments of non-
defaulting customers of the same FCM that are contained in the same omnibus account as the defaulted customer’s
funds.29
After these two sources are exhausted, the DCO would use its own proprietary capital. If these three sources of
capital are insufficient to cure the default, the clearinghouse will mutualize the loss among market participants completely
unaffiliated with the defaulted customer through tapping the guaranty fund contributions of non-defaulting clearing
members. If the default remained uncured, the DCO has the authority to levy special assessments from clearing members’
entire balance sheets – not just their derivatives operations – to satisfy the default.30
However,one distinction is important:
in an omnibus account, another customer’s margin can be used to cure the defaulting customer’s liabilities, and the
proprietary margin of the clearing FCM may also be used to satisfy a customer’s default. However,the funds of customers
are never able to satisfy the FCM’s own proprietary margin obligations.
(b) Central clearing prevents building up large uncapitalized exposures and involves less disruptive margin calls
Another important benefit of centralclearing is its ability to prevent firms from building up systemically-significant risk
exposures without also setting aside adequate capital to meet those exposures. In the Congressional hearings and debates
preceding the Dodd-Frank Act, this was a recurring theme in witness testimony. 31
There are two separate components of
this benefit.
1. Initial margin requirements not evadable: Fixing a previously-imperfect market
The first component is that, in centralclearing, swap counterparties cannot avoid posting margin. The clearinghouse will
demand both initial and variation margin according to a universally-applicable system that all clearing members (and their
customers) must comply with. No clearing members and no customers are exempt from the need to post initial margin.32
By contrast, in the bilaterally-cleared OTC swap market, margin and collateral practices were unorganized and
idiosyncratic:33
they depended on the negotiations between the parties.34
The result was that large financial institutions
28 Gregory at 21 (“Any unexpected losses caused by the failureof… counterparties would be shared amongst all members of the CCP
(justas insurancelosses areessentially shared by all policyholders) rather than being concentrated within a small number of
institutions… heavily exposed to the failingcounterparty”)
29 Gregory at 221.
30 Darrell Duffie,Theo Lubke, and Ada Li, “Policy Perspectives on OTC Market Infrastructure,”Fed. Res. Bank of New York Staff
Report No. 424 (Mar. 2010), Appx. A (discussingorder of loss waterfall).
31 Over The Counter Derivatives Reform and Addressing Systemic Risk, 111th Cong., S. Hrg. 111-802,at 16 (Dec. 2, 2009) (remarks of
Treasury Secretary Timothy Geithner)(“it would not have been possiblefor AIG and a set of insurancecompanies to write hundreds
of billions of dollarsof commitments without capital to back those up”)
32 Kimberly Anne Summe, “An Examination of Lehman Brothers’ Derivatives Portfolio Post-Bankruptcy and Whether Dodd-Frank
Would Have Made Any Difference”, RESOLUTION OF FAILED FINANCIAL INSTITUTIONS: ORDERLY LIQUIDATION AUTHORITY AND A
NEW CHAPTER 14, Hoover Institution WorkingGroup on Economic Policy,Resolution Policy (Apr.24, 2011), at11 (“what has shif ted
under Dodd-Frank is that the CCP’s calculation of required collateral is substituted for the individual counterparty.”) availableonline
at http://www.hoover.org/sites/default/files/kimberly-summe-dodd-frank-20110421.pdf
33 Rena Miller,The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives, Congressional Research
Service Report R41398,at 7-8 (Nov. 6, 2012)(“In the OTC market, some contracts required collateral or margin,but not all”)

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were able to negotiate contractual margin terms which completely exempted them from the need to post initial margin.
They would only need to post variation margin in rare circumstances,such as following a credit downgrade.35
Since, in
normal times, these large institutions were well-capitalized and appeared unlikely to suffer credit problems, a credit rating
downgrade was only perceived to be possible if a highly unlikely event – such as a fall in real estate prices,something the
vast majority of market participants considered outside the realm of normal possibility – was to occur. Since highly
unlikely events were deemed to not to require protecting against, swap counterparties of large financial institutions cut
back on the margin they required the large financial institutions to post. For instance, AIG, which provided issuer-default
protection for many buyers of Mortgage-Backed Securities (MBSs) in the form of Credit-Default Swaps (CDSs), posted
no – $0 of – up-front (“initial”) margin on its $2.7 trillion36
CDS portfolio because its counterparties believed that its
AAA-credit rating meant that requiring collateral from such a secure,creditworthy entity was unnecessary.37 This of
course turned out to be an inaccurate assumption during the 2008 crisis.
The OTC bilateral clearing system thus created an imperfect market: 38
it allowed large financial institutions to enter an
inefficiently large number of swap contracts and take on an inefficiently large amount of risk without also forcing them to
internalize the true risk of their own future non-performance through the posting of sufficient margin to cover those
risks.39
Adequate initial margin requirements would fix this imperfect market in two ways: (1) the initial margin
liabilities required to enter swap contracts would force firms to run out of money before they could enter enough contracts
to threaten the system as a whole; and (2) if firms had sufficient capital to satisfy properly-calculated initial margin on all
their swaps,then the swap exposures they did in fact take on would not threaten the system. This is because,if sufficient
capital backs a risk exposure, then the risk is not systemically-significant. No “domino effect” chain of defaults triggered
by the failure of a systemically-important swap counterparty to meet its obligations would occur or be in danger of
occurring.
2. More orderly, less disruptive margin call procedures
The second benefit of central clearing’s ability to prevent firms from building up risk without backing it with capital is
that it will make margin calls more orderly and less disruptive. As discussed above, in the bilaterally-cleared OTC swaps
market, large financial institutions like AIG with good credit ratings (and bargaining power) were able to secure favorable
margin terms – avoiding entirely posting initial margin – during bargaining with their OTC counterparties. The problems
with this approach were exposed by the 2008 financial crisis, when these large financial institutions – suddenly subject to
events that had been perceived to be extraordinarily unlikely ex ante,such as a worldwide crash in housing prices that
destroyed the value of the Mortgage-Backed Securities (MBSs) which so many large financial institutions owned–
received credit rating downgrades as a result of the drop in the value of their proprietary assets,triggering vast margin
call obligations for them on their swap contracts.
34 Summe, “Examination of Lehman Brothers”, at 8 (Citing“mandatory clearingof certain derivatives through a central counterparty
and consequent imposition of more uniform derivatives collateralization" as primary goal of Dodd-Frank)(emphasis added).
35 Gregory at 25 (“monoline [insurers] and [derivatives subsidiaries of parent banks] would essentially postonly variation margin and
would often only do this in extreme situations (e.g. in the event of their ratings beingdowngraded).”)
36 This is a net figureof actual exposure, not a figurebased on (much larger) gross outstandingnotional amounts. See Robert
O’Harrow Jr. and Brady Dennis,“Downgrades and Downfall”, part3 in the series,chapter 9, Washington Post,Dec. 31, 2008,
availableonlineat
http://www.washingtonpost.com/wpdyn/content/article/2008/12/30/AR2008123003431.html?sid=ST2010062905395
37 Miller,Title VII, at 8 (“Because there was no… margin, largeuncollateralized losses could and did build up in the OTC market… the
best example is AIG… AIG did not postinitial margin,becausethis was unnecessary becauseof the firm’s triple-Arating…[a]s the
crisisworsened,AIG faced margin calls itcould notmeet”)
38 Viral Acharya, Regulating Wall Street
39 S. Hrg. 111-802,at 16 (Dec. 2, 2009) (remarks of Treasury Secretary Geithner)(“It would not have been possiblefor AIG and…
insurancecompanies to write hundreds of billionsof dollarsof [creditdefaultswap] commitments without capital to back thoseup”)

