Chicago Journal of International Law


In the wake of the global financial crisis, American and European regulators quickly converged on a reform intended to help stave off similar crises in the future: central counterparty clearinghouses for credit default swaps. On both sides of the Atlantic, regulators identified credit default swaps (CDS) as a central factor in the crisis that seized Bear Stearns, Lehman Brothers, American International Group (AIG), and ultimately the world. Regulators quickly agreed that improving the conditions under which CDS are traded, specifically, the addition of a central counterparty in clearing, would prove a key reform to the global financial architecture. Introducing a well-capitalized central counterparty between CDS buyers and sellers would, regulators came to believe, help contain financial failures in the future. How and why did this convergence occur? This Article reviews the American and European responses, concluding that they converged on a similar clearing structure largely because of its compelling logic. The financial crisis revealed the vulnerabilities of a system in which buyers and sellers entered into CDS directly, through bilateral contracts. These bilateral derivatives contracts created a web of interconnected obligations, such that the failure of one firm could bring down a chain of others. The threat of this domino effect led governments to intervene in the financial markets with massive direct and indirect support. Forced to spend public money to bail out private firms, regulators risked an unsustainable moral hazard-firms that were "Too Interconnected to Fail." Regulators concluded that the introduction of a central counterparty (CCP) would reduce the risk that the bankruptcy of a principal in a credit default swap would precipitate a domino fall through the credit markets. [CONT]