This post summarizes “The Dodd-Frank Act’s Maginot Line: Clearinghouse Construction,” which will appear in the California Law Review later this year.
Regulatory reaction to the 2008–2009 financial crisis, following the failures of AIG, Bear Stearns, Lehman Brothers, and the Reserve Primary Fund, focused on complex financial instruments that deepened the crisis. A consensus emerged that these risky financial instruments should move through safe, strong clearinghouses, which would be bulwarks against systemic risk.
The consensus turned into law, via the Dodd-Frank Wall Street Reform Act, in which Congress instructed regulators to construct clearinghouses through which these risky financial instruments would trade and settle. Clearinghouses could repel financial risk, reduce contagion, and halt a local financial problem before it became an economy-wide crisis.
But clearinghouses are weaker bulwarks against financial contagion, financial panic, and systemic risk than is commonly thought. They may well be unable to defend the economy against financial stress such as that of the 2008–2009 crisis. Although they can be efficient financial platforms in ordinary times, they do little to reduce systemic risk in crisis times.