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All of a sudden, these financial institutions had to find highly liquid assets (cash and government securities) to meet
margin calls in the tens of billions of dollars in a very short period of time. This created major liquidity problems, as these
firms had to quickly liquidate large amounts of assets – including MBSs – at the same time, in a down market, in order to
generate cash. This produced asset “fire sales”,reducing both the value of the assets being sold, and the assets retained by
the firms, which in turn made it harder to meet the margin calls that had triggered the margin calls in the first place.40
Where the assets being unloaded were MBSs that the crisis itself had devalued, then the financial institutions found
themselves in some cases without any buyers at all, regardless of price. This converted liquidity problems into
fundamental firm solvency issues – not only could the firms not find the cash,but in their rush to liquidate other assets
(including assets losing value on a daily basis, like MBSs) to obtain cash for margin calls, the firms’ asset-side of the
balance sheet kept plummeting in value (whether because of the loss of assets which were being sold, or due to the
depreciation in value of remaining assets due to fire-sale dynamics), while the value of the liabilities (for instance margin
calls) stayed the same – or increased if triggered by ratings downgrades – thus propelling the large institutions toward
bankruptcy.
In response to a question about whether centralclearing would have avoided the need for the federal government to bail
out AIG, CFTC chairman Gensler specifically singled out the disruptiveness – in the bilaterally cleared OTC market – of
sudden margin calls linked to a swap counterparty’s credit rating downgrade: “when the rating agencies downgraded AIG,
all of a sudden they had to post significant collateral. I think it was over $30 billion within a day or two.” By contrast,
under central clearing, chairman Gensler noted that firms that were required by a clearinghouse to post margin “would
have to have done that [posted margin] on a daily basis.”41
In turn, the availability of initial margin – collateral already set
aside by the firm to meet its future swap exposures – would reduce the need to liquidate assets at a forced fire-sale
discount in order to meet margin calls. Further, if a firm did not have enough liquid assets on hand to meet initial margin
requirements, the firm would be prevented from entering any new swap contracts at all. This, of course,would have
reduced the likelihood of a firm amassing such a large amount of swap exposures as to cause systemically-significant
consequences if it defaulted on them.
(c) Netting
Netting another benefit of centralclearing. Because a clearinghouse becomes a party to each counterparty in a futures
contract (through novation), it can reduces the gross amounts parties owe one another to net amounts, by means of
cancelling precisely-offsetting obligations that the parties owe to the clearinghouse.42
If a Party A owes $100 to Party B
and is owed $150 from Party B, and all the transactions are made with the same clearinghouse, then the clearinghouse can
settle both A’s and B’s obligations by paying A $50. This obviates the need to have Party A pay $100 to Party B first, and
then have Party B pay A the full $150 in a second transaction; instead, the clearinghouse pay A only A’s net balance in a
single step. Instead of $250 changing hands, only $50 changes hands. Netting can massively reduce the amount of cash
and collateral which needs to be transferred between parties to the de minimis amount. Since netting allows a party to post
less total margin across all trades, then the party has lower liquidity needs; and since liquidity needs are lower, the party
does not need to obtain as many short-term assets in a short time period to meet margin calls.
(d) Transparency
40 This negative effect – requiringmore assetsales,atdecreasingprices,to produce the same amount of proceeds – is dueto the
depreciation in valueof the assets beingsold.The more assets liquidated in order to meet margin calls,the lower the market value
of those assets,and therefore the more of them need to be sold in order to meet the same margin call.
41 S. Hrg. 111-248,at 19.
42 Franklin Edwards, The Clearing Association in Futures Markets: Guarantor and Regulator, 3 The Journal of Futures Markets 369,
370 (Winter 1983).

10
Increased transparency and tracking of market transactions is another benefit of having a central clearinghouse. However,
any system-wide benefits that a clearinghouse provides, in terms of centralized private monitoring of amounts which
parties owe to each other, are probably eclipsed by Dodd-Frank’s separate statutory mandatory disclosure regime, so this
paper will not discuss the transparency benefits of central clearing in any detail.
§3: The “Central Role of [Central] Clearing”43
: Loss mutualization in past financial crises
2008 was not the first financial crisis in world history, nor will it be the last. Comparing the events of 2008 to other
financial crises illustrates how the loss mutualization function of centralclearing helps to contain systemic risk and
prevent contagion from spreading. This historical analysis supports the central argument of this paper, which is that loss
mutualization is the primary role of centralclearing during a financial crisis. Attempts to achieve other goals through
regulation – such as consumer protection or various equitable objectives – may conflict with central clearing’s ability to
serve that fundamental purpose, and should therefore be avoided.
Given that exactly 100 years separates them, it is interesting to note that the Panic of 1907 and the Financial Crisis of
2008 shared certain similar features. In both, the parts of the market which were centrally cleared – banks in 1907, trust
companies in Chicago in 1907, and futures in 2008 – were able to contain systemic risk due to the backstop guarantee
against counterparty default that access to a clearinghouse provided. However,in both, the non-cleared parts of the market
– OTC swaps in 2008, trust companies in New York in 1907 – suffered the worst runs. Loss mutualization played a role in
solving both crises: In 1907 a consortium of strong trusts mutualized the risk of loss posed by weak trusts to their
depositors, by guaranteeing the weak trusts’ debts, and in 2008 the US government arguably engaged in loss
mutualization by lending to AIG during a time when it was perceived that lending to AIG was extremely risky. The
burden of any losses to the government caused by AIG’s failure to pay the loans back would arguably have been
mutualized among US taxpayers. To be sure, this reasoning can be taken too far,because assumption of the risk of loss by
the government is structurally different from assumption of loss by private sector entities like a clearinghouse. However,
the basic principle remains that the two crises were each resolved through loss mutualization, and that the role played by
the US taxpayer in 2008 could have instead been played – theoretically – by a private sector swap clearinghouse, if one
had existed.
(a) Panic of 1907: The Loss Mutualization role of a private bank clearinghouse in a bank run
Futures and swaps are not the only markets where clearinghouses operate; there are also clearinghouses in securities (as
noted in §1) and in banking. Modern bank clearinghouses are different from futures clearinghouses in at least two
relevant ways: (1) modern bank clearinghouses do not become counterparties to contracts through novation; and (2)
modern bank clearinghouses do not guarantee contractual performance by, or insure against credit risk of, clearing
members.44
However, historical bank clearinghouses did provide bank depositors with a form of guarantee that the bank
itself would not fail during financial crises.45
The New York Clearinghouse Association in the Panic of 1907 illustrates the
nature of this institutional guarantee. Now,the FederalReserve – through the Fedwire payments system – does perform a
guarantee function against credit risk on a transaction-by-transaction basis.
The upshot is that the central function of clearinghouses – loss mutualization – is similar, whether the clearinghouse is a
bank or futures clearinghouse: “The mutualization of risk and losses in banking crisistimes is precisely the explicit role
43 See Clearing Requirement Determination Under §2(h) of the CEA, CFTC Final Rule, 77 F.R. 74284,74285 (Dec. 13, 2013)(Titleof
subpart(c) of partI)
44 Edwards, Guarantor and Regulator, at 370.
45 Kroszner, Can the Financial Markets Privately Regulate Risk, at 604.

11
that the futures clearing association fulfilled in normal times .” 46
However,the mechanism by which loss mutualization is
accomplished differs between bank clearinghouses and futures clearinghouses, and also differs within bank clearinghouses
over time. Futures clearinghouses use novation and guarantee performance of contracts on a transaction-by-transaction
basis, while bank clearinghouses never used novation as a mechanism for guarantee. Historical bank clearinghouses also
guaranteed its clearing members as a whole, on an institutional basis, rather than guaranteeing each institution’s individual
transactions only. Now the Fed guarantees both individual transaction performance through the Fedwire system, and –
arguably – guarantees the solvency of systemically important banks which are “too big to fail” on an institutional basis, as
well, at least in some circumstances (such as during a major financial crisis).
1. Development of Loss-Mutualizing Bank Clearinghouses before 1907
Between 1850 and 1915 there were twelve banking panics in the United States.47
Unlike today, there was no government-
run central bank which performed the function of a lender of last resort, nor was there government-provided deposit
insurance to eliminate the incentives of a bank’s depositors to withdraw their money during a bank run. Following a shock
– whether an adverse economic event, or another bank’s failure – anxious depositors in all banks feared that their bank
would suffer losses. In this context, a “loss” means that, for every $1 the depositor had deposited in the bank, the
depositor would receive assets worth less than $1 upon withdrawal.48
Given that depositors did not have information ex
ante about which banks (particularly their own) were undercapitalized or without adequate liquid assets, the result of a
financial shock would be to immediately provoke panicked depositors to seek to withdraw their funds from their
(currently solvent but potentially distressed in future) bank(s),49
or risk being left with nothing if others withdrew first and
the bank failed before they received their deposits back. If a run was triggered on one bank, then the depositors in the next
bank might come to fear – for good reason, or not –that their bank would force them to suffer losses as well. If such a
spiral continued, depositors might lose confidence in the safety of funds deposited at depository banks as a class. In this
way, contagion could spread to other banks, even if the banks to which the contagion spread were fundamentally solvent
and well-capitalized to begin with.50
Even if banks suffering contamination were fundamentally solvent, their assets might be held in an illiquid form (such as
in long-duration fixed term loans) that could not be easily converted to cash: under the “fractional reserve” system,a bank
only maintained cash reserves to cover a specified subset (less than 100%) of its aggregate potential depositor liabilities.
If 100% of its liabilities actually came due in an extremely short period of time – triggered by a bank run – and all 100%
had to be met with liquid assets,the bank would be unable to meet its obligations, even if it was fundamentally solvent,
and thus a mere liquidity crisis would transform into a solvency crisis.51
As a result, bank runs following financial shocks
were frequent,and their deleterious effects for all banks – a collective problem, not just an individual problem –began to
be recognized.
In response, the industry began to evolve mechanisms over time to deal with the problem of bank runs.52
The perception
of a common interest in avoiding depositor runs led banks during this period to seek an institutional solution that would
either solve the problem by preventing a failure of any bank, or – if that proved impossible – to keep the contagion from
46 Id. at607.
47 Gary Gorton, Private Clearinghouses and the Origins of Central Banking, Fed. Res. Bank of Philadelphia Bus.Rev., 5 (Jan.-Feb.
1984).
48 Gorton, at 5.
49 Id.
50 Id., at 8 (“Clearinghouseactivity duringpanicswas motivated by the recognition that, in the bankingindustry,the performance of
individual bankshad effects on other banks. If a bank failed duri nga panic or recession,depositors perceived other banks as possibly
insolvent,and a run on other banks could be sparked or exacerbated”).
51 Id, at5.
52 Id. at10.

12
spreading to other banks. This institutional solution was the clearinghouse. The clearinghouse’s mechanism for preventing
contagion for spreading is loss mutualization. As noted above, loss mutualization works by taking the liabilities of an
individual clearinghouse member and spreading those losses collectively among the other clearinghouse members. In
contemporary derivatives clearing, the loss mutualization mechanism is the clearinghouse’s guaranty fund. Before 1907,
the primary instrument used to accomplish loss mutualization was the clearinghouse loan certificate,along with a
clearinghouse’s commitment – or that of its strongest, most well-capitalized members – to guarantee that depositors in a
weak clearinghouse member bank would be fully repaid.
(A) First Loss Mutualization Mechanism: Clearinghouse Loan Certificates
Essentially, clearinghouse loan certificates were a means by which the credit of strong clearinghouse member banks could
be placed behind the liabilities of weak ones. A loan certificate represents a claim on the assets of the clearinghouse itself
backed by the assets of all of the clearinghouse’s members.53
In fact, some academic commentators have observed that the
level of integration was so high during 1907 that the New York Clearinghouse Association actually acted as if it were a
holding company, and each of its members a consolidated subsidiary. During the crisis, the clearinghouse would then
merge the balance sheets of all its member-subsidiaries, issuing a single consolidated accounting statement for all of them
together as if the clearinghouse were a holding company. Each liability issued by a member (subsidiary) was thus backed
by the holding company as a whole (the clearinghouse).54
(1) Benefits for Depositors
The use of clearinghouse loan certificates had benefits for both the recipients – depositors – as well as the member banks
themselves. For depositors, any danger that the depositor’s individual bank would pay out less than $1 for every $1 the
depositor was entitled to – exposure to an individual bank’s credit risk – was replaced by the superior credit risk posed by
all clearing member banks (and the clearinghouse itself) acting collectively, including banks with much stronger credit
and much larger financial resources than the depositor’s own bank.55
Any losses caused by an individual bank’s failure to
pay depositors would be mutualized and borne by all the other banks that were clearinghouse members, in proportion to
each member bank’s capital compared to the aggregate capital of all clearing member banks;56
only if all of these banks
simultaneously defaulted, would the depositors realize losses on the clearinghouse loan certificates. There was thus a
vastly lower risk that all of the clearinghouse’s members would default on their obligations collectively, than there was a
risk of a default by the depositor’s individual bank,57
making clearinghouse loan certificates far more valuable than an
individual bank’s promise to pay its own debt. As for liquidity, the loan certificates were as good as cash.
(2) Benefits of Clearinghouse Loan Certificates for Banks
(i) Improved Liquidity via Issuance of Clearinghouse Loan Certificates
53 Id. at6 (“loan certificates were the jointliability of clearingmember banks”)
54 Kroszner, Can the Financial Markets Privately Regulate Risk, at 607 (“The actions by the bank clearinghousein panic times thus
was very similar to the mutualization of risk… in the futures markets. During distress,the[clearinghouse] temporarily “merged” the
member banks and issued obligationsfor which the members were jointly liable….The [clearinghouse] acted as the holding
company that reported a “consolidated”balancesheet for its subsidiaries and issued obligationsof the holdingcompany, not of
individual subsidiaries”)
55 Gorton, at 8 (“Since the money issued by clearinghouses was the jointliability of all themember banks,individual depositors were
insured againstindividual bank failures.Therisk that an individual bank would be unableto a dollar of gold for a dollar in its checking
accounts was reduced sincethe loan certificatewas a claimon all thebanks in the clearinghouse”)
56 Id at 6.
57 Id. at8 (“Clearinghousemoney was acceptableto depositors becauseitwas a claimon the association of banks,notjuston a
singlebank,insuringthem againstindividual bank failure”).

13
For banks, the benefit was that the liquidity crunch triggered by a depositor run would be largely alleviated upon receiving
the loan certificates and using them to pay any liabilities – such as demands by depositors – that required liquid cash. The
banks would “temporarily” sell illiquid assets to other clearing member banks, who would pay for the illiquid assets using
the liquid clearinghouse loan certificates.58
Initially, clearinghouse members used the loan certificates to settle obligations
only between themselves, where the certificates took the place of gold or cash, but would not pay depositors or the public
using loan certificates. Instead, the clearinghouse members would use clearinghouse certificates to transact with each
other (instead of cash),and then use their scarce cash to pay out to their withdrawing depositors. This alleviating the
liquidity problems created by a bank run, and was how the first clearinghouse loan certificates were employed in the Panic
of 1857 – internally, as currency used in dealings between two banks, in order to save gold and cash to pay to depositors.59
However,the clearinghouse member banks eventually began to use the certificates – instead of cash – to pay out to their
withdrawing depositors and the public in general during runs, starting with the Panic of 1873.60
Because of the improved
credit risk the certificates represented compared to the credit of an individual bank potentially subject to a run, depositors
were willing to accept them freely.
(B) Second Loss Mutualization Mechanism: Clearinghouse Direct Guarantees of Member Banks
In addition to issuing clearinghouse loan certificates, the clearinghouse could simply guarantee the debts of weaker
members in danger of insolvency or facing a liquidity crisis. This method directly mutualizes the risk of loss by placing
the assets of its stronger members behind the liabilities of its weaker members. Any losses caused by weaker members’
financial distress will be borne by other clearinghouse members, not by depositors and not by creditors.61
This method of
loss mutualization is exemplified by the New York Clearinghouse Association’s promise to guarantee all liabilities
belonging to a member called Mercantile National Bank.
2. Benefits of Loss Mutualization in 1907: Clearinghouse member banks able to halt runs and restore
Depositor Confidence Early, while uncleared Trust Companies suffered the worst runs
The Panic of 1907 was triggered by events revolving around two men named Augustus Heinze and C.F. Morse. Heinze
and Morse were both large scale speculators, as well as owners of both banks and trusts. Heinze personally controlled
banks possessing over 3.5% of the total aggregate assets of all New York banks combined,62
and was on the boards of
eight different banks and two trusts.63
Morse himself was on the board of directors of seven New York banks, and wholly
controlled three of them.64
Together, they attempted to corner the market in the stock of a company called United Copper,
in pursuit of which they invested a massive amount of resources. When the stock corner attempt failed, they lost all of
their invested capital.65
Depositors in banks they controlled feared that the losses incurred by Heinze and Morse on their
corner attempt would deplete the financial resources of banks they controlled, forcing those banks to return less than $1 of
58 Id.
59 Gorton at 5.
60 Id. at7.
61 Ellis Tallman and Jon Moen, Clearinghouse Access and Bank Runs: Comparing New York and Chicago during the Panic of 1907, Fed.
Res. Bank of Atlanta, WorkingPaper No. 95-9, at6 (Oct. 1995)(“the local clearinghouse..would take into accountthe potential loss
of [illiquid long-duration term] loans [which would be] imposed on the clearinghouseif thestricken bank [which had made the term
loans] eventually failed”)
62 Ellis Tallman and Jon Moen, Lessons from the Panic of 1907, Fed. Res. Bank of Atlanta Econ. Rev., at 4 (May 1990)(Heinze
controlled banks who in turn controlled $71 million in assets,which was 3.5%of the total aggregate New York bank assets at the
time of $2 billion).
63 Id. at5.
64 Id. at4.
65 Id. at5.

