In a working paper published by the London School of Economics, Visiting Professor David Murphy recommended improvements to regulatory review, and used the requirement of mandatory clearing of OTC derivatives as a case study.
Mr. Murphy highlighted certain regulatory review procedures, such as (i) questioning whether the outcome of regulations was consistent with its intended effect, (ii) considering whether alternative regulations could achieve a similar outcome at a lower cost but higher benefit, (iii) looking at the "size and allocation of redistributional effects" and (iv) implementing policy.
On the basis of his review, Mr. Murphy concluded that the regulation of derivatives could be improved in a variety of ways, including by:
- basing the threshold for mandatory clearing on risk as opposed to notional amount;
- setting the threshold for mandatory clearing to capture only firms that are a risk to financial stability; and
- potentially requiring very large end-users of derivatives to become members of central counterparties.
Commentary
Although the paper is written in a very measured tone, it is highly critical of Dodