The financial crisis of 2008 saw excessive risks in the over-the-counter market and lead to governmental intervention in a “Wall Street bailout” while listed markets and their central counterparty (CCP) clearinghouses performed well. This prompted global legislators and regulators to push for more OTC transactions to be cleared. In turn, this push led to greater scrutiny of CCP clearinghouse operations.
Today, as more OTC products move from a bilateral to a CCP cleared environment, several major U.S. clearinghouses have been designated as Systemically Important Financial Market Utilities (SIFMU) resulting in expanded regulatory requirements with which they must now comply. The designation, made by the Financial Stability Oversight Council (FSOC), brings with it additional new oversight by the Federal Reserve Board.
Along with the new regulatory requirements, one consequence of the rule changes is the possibility of formalizing a process for clearinghouses to gain emergency access to the Fed window in the event of a liquidity crisis. CCP discussions with the Fed about potential access to liquidity via the Fed window bounced around for many years. At OCC, we were actively engaged in discussions with the Fed about accessing the Fed window, even before being designated as a SIFMU. The financial crisis of 2008 brought this issue into greater focus when the repo markets dried up and OCC, and other CCPs, were concerned about liquidity even with committed secured credit facilities with commercial banks. OCC’s intent has always been to ensure a liquidity source of last resort based on U.S. Government Security secured advances.
All clearinghouses operate a daily settlement cycle that depends on collecting sufficient cash from the clearing members who owe it in time to pay cash a short time later to the clearing members who are due it. Tight deadlines in this cycle give a clearinghouse very little time to act if any clearing member—or, worse, a bank through which multiple members make settlement—defaults on its obligations. Most clearinghouses maintain secured credit lines to deal with their potential need for cash on an expedited basis. However, in an extreme situation, a clearinghouse’s need for cash may exceed its credit lines, or one or more lenders may delay or default on their obligation to extend credit as promised.
If a clearinghouse does not have access to short-term liquidity from the Fed in such a situation, the clearinghouse would fail to effect settlement, potentially setting off a domino effect and a financial panic. As part of their protections against member defaults, clearinghouses such as OCC hold substantial clearing or guarantee funds containing Treasury or other highly liquid securities valued in the billions of dollars that could collateralize any short-term loan from the Fed, ensuring taxpayer dollars would not be at risk.
That last point is the key as the possibility of clearinghouse access to the Fed has been mischaracterized as a “bailout” a number of times over the past few years, and as recently as last month. Whether CCPs will have access to the Fed window, and under what terms, is not yet certain. However, it is certain that, unlike the recipients of Fed funds in 2008, CCPs do not need funds to be extended as a form of credit – they instead need funds to be extended for short-term liquidity. In no sense should the exchanging of Treasurys for a fully secured (in fact, over secured) short-term loan from the Fed to keep a liquidity crisis from becoming something much worse be characterized as a “bailout.”