14
cash or gold to depositors for each $1 the depositors had previously placed with the bank. This triggered a depositor run
on a bank affiliated with Heinze and Morse called the Mercantile National Bank.
However,because Mercantile National was a member of the New York Clearinghouse Association – and the
clearinghouse publicly announced that it would guarantee all of Mercantile National’s liabilities – the run on Mercantile
National was stopped. The clearinghouse issued a total of $110 million in clearinghouse loan certificates to its bank
members during the Panic; in a parallel to 2008, the US Treasury contributed $37.6 million in cash to the national banks
as well.66
The replacement, through loss mutualization, of individual weak banks’ credit risk with the credit risk of all
clearinghouse members collectively – including much stronger, better-capitalized banks – restored market confidence in
the liquidity and solvency of most banks, and no large clearinghouse member banks failed.67
3. Runs on Non-Clearinghouse-Member Trusts Eventually Halted By Formation of Loss
Mutualizing Clearinghouse-like Trust “Consortium”
Unfortunately, instead of stopping the panic entirely, the run merely switched from the banking sector to the trusts sector,
where depositors’ en masse withdrawals from their accounts deposited at trusts created severe liquidity problems. As
demonstrated by Mercantile National Bank – which was a New York Clearinghouse Association member bank –
clearinghouse membership could, through mutualizing loss, restore the confidence of depositors in a failing firm and halt
a run. However,while most New York banks were members of the clearinghouse, the vast majority of New York trusts –
the hedge funds of the early 20th
century – were not. Trusts gained popularity as an investment vehicle due to their
advantages over the state-chartered or nationally-chartered bank entity in terms of regulation– like hedge funds, trusts
were able to evade numerous regulatory requirements applicable to regulated banks.68
Most importantly, while trusts were
depository institutions just like banks, trusts could also engage in risky investment activity – such as owning realestate
and securities – which regulated banks were prohibited from doing.69
Also, lower regulatory capital requirements applied
to trusts compared to banks.70
However,the cost of these deregulatory advantages was that when New York trusts tried to join the New York
Clearinghouse Association (made up primarily of regulated banks), the clearinghouse adopted rules requiring trusts to
conform to the same – higher – standards regarding capital and reserves that banks had to meet: “in 1904 the national
banks were successfulin persuading the [clearinghouse] to pass a rule that required all members [including trusts] to hold
as much reserves as the national bank members.” Apparently, most trusts felt that it was better to stay out of the
clearinghouse rather than comply with these more onerous regulatory requirements: “the trust companies… responded by
ending their membership in the [clearinghouse].”71
During the Panic of 1907, New York trust companies thus were not
clearinghouse members and did not have access to the loss mutualization mechanisms – like clearinghouse loan
certificates and joint guarantees of weak members’ debts – which had stopped the run on Mercantile National Bank:
“trusts’… ambiguous relationship to the New York Clearinghouse signaled to [trust] depositors that that the trusts were
likely to become insolvent during an economic and financial downturn.”72
Since trust companies took deposits from depositors, spooked depositors began to make runs on the trusts starting in late
66 Tallman and Moen, Lessons from the Panic of 1907, at8.
68 Id., at 11.
69 Tallman and Moen, Comparing New York and Chicago in the Panic of 1907, at 4.
70 Id.
71 Jason Buol, A Comparison of Clearinghouse Associations During the Panic of 1907,University of Missouri-St.Louis eReview of
Economics,at 6 (Fall 2002),availableonlineat http://www.umsl.edu/~nabe/buol1.pdf
72 Tallman and Moen, Lessons from the Panic of 1907, at11 (“The trusts,therefore, had an assetportfolio that may have been riskier
than those of other intermediaries”)

15
October 1907. The first trust company to be subject to a depositor run was a trust associated with Augustus Heinze called
the Knickerbocker Trust, shortly after Heinze’s corner attempt failed and worries about the solvency of enterprises
affiliated with him were at their highest.73
Amid mounting depositor demands, the Knickerbocker Trust desperately
begged for help from the New York Clearinghouse Association, even though it was not a member. Like the federal
government’s position toward Lehman Brothers in September 2008, the clearinghouse refused to help Knickerbocker.
However,Knickerbocker did not go bankrupt immediately, but rather suspended convertibility of its depositors’ deposits
into cash. While Knickedbocker survived, the run on trusts continued, spreading to one of the largest – Trust Company of
America – which shared management in common with the Knickerbocker Trust (and by extension, may have been
exposed to losses arising from Heinze’s failed cornering attempt).74
Ultimately, the New York Clearinghouse Association (made up almost exclusively of regulated banks) was forced to bail
out their underregulated, improvident cousins – the trusts – by both injections of liquid assets and guaranteeing the
liabilities of individual trusts, in order to prevent a wave of trust company failures that would likely trigger runs on the
banking industry as well.75
In addition to the fear of trust company failures constituting a financial shock that might send
depositors fleeing from all depository institutions (trusts and banks) indiscriminately, the clearinghouse also feared that
‘fire sales’ of trust company assets would devalue the assets being sold as a class, and that would harm the many banks
who owned the same types of assets as the trusts did.76
Thus, the banks and the New York Clearinghouse Association –
spurned by trusts so that trusts could invest in riskier assets and be subject to lower capital requirements than banks – had
no choice but to bail out the major trust companies.77
In addition, wealthy private individuals helped recapitalize the trusts – like Warren Buffet’s loan to Goldman Sachs
during the 2008 crisis, Standard Oil head J.D. Rockefeller contributed $10 million to the Union Trust.78
The US
government actually ran out of money to bail the trusts out with (as they had already bailed out the banks), so the majority
of the rescue funds came from other trust companies.79
In an archetypical example of loss mutualization in action, stronger
trust companies (or those not themselves subject to runs, such as companies that were entirely unaffiliated with Heinze
and Morton) organized themselves into an informal clearinghouse-type institution and bailed out the weaker ones,or those
subject to runs.80
This institution – called a “consortium” – finally restored depositor confidence in the solvency and
liquidity of trusts.81
4. Trusts that were clearinghouse members in Chicago suffered less runs, while Trusts that were
not clearinghouse members in New York suffered more (and worse) runs
In New York, the basic difference between banks and trusts during the Panic of 1907 was that trusts did not have access to
clearinghouse loss mutualization, until (at the end of the crisis) the trusts finally formed a clearinghouse-like collective
institution called the “consortium”. The result of trusts’ lack of access to a clearinghouse is that “the most severe runs in
73 Id, at7.
75 Tallman and Moen, Comparing New York and Chicago During the Panic of 1907,at 8 (“When the trust panic became widespread
and appeared to threaten the banks… the clearinghouseorganized mechanisms to supply liquidity to the trust companies”).
76 Tallman and Moen, Lessons, at12 (“Runs forced trusts to liquidatetheir most liquid assets,call loanson the stock market…
extensive liquidation of call loans by the trusts threatened the assets of national banks”)(emphasis added).
77 Id. (“It was because national banks and the clearinghousewere awarethat the runs on the trusts could spread to the entire
financial systemthat they acted to stop the runs” on trusts)
78 Id. at8.
79 Id. (“The US Treasury’s workingcapital had dwindled to $5 million… the Treasury could not, and did not, contribute much more
aid”)
80 Id.
81 Id. at11 (“The panic began to ease when the trust company presidents organized… [and] agreed to form a consortiumto support
the trust companies facingruns”)

