Swapped Disincentives: Will Clearinghouses Mitigate the Unintended Effects of the Bankruptcy Code's Swap Exemptions?
The Bankruptcy Code contains exemptions for swap agreements that allow creditors to seize collateral, to terminate their contract, and to net obligations once the debtor files for bankruptcy. By privileging this class of creditors, these provisions reduce incentives to monitor counterparty risk, and thus magnified losses experienced during the recent financial crisis. Congress overlooked this role of the Bankruptcy Code in destabilizing the financial system. Instead, its response was to require that all swaps be traded through a clearinghouse. This failure to address one of the contributing factors to the swap market’s collapse should be worrisome, as a clearinghouse’s traditional risk management devices likely cannot prevent a similar crisis in the future. Nonetheless, under the proper conditions, a clearinghouse theoretically has greater incentives to monitor counterparty risk than its individual members, thereby strengthening market discipline and financial stability. In order to realize this incentive structure, certain regulatory measures are necessary, namely heightened disclosure requirements and strict governance rules designed to preserve the independence of the clearinghouse’s board from its members.
Timothy P.W. Sullivan,
Swapped Disincentives: Will Clearinghouses Mitigate the Unintended Effects of the Bankruptcy Code's Swap Exemptions?,
80 Fordham L. Rev. 1491
Available at: https://ir.lawnet.fordham.edu/flr/vol80/iss3/17