Central clearing for credit default swaps. A legal analysis of the new central clearing regulations in Europe and the US
| DOI | https://doi.org/10.1108/13581981211218414 |
| Date | 04 May 2012 |
| Pages | 212-244 |
| Published date | 04 May 2012 |
| Author | Stan Cerulus |
| Subject Matter | Accounting & finance |
Central clearing for credit
default swaps
A legal analysis of the new central clearing
regulations in Europe and the US
Stan Cerulus
Katholieke Universiteit Leuven, Leuven, Belgium
Abstract
Purpose – The purpose of this paper is to answer a specific research question: How have EU and US
regulators translated the idea of central clearing into law?
Design/methodology/approach – A meticulous legal research is carried out. First, the pre-crisis
regulatory regime for credit default swap (CDS) is reviewed, from a securities law angle as well as from
a comparative Euro-American perspective. Next, the regulatory processes leading to the adoption of
the central clearing regulations are discussed. Thereafter, a material comparative analysis is made
of the provisions related to central clearing in the EU and US regulatory initiatives. Finally, the paper
is concluded with an evaluation of both legislations in the light of all previous analyses.
Findings – The research first shows that central clearing regulations rely on a series of
presumptions, both concerning the gravity of counterparty risk threats and the necessity of central
clearing. Additionally, the EU and US clearing regulations are similar with regard to the broad
innovations they introduce, i.e. the mandatory central clearing of a variety of over-the-counter
derivatives and counterparty risk management requirements for central clearing institutions and for
non-cleared swaps. However, the specific content of the provisions often differs. Furthermore, both
legislations are limited to enouncing broad principles. This is also the case for the crucial provisions
related to counterparty risk management. Therefore, these provisions in se do not guarantee the proper
regulation of counterparty risk management practices. Consequently, much is to be expected from the
implementing measures adopted by regulatory institutions.
Originality/value – The paper provides an overview of those provisions in the European and US
regulations that specifically concern central clearing for CDS. It is one of the first papers which does
this in a very well-structured and clearly written manner. Also it is one of the first to provide a clear
comparison between the provisions in the EU and the US regulations.
Keywords European Union,United States of America, Financial regulation,Derivative markets,
Legislation,Credit default swaps, Central clearing
Paper type Conceptual paper
Introduction
1. Situating the subject
In the early 1990s,the financial sector produced one of its latestfinancial innovations, the
credit default swap (CDS)[1]. This financial derivative instrument made possible the
contractual transfer of credit risk, i.e. the risk of a borrower defaulting on his debt
obligations.It did not take long for this productto attract investor attention,leading to an
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1358-1988.htm
This paper is a shortened version of the author’s Master thesis entitled “Central clearing for
credit default swaps – efforts in the US and the EU to combat systemic risk through regulation”.
The author would like to thank Prof. Dr Robbie Tas, Prof. Dr Koen Geens and Stijn de Dier for
their invaluable assistance.
JFRC
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Journal of Financial Regulation and
Compliance
Vol. 20 No. 2, 2012
pp. 212-244
qEmerald Group Publishing Limited
1358-1988
DOI 10.1108/13581981211218414
explosive growth of the CDS market. CDS were heralded by many for their capacity to
disperse creditrisk throughout the financial market, thus enablingcredit risk to be borne
by those investors most capable of handling them. Thisview was shared by regulators,
who believed CDS madethe financial system safer[2]. Consequently, CDS enjoyeda very
light regulatory regime. However, during the financial crisis views with regard to CDS
changed significantly. The instruments regularly made the headlines, as a number of
financial institutions that were heavily involved in CDS trading, faced financial
difficulties. Thecrisis demonstrated that CDS do not only enable the dispersion ofrisks,
but that they alsoallow for large amounts of risk to be concentratedin a few entities. This
was for instancethe case for AIG, which had assumedenormous amounts of credit riskby
trading in CDS[3]. Even more worrying than the fear for credit risk concentration,
however, was the fear for counterparty risk, i.e. the risk of one of the parties to the CDS
contract defaulting on his obligations. The idea was that the bankruptcy of a large CDS
marketparticipant could lead to a chain reactionof defaults throughout theCDS market. It
was argued that,in the end, this might even result in theimplosion of the entire financial
system. Whether this fear for so-called systemic risk was a legitimate concern or
unnecessaryhysteria, in any case it encouragedthe US government to rescue a numberof
troubled financialinstitutions, such asAIG and Bear Stearns. Consequently,CDS became
subject to public criticism[4]. The non-regulated nature of the CDS market came under
severe scrutiny,with many calling for a strong regulatoryreform. Various reforms were
proposed by commentators, with the aim of reducing the systemic risk concerns
associated with CDS trading. An important category of proposals focused on
modifications to the infrastructure of the CDS market and of the over-the-counter (OTC)
derivatives market in general. Within this category, the proposal most relevant with
regard to counterparty risk and systemic risk reduction has been the introduction of
central clearingin the CDS market. The ideais that a central clearing institution (CCI) will
step in between CDSparties to assume all counterparty risk.Regulators, both in the USA
and the EU, have supported this proposal and have launched legislative initiatives
intendedto translate the idea of central clearinginto regulations. Exactly these regulatory
initiatives are thesubject of this article.