16
New York City were limited to the trusts”,82
not to clearing member banks. The determining factor for whether depositors
would feel the need to remove their funds from depository institutions during 1907 was therefore the presence,or absence,
of the institution’s membership in a loss mutualization arrangement that would back weaker members’ liabilities with the
resources of stronger ones.83
This also holds true across cities. A study which compared the effects of the 1907 Panic in
two cities – New York and Chicago – confirms that access to a centralclearinghouse prevented runs being made, and that
the lack of access to a clearinghouse itself caused runs:84
“the most important difference between the trusts in Chicago and
New York was the relationship of trust companies to their respective clearinghouses.”85
In New York, where trusts were not clearinghouse members, they were subject to runs, whereas banks – who were
clearinghouse members – were not (at least, after Mercantile National’s rescue by the clearinghouse). However,in
Chicago – where,unlike New York, the trusts were members of the Chicago clearinghouse and had access to its loss
mutualization function during the Panic86
– the empirical evidence confirmed that there was no difference in depositor
withdrawal rate between banks and trusts, because both institutions there had access to centralclearing: “there was no
large-scale withdrawal of deposits from Chicago trust companies and no obvious difference between the treatment of
trusts and national banks in Chicago by depositors.”87
Thus, the Panic of 1907 demonstrates that clearinghouse
membership – the most important benefit of which is loss mutualization – is the independent variable on which depositor
confidence in a bank run depends.
5. Differences between Bank Clearinghouses in 1907 and Modern Derivatives Clearinghouses
The main difference between bank clearinghouses in 1907 and contemporary clearinghouses for derivatives is that
historical bank clearinghouses did not protect against credit risk on a transaction-by-transaction basis. Instead,the old
bank clearinghouses guaranteed the liabilities of a member at the entity level – credit risk on each individual transaction
was eliminated because the clearinghouse would ensure that the entity making the transaction remained solvent, and not
because the transaction itself was guaranteed by the clearinghouse. This is different from the way a contemporary
derivatives clearinghouse works: the clearinghouse does not guarantee derivatives counterparties against the insolvency of
a clearinghouse member at the entity level. In modern conditions, clearinghouse members can,and do, go bankrupt, as
Lehman Brothers’ bankruptcy – despite the existence of its cleared futures contracts – illustrates; a modern clearinghouse
does not guarantee the entity’s solvency or continued existence. If it did, then any clearinghouse on which Lehman
Brothers had open futures contracts would have bailed Lehman Brothers out like the New York Clearinghouse did for
banks and trusts in 1907. Instead, a contemporary derivatives clearinghouse guarantees only that the individual derivative
contract will be completed, regardless of what happens to the entity making the contract. A counterparty to a cleared
derivatives contract may go bankrupt, but the clearinghouse will ensure that the other party gets paid on the contract (but
the clearinghouse will not do anything more).88
(b) The Financial Crisis in 2008: ABSENCE of Loss Mutualization due to lack of OTC Swap clearinghouse
82 Id. (“The probability thata New York trust would run out of reserves was significantly higher than the probability thata bank…
with direct access to the New York City Clearinghousewould run out of reserves”)
83 Tallman and Moen, Comparing New York and Chicago During the Panic of 1907, at 1.
84 Id. (“Members of clearinghouseassociations,with potential access to the pool of liquidity under clearinghousecontrol,would be
less likely to be subjectto panic-induced runs… nonmember[s]… would be more likely candidates for runs”)
85 Id. at6.
86 Tallman and Moen, Comparing New York and Chicago during the Panic of 1907,at 1.
87 Id. at6.
88 See infra §4(a) for an analysis of the effects on incentives facingmarket participantswhen the government bails outan entity –
preservingthe bailoutrecipient’s continued existence – compared to when a clearinghousecures the entity’s defaults on a
transaction-by-transaction basis(after lettingthe defaultingclearingmember go bankrupt).

17
In both the Panic of 1907 and the 2008 Financial Crisis, crisis hit hardest in those parts of the financial system that did not
have access to organized loss mutualization mechanisms. Both the New York trust companies in 1907 and the OTC swap
market in 2008 were not centrally cleared (although Chicago trusts were clearinghouse members, which is why Chicago
trusts avoided runs). It is therefore probably not entirely coincidental that the trust companies (in New York) experienced
the most severe runs in 1907, or that market fears about the solvency of financial institutions with large uncleared OTC
swap exposures (e.g., AIG) drove those institutions to fail (or come close) in 2008. By contrast,due to the backstop
guarantee against counterparty default that clearinghouses provided, the centrally cleared portions of the market – banks
in 1907, futures and cleared OTC swaps in 2008 (including Lehman’s cleared OTC swaps)89
– were able to contain the
systemic risk they posed and ultimately restore depositor/counterparty (respectively) confidence, compared to the non-
cleared markets.
Furthermore, the way the crises were ultimately resolved in 1907 and 2008– by mutualizing the losses through guarantee
of struggling firms as a whole rather than on a mere transaction-by-transaction basis (the current approach to loss
mutualization by private clearinghouses in 2015) – was the same. In both 1907 and 2008, the choice was made to keep the
struggling firm in business rather than to allow the firms to fail, but to have a clearinghouse cover each of the firm’s
individual contractual exposures on a transaction-by-transaction basis, using the clearinghouse’s guaranty fund. In 1907,
the New York Clearinghouse Association issued clearinghouse loan certificates to weak banks, backed by the credit of
strong banks and the clearinghouse itself, to meet depositor redemption requests. Weak New York trusts – like the
Knickerbocker Trust and the Trust Company of America—had their risk of losses mutualized among a consortium of
strong trusts, who provided them with massive loans and capital injections – thereby keeping them in business, rather than
allowing them to fail. Further financial support for keeping struggling trusts solvent – rather than allowing them to go
bankrupt, but curing their defaults on a transaction-by-transaction basis (the modern approach to centralclearing) – came
from the (bank) clearinghouse.
In 2008, the US government – a very creditworthy party – made loans to AIGdespite the material possibility that AIG’s
market losses on CDSs and CDOs might render AIGunable to pay the government back. The placing of a strong
institution’s credit behind the credit of a weak one, and sharing any losses caused by the potential default of the weaker
party – mutualizing the risk of loss – is a function that could have been performed by a private clearinghouse rather than
by the government. That idea, of course,animates the centralclearing reforms contained in the Dodd-Frank Act,90
although there are other important components of the Dodd-Frank reforms beyond centralclearing. However,if a private
clearinghouse had in fact cleared AIG’s swap contracts,then – when AIGwas facing default – the private clearinghouse
would have allowed AIG to go bankrupt. Then,on a transaction-by-transaction basis, the private clearinghouse would use
its own guaranty fund pool to pay in full each of AIG’s counterparties. The differing effect on the incentives facing
market participants will be discussed in detail below.91
This section will analyze the 2008 financial crisis. It will discuss, first, credit risk mechanisms other than central clearing
which were used in the OTC swap market before 2008. It will then discuss why these mechanisms were inadequate, and
why and how they failed in 2008. Second, it will briefly examine AIG’s role during the financial crisis, showing why the
lack of both ex ante margin requirements and a loss mutualization mechanism (such as clearinghouse membership) for
89 Gregory, at 4 (“In contrastto OTC derivatives,the derivatives market that was cleared via central counterparties (CCPs)… wa s
much more stableduringthe [crisis]… CCPs such as LCH.Clearnet coped well with the Lehman bankruptcy…CCPs… were able… to
transfer or closeout a largevolume of Lehman derivatives positions withoutmajor issues… centrally cleared OTC derivatives were
seemingly much safer than their bilateral equivalents”)(emphasis added).
90See Clearing Requirement Determination Under §2(h) of the CEA, CFTC Final Rule, 77 F.R. 74284,74285 (Dec. 13, 2013)( “Clearingis
at the heart of the Dodd Frank financial reform”)
91 See infra §3(b)2(ii).

18
AIG’s OTC swap positions proved disastrous. In this way, the 2008 crisis resembles the run on non-clearinghouse-
member trusts in the Panic of 1907.
1. Pre-2008 methods for addressing credit risk: Dealing with losses WITHOUT mutualizing them
First, it is critical to note that there are other ways to deal with financial crisis-driven losses other than by mutualizing
them between the members of a clearinghouse. There is a tendency to read history backwards: because Congress
ultimately chose the loss mutualization mechanism of clearinghouses as the primary (although not exclusive) solution to
systemic credit risk arising in previously-OTC swap markets, it can seem like mutualizing losses through a clearinghouse
is the only possible solution to credit risk. In reality, interposition of a centralcounterparty is but one of a menu of choices
to deal with derivatives counterparty non-performance. However,the problem with some of these other solutions is that
they failed to perform during the crisis. Since they did not work during the crisis while central clearing did, an inference
that centralclearing is a superior solution to systemic risk presents itself. This section will briefly discuss these other
mechanisms, and why and how they failed.
Three pre-crisis methods of dealing with risks of losses due to bilateral counterparty non-performance – other than by
mutualizing the loss – are (i) Special Purpose Vehicles and Derivatives Product Companies, (ii) Lines of credit, and (iii)
contracting with seemingly large and well-capitalized financial institution counterparties only, among many others.
(i) Special Purpose Vehicles (SPVs) and Derivatives Product Companies (DPCs)
In the pre-crisis OTC swap market, one way of dealing with credit risk other than a loss mutualization scheme such as
clearinghouse membership was the creation of Special Purpose Vehicles (SPV) or Derivatives Product Company (DPC)
subsidiaries by swap counterparties (parents). The purpose of a parent corporation creating SPVs and DPCs was to reduce
credit risk to swap counterparties of the parent, and to insulate the counterparties from loss if the parent went bankrupt. If
the parent went bankrupt, the idea was that the SPV or DPC was supposed to remain unaffected. Because the SPV is
supposed to be unaffected by the bankruptcy of its parent, the counterparty will get paid by the SPV/DPC in full the
amounts due under the swap, even if the SPV’s parent goes bankrupt. Because of this supposed insulation from its
corporate parent’s bankruptcy, the credit rating of the SPV will be AAA (very high), whereas the credit rating of the
parent will be lower.92
Thus, in theory, the use of a bankruptcy remote subsidiary SPV or DPC may lead to a major
reduction in credit risk for the SPV’s counterparty, compared to the credit risk the counterparty would face if it directly
contracted with the parent.
Unfortunately, in practice,it did not work out that way, because courts (for instance in the case of Lehman Brothers’
SPVs) treated the parent and the SPV-subsidiary as part of a single integrated enterprise. When the parent declared
bankruptcy, the supposedly-bankruptcy-remote subsidiary was also treated as being bankrupt, and the subsidiary’s assets
were used to satisfy the parent’s debts. Because the higher-rated subsidiary actually has no protection from its parent’s
creditors if the parent goes bankrupt, the SPV/DPC mechanism does not reduce credit risk at all.93
DPCs and SPVs
therefore do not represent a viable alternative to loss mutualization in solving the problem of counterparty credit risk in
derivatives contracts.94
(ii) Entering swaps only with large and well-capitalized financial institutions as counterparties
92 Gregory at 21.
93 See, e.g., Fitch withdraws Citi Swapco’s ratings,Reuters (Jun. 10, 2011),(“Fitch no longer rates any derivativeproductcompanies
[separately from their parent corporation ]”) availableonlineat http://www.reuters.com/article/2011/06/10/idUS187780+10-Jun-
2011+BW20110610
94 See Gregory at23 (“the GFC [Great Financial Crisis] essentially killed an already decliningworld of DPCs.”)

19
Pre-crisis, entering swaps with large and well-capitalized counterparties was thought to be a way that counterparty credit
risk could be overcome:95
“counterparties were willing to pay AIGFP a higher premium for protection because of [parent]
AIG’s guarantee than they were willing to pay for the same protection from a seller with a lower credit rating [or] lesser
balance sheet”.96
This did not protect Lehman Brothers’ counterparties, nor AIG’s counterparties, during the crisis. Also,
if fire sales of assets, and government bail outs, of Merrill Lynch, Citigroup, and other large financial institutions with
swap dealing subsidiaries had not been arranged, these institutions would have collapsed like Lehman and AIG. Thus,
entering swap contracts only with large financial institutions as counterparties does not protect against credit risk, and
therefore does not represent a viable alternative to loss mutualization.
2. Problems caused by the lack of central clearing: The AIG Case
This section will not conduct a descriptive survey of the events of the financial crisis. Rather, it will analyze AIG’s near-
collapse and subsequent $180 billion government bailout for the purpose of demonstrating that the lack of an effective
clearinghouse-like loss mutualization mechanism in the OTC swap markets exacerbated the severity of the crisis.
(i) Why This Paper Does Not Discuss Lehman Brothers
Lehman Brothers failed due to a combination of its reliance on short-term financing (such as “repo” lending) and bad
investments in real estate and mortgage securities (which caused the short-term financing to dry up in the first place).97
Unlike AIG, whose derivatives exposure caused the firm to fail, Lehman Brothers’ derivatives contracts did not cause its
failure.98
At $35 trillion in gross notional value,99
Lehman’s derivatives positions seemed large, but – unlike AIG –
Lehman had bets going both ways,some of which were in the money (positive net worth of $21 billion), and some out of
the money (totaling $45 billion in liabilities payable).100
By contrast, AIG’s directional one-way CDS bets on residential
real estate,multi-sector CDOs (where realestate might be one underlying class of asset on which the CDO was built)
whose gross notional amount was only $227 billion,101
almost universally were out-of-the-money against AIG,meaning
AIG was losing money and had to pay the counterparty on almost every one of them. Also,although the vast majority
(96%) of Lehman’s derivatives were OTC rather than exchange-traded,102
nevertheless a significant amount of Lehman’s
OTC exposure was centrally cleared – such as $9 trillion of OTC interest rate swaps that were centrally cleared by
LCH.Clearnet (notwithstanding that they were traded off-exchange),and which were generally terminated by their
95 Nathan Blair and Maureen McNichols, AIG– Blame for the Bailout, Stan. Grad. Sch. Bus. CaseA-203, at 4 (March 12, 2009)
(“counterparty risk [was] a significantconcern among players in the [CDS] market; hence AIG, with its AAA rating,made for a n
attractivetradingpartner”)
96WilliamSjostrom, The AIG Bailout, 66 Wash.& Lee L. Rev. 943,958 (Nov. 2009).
97 Kimberly Anne Summe, “Chapter 5: Lessons Learned From the Lehman Bankruptcy”, ENDING GOVERNMENT BAILOUTS AS WE
KNOW THEM, Kenneth Scott, George Shultz, John Taylor,eds. (Palo Alto, CA: Hoover Institution Press,Stanford University,201 0),at
81, availableonlineat
<http://media.hoover.org/sites/default/files/documents/Ending_Government_Bailouts_as_We_Know_Them_59.pdf >
98 Rosalind Wigginsand Andrew Metrick, The Lehman Brothers Bankruptcy: The Special Case of Derivatives, Yale Program on
Financial Stability CaseStudy 2014-3G-V1, at1 (Oct. 1, 2014),availableonlineat
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2593080
99 Id. (“Lehman Brothers did not fail becauseof losses experienced in its derivativeportfolio”)
100 Michael Flemingand Asani Sarkar, TheFailure Resolution of Lehman Brothers, 20 Econ. Policy Rev. 175, at 184 (No.2, Dec. 2014),
availableonlineathttp://www.ny.frb.org/research/epr/2014/1412flem.html
101 Sjostromat 955. The $227 billion figureis computed by addingAIG’s residential mortgage CDS exposure ($149 billion) to AIG’s
multi-sector CDO exposure ($78 billion).Many AIG multi-sector CDOs contained real estate assets as oneof the underlyingasset
classeson which the CDO was built.
102 Fleming and Sarkar,Failure Resolution of Lehman Brothers, at 184..