2. Scope of the research
For the legal analysis to be feasible, it is necessary to first clarify a number of
limitations with regard to the scope of this research. In addition, this paragraph seeks
to identify some important notions and distinctions related to the regulation of
financial instruments and markets.
A. Limited to non-basic legal analysis. This article shall not explain the basic aspects of
the CDS instrument[5], nor will it explain the concepts of counterparty risk and systemic
risk (Stulz, 2009; Vause, 2010; Arora et al., 2010; European Central Bank, 2009; Kaufman
and Scott, 2003) and the reduction of these risks through (bilateral and) central clearing
(Bliss and Kaufman, 2005; Bliss and Papathanassiou, 2006; Mengle, 2010; Kiff et al., 2009;
Vause, 2010; Pirrong, 2008/2009; Shadab, 2010). Also, the research scope will be limited
to a legal analysis of the new central clearing regulations. The economic impact
and efficiency of these regulations will not be investigated[6].
B. Focus on securities regulations. A first question that comes to mind when
embarking on a legal research with regard to CDS, is which type of regulations is
applicable to these instruments. The generally accepted view among commentators
Central clearing
for CDS
213
is that CDS and other OTC derivatives[7] are to be regulated as securities. Therefore,
the legal analysis carried out in this article will focus on securities law. However, it is
interesting to note that dissenting opinions have been expressed with regard to the
legal nature of CDS and thus also with regard to the type of regulations that should
be applicable to these instruments[8]. However, most regulators share the majority
opinion that CDS must be regulated as securities[9].
C. Focus on central clearing regulations. The scope of the research is also limited to the
regulatory initiatives related to the central clearing of CDS[10]. As noted above, this
regulatory innovation introduces a CCI in the CDS market, which will step between CDS
parties to assume all counterparty risk. A CCI is a type of financial market infrastructure
(FMI). FMIs have often been described as the “plumbing” of the financial sector[11]. A recent
report by the CPSS and the IOSCO Technical Committee defines an FMI as a “multilateral
system among participating financial institutions, including the operator of the system,
used for the purposes of recording, clearing, or settling payments, securities, derivatives, or
other financial transactions” (CPSS-IOSCO, 2011). The report contains principles for five
types of FMIs[12]: payment systems, central securities depositories (CSD), securities
settlement systems (SSS), central counterparties (CCP) and trade repositories (TR). It
does not apply to exchanges, trade execution facilities or multilateral trade-compression
systems, but indicates that these are also FMIs (CPSS-IOSCO, 2011, p. 5).
In essence,the establishment of an FMI leads to the centralizationof a certain aspect of
financial transactions, i.e. payment,clearing, securities holding and transparency. Before
the financial crisis the CDS market and the OTC derivatives market in general were
completely decentralized, meaning that all aspects of the transaction were arranged
bilaterally,i.e. between the individual CDS parties. The fact that CDS werenot traded on
exchanges or onother centralized trading platforms is specificallyreferred to as the OTC
nature of theCDS market[13]. In addition,payments, clearing and transparencywere also
arranged bilaterally. However,new regulatory initiatives in theaftermath of the financial
crisis have sought to change the market infrastructure nature, by introducing specific
FMIs in theOTC derivatives markets[14].The introduction of centralclearing can be seen
as the centerpiece of the regulatory market infrastructure initiatives. Indeed, most
concerns expressed with regard to CDS relate to counterparty risk. Other market
infrastructureinitiativesalso seek to reduce systemicrisk in the OTC derivativesmarkets,
but they target causesother than counterparty risk[15].
3. Overview of the article
Title 1 will discuss the regulatory regime for CDS before the crisis, as well as the
regulatory initiatives leading to the adoption of central clearing regulations. Next, title 2
will contain an in-depth analysis and comparison of the EU and US regulatory
initiatives, focused on those provisions directly related to the central clearing obligation.
Finally, an evaluation of the EU and US clearing regulations will be enclosed in the
conclusion of this article.
Title 1. From the absence to the emergence of central clearing for CDS
1. The non-regulated nature of CDS before the financial crisis
In this section the pre-crisis regulatory context for CDS will be examined. As already
noted, the focus will be on securities regulation and a comparison will be made between
Europe and the USA.
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