20
respective clearinghouses without major problems.103
Thus, in general, Lehman Brothers’ derivatives exposures were not
systemically significant in the way AIG’s were,so this paper will not discuss Lehman Brothers’ failure in detail.
(ii) AIG
(1) Narrative of AIG’s downfall
The story of AIG’s downfall is well-known. Believing certain events were extremely unlikely to occur, an insurance
company provided insurance against them without making any provision to meet its liabilities if the events did, in fact,
occur. When the unlikely events occurred, the uncollateralized liabilities they created destroyed the insurance provider
(AIG). AIG’s insurance-like Credit Default Swaps (CDS) promised payments, by AIG, to the CDS counterparty, in the
event that a reference entity defaulted on a payment or obligation, or went bankrupt. If the reference entity in fact did not
go bankrupt, the counterparty would pay AIG a fee similar to an insurance premium.104
AIG came to insure (via CDS) large numbers of residential Mortgage Backed Securities (MBSs), as well as Collateralized
Debt Obligations (CDOs) built using MBSs as a foundation.105
If the assets underlying an MBS – mortgages – started to
default on their payment obligations, then AIG, playing its role as an insurer, would have to compensate the party to
whom the defaulted MBS payment was owed. However,if the underlying assets did not default, then AIG would keep the
premiums, which were described by one AIG executive as “free money”.106
Gross notional amounts that AIG essentially
insured came out to over $500 billion in 2007, 107
though it decreased to $377 billion as of September 30, 2008108
(when
AIG failed and had to be rescued).
Because AIG had a AAA credit rating, swap counterparties allowed AIG to avoid posting any initial margin to secure its
future performance. This lack of initial margin posting meant that, for as long as it retained its high credit rating, AIG
could enter CDSs and provide protection against MBS default without preparing for the possibility that it would have to
pay anything if the MBSs did, in fact,default.109
As for variation margin,there were two main procedures: (1) adverse
market movements would require AIG to post the difference between the CDO’s current market value and the reference
notional amount established at contract formation;110
or (2) no variation margin was required to be posted at all, despite
adverse market movements, unless AIG itself suffered a credit downgrade.111
Under the first margin system, AIG had to
post progressively increasing amounts of collateral as CDO market values decreased (“pay as you go”), while under the
103 Gregory at 42.
104 AIG’s CDSs were made with some parties who owned the underlyingdebt assetand needed to hedge the risk of defaulton the
underlyingdebt asset.However, AIG also entered CDSs with numerous speculativeparties who did not own the underlyingasset –
“naked” CDSs – and who were merely speculatingon future pricechanges.
105 There are 3 steps to an ABS, of which an MBS is a sub-species:(1) An SPV is setup, and issues –sells –its bonds to investors;(2)
SPV uses the proceeds of bond saleto purchasefinancial assets (if an MBS, mortgages) from someone (if an MBS, the mortgage
originator);(3) SPV uses future income stream from the assets to pay the interest and principal on the bonds. A CDO is an ABS issued
by an SPV whose underlyingassetpool consistsof other ABSs; thus, a CDO is an ABS made up of ABSs. The CDO’s SPV would
purchasebonds issued by the original ABS-issuingSPV,and the purchasingCDO SPV would then issuebonds of its own. AIG insured a
lot of single-sector CDOs whose underlyingassetwas MBSs (mortgage-sector CDOs) only; but AIG also insured multi-sector CDOs,
where the ABSs included both MBSs (mortgage-based ABS) and other types of ABS (student loan ABSs, car loan ABSs) in the same
asset pool (owned by a singleSPV).
106 Sjostromat 958.
107 Sjostromat 955.
108 American International Group 10-Q Filing,Filed 11/10/2008,coveringperiod ending9/30/2008,at 114, availableonlineat
http://www.sec.gov/Archives/edgar/data/5272/000095012308014821/y72212e10vq.htm (hereafter “AIG 10-Q”)
109 Rena Miller,The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives, Congressional Research
Service Report (Nov. 6, 2012),at 7-8.
110 Sjostromat 960.
111 Gregory, Central Counterparties, at 25.

21
second system AIG would post no margin at all until downgraded, at which point it would have to post a large amount.
Thus, in the latter contracts,AIG posted no margin at all – neitherinitial nor variation – until it received a credit
downgrade, when it had to post a large amount.
The story’s ending is familiar. Once the bubble in the residential housing market burst, mortgagors started defaulting on
their mortgages. Their default on their underlying mortgages caused defaults by MBS-issuing SPVs. Defaults on MBS
payments triggered AIG’s payment obligations on its CDSs that were written on the MBS issuers.112
AIG’s SEC filings
state that the “principal caus[e] of the liquidity strain were […] collateral calls on AIGFP’s […] credit default swap
portfolio.”113
In August 2008, AIG had already posted $19.7 billion of collateral.114
However,the credit downgrade on
September 15 triggered $20 billion of additional margin call liabilities.115
By September 30, AIGwas required to post $32
billion more margin on its swaps portfolio,116
which it did not have. This drove it to the brink of default and bankruptcy.
Ultimately, AIG was rescued by the US government. As of December 31, 2008, AIG borrowed $47 billion from the Fed
specifically to meet margin calls on its CDS portfolio.117
Between September 8 and September 16, the stock price declined
from $22.76118
to $3.75 per share.119
(2) Effect of Government’s Preservation of AIGas a Going Concern on Incentives
Facing Other Market Participants
The method adopted by the government to rescue AIG is an example of loss mutualization. Private sources of capital
deemed AIG too risky to lend to at any interest rate,and AIGwas completely frozen out of the capital markets.120
The
government made a loan to a potentially-insolvent AIG, and this loan allowed AIG to pay its swap counterparties the
margin it owed. Instead of guaranteeing to AIG’s counterparties that AIG would perform its obligations, swap-by-swap –
a transaction-by-transaction approach – the government prevented AIG the entity from becoming insolvent by loaning
money to it (an institutional guarantee). In so doing it shouldered the risk of loss that a potentially insolvent AIG would be
unable to pay it back, a loss that otherwise would have been borne by AIG itself (resulting in its bankruptcy) and by
AIG’s private creditors.
The government would not allow AIG as an institution to become insolvent – it guaranteed AIG as a firm. However,if a
private clearinghouse had cleared AIG’s contracts,the result would have been very different – the clearinghouse would
have allowed AIG the institution to fail and go bankrupt. It is irrelevant to a clearinghouse whether a clearing member (as
AIG would have been) goes out of business; the only thing that matters is that AIG’s counterparties receive the benefit of
their contractualarrangement. A clearinghouse guarantees that AIGwould perform on a transaction-by-transaction,
contract-by-contract basis. After AIG failed, the clearinghouse would use the guaranty fund contributions of its clearing
members to cure the defaults on each contract left by the bankrupt AIG. Again, the clearinghouse only guaranteed AIG’s
swap contracts (transaction-by-transaction guarantee) and did not guarantee the solvency of AIG as a whole (institutional
guarantee). The government’s choice to guarantee AIG’s solvency and continuing existence as a firm is clearly worse,
from the point of view of market incentives, than if a private clearinghouse had allowed AIG as a firm to fail, and
112 Sjostromat 960.
113 American International Group SEC 10-K Filing,filed 3/2/2009,coveringperiod ending 12/31/2008,at40, availableonlineat
http://www.sec.gov/Archives/edgar/data/5272/000095012309003734/y74794e10vk.htm#111 (hereafter “AIG 10-K”)
114 Id.
115 Sjostromat 962.
116 AIG 10-Q at 56.
117 AIG 10-K at 45.
118 AIG 10-Q at 50.
119 Sjostromat 968.
120 Sjostromat 962.

22
thereafter satisfied AIG’s liabilities to counterparties on a contract-by-contract basis. The clearinghouse’s curing of AIG’s
defaults on its individual transactions only occurs after AIG the entity goes out of business. Therefore,other market
participants contemplating default face very different – arguably more healthy – incentives when they are exposed to the
possibility they may as a firm go out of business, than when their continued existence as a firm is guaranteed.
§4: Will Dodd Frank reduce Systemic Risk?
This section will examine two areas of the Dodd-Frank reforms and related CFTC rulemakings in order to see whether
they promote loss mutualization, and – in a more fundamental way – whether they would have stopped AIG’s failure had
they been in place ex ante during 2008.
(a) Dodd Frank’s Central Clearing Rules Would Not Have Applied to AIG’s Non-Standardized CDSs,But Both
Uncleared Margin Requirements and AIG’s Being Required To Register As A Swap Dealer Would Have
In considering whether Dodd-Frank’s reforms – had they been in place beforehand – would have prevented AIG’s
amassing the vast uncollateralized swap exposures that caused its systemically-significant failure, there are 3 moving
parts. First, there is Dodd-Frank’s central clearing requirement for swaps. Second, there is Dodd-Frank’s uncleared swap
margin requirements. Both of these apply at the product level, on a transaction-by-transaction basis. Third, there is Dodd-
Frank’s new Swap Dealer registration requirement. The registration requirement attaches at the entity level, applying to
the firm as a whole.
1. Because AIG’s CDSs were Non-Standardized, They Would Have Not Have Been Required To Be
Centrally Cleared
Section 723 of the Dodd-Frank Act, codified in 7 U.S.C. §2(h),makes it unlawful for a person to enter a swap unless the
swap is cleared, if the CFTC determines that the swap must be cleared. However,clearinghouses retain ultimate authority
over whether or not a swap should be centrally cleared. The CFTC is prohibited from forcing a clearinghouse to clear a
swap.121
The CFTC’s mandatory clearing determinations have not all been completed at the present time, although
eventually it is envisioned that most swaps will be centrally cleared.122
In considering whether or not a swap should be
subject to mandatory centralclearing, the following factors are statutorily required to be taken into account: (1) large
notional amounts, liquidity, and pricing data, (2) capacity and operational expertise, (3) effect on mitigation of systemic
risk (size of market and resources of DCO),(4) effect on competition, and (5) the existence of legal certainty in the event
of insolvency of the DCO or clearing members regarding customer and counterparty positions, funds, and property.123
(A) Clearinghouses Lack the “Capacity and Operational Expertise” to Clear the CDSs AIGSold
Based on ABSs/MBSs/CDOs/CLOs
Under these factors, some market commentators believe that the CDS products that brought AIG down would not be
subject to a mandatory clearing determination under §2(h): the “credit default swaps on subprime mortgages… that AI[G]
engaged in were non-clearable due to theircomplexity.”124
AIGwrote derivatives where the underlying asset was
121 7 USC §2(h)(4)(c)(i) (prohibitingCFTC from “adopt[ing] rules requiringa derivatives clearingorganization to listfor clearinga
swap… if the clearingof the swap… would threaten the financial integrity of the clearinghouse.”)
122 See Rena Miller,supra n.11, at 5 (“The Dodd-Frank Act requires that most derivatives contracts formerly traded exclusively in the
OTC market be cleared”).
123 7 USC §2(h)(2)(D)
124 Jon Gregory, CENTRAL COUNTERPARTIES: MANDATORY CLEARING AND BILATERAL MARGIN REQUIREMENTS FOR OTC
DERIVATIVES, 238 (2014).

23
complex Asset-Backed Securities (ABSs) like MBSs, CDOs,and CLOs. Some of the ABSs AIG wrote protection on were
actually derivatives built on top of an underlying asset which was also an ABS (so-called “CDOs-squared”). Furthermore,
out of AIG’s gross total of $527 billion CDSs, $78 billion was written on “multi-sector” CDOs.125
A multi-sector CDO is
a mixture of multiple tranches of ABSs issued by different SPVs126
hailing from different economic sectors – a
hypothetical example would be a CDO issued by an SPV holding ownership of assets within a single asset pool which
contains, simultaneously, residential MBSs, car loan ABSs,and student loan ABSs. In theory, the different sectors offer
diversification because the different economic sectors would not be subject to the same types of risks, so these multi-
sector CDOs were seen as less risky than single-sector CDOs.127
However,in practice, AIG proved unable to understand
the risks even of single-sector CDOs, let alone understand the multi-sector CDOs that it wrote default protection swaps
on. In this, it was not alone – neither the people who put the MBSs, ABSs, CDOs, and CLOs together, nor the investors
who bought them128
, understood them either.129
Instead of risk diversification, the underlying assets were actually subject
to risk correlation.
In other words, AIGwrote protection based on a hall of mirrors that it did not properly understand, and doing so brought
AIG to the brink of bankruptcy. If AIG – the protection seller – had trouble understanding the very products that it sold
default protection from, it seems even more unlikely that a clearinghouse – a third party without the same capability to
conduct due diligence and informational monitoring as a direct party to the transaction like AIG would have – would be
able to understand all of the relevant risks posed by multi-sector CDOs and similar instruments. Thus, a clearinghouse is
unlikely to have the statutorily-required “capacity and operational expertise”130
to centrally clear AIG’s CDSs written on
ABSs/MBSs/CDOs,and such instruments would therefore likely fail the CFTC’s mandatory central clearing
determination test. They would therefore remain non-centrally-cleared. Also, many of AIG’s CDSs were extremely
illiquid, which is a further factor counting against mandatory central clearing.131
The CFTC has made a mandatory clearing determination for severalclasses of Credit Default Swaps (CDSs),which are
the same type of instrument that brought AIGdown. However,the underlying asset beneath the CDSs the CFTC has
approved for mandatory clearing are indices of corporate bonds.132
Corporate bonds – whether single name or built from
an index amalgamating numerous issuing corporations – are much easier to understand and predict the risks of, than are
the kinds of swaps constructed on underlying ABS/CDO/MBS/CLO assets that brought AIG to the brink of failure.
Therefore the CFTC’s finding that clearinghouses had the “capacity and operational expertise” to clear CDSs constructed
on corporate bond indices does not compel an inference that the CFTC would make the same finding if the assets
underlying the CDSs were not corporate bonds, but were instead CDOs and CDOs-squared.
2. AIGWould Have Had to Register As A Swap Dealer,Imposing Minimum Capital Requirements
AIG would have had to register as a Swap Dealer. A Swap Dealer includes any entity that “regularly enters swaps with
counterparties as an ordinary course of business for its own account.”133
AIG’s Financial Products unit was in the business
125 Sjostromat 955.
126 “SPV” stands for Special PurposeVehicle,an entity created for the sole(“Special”) purposeof holdingownership to pooled assets
and issuingsecurity interests in thatassetpool,to be purchased by investors.
127 Steven Schwarcz, Regulating Complexity in Financial Markets, 87 Wash.U. L. Rev. 211, 223 (2009)(“although ABS transactions
were backed by what appeared to be significantly diversesecurities,there was an underlyingcorrelation”).
128 Id. at225 (“Investors did not always understand howCDO and ABS CDO securities worked”)
129 Id. (“When securities arehighly complex,parties reviewing,or even structuring,the securities may not always appreciateall the
consequences”)
130 7 USC §2(h)(2)(D) (ii)(II).
131 7 USC §2(h)(2)(D)(ii)(I).
132 See Clearing Requirement Determination Under §2(h) of the CEA, CFTC Final rule, 77 Fed.Reg. 74284,75290 (Dec. 13, 2013).
133 7 USC §1(a)(49)(A)(i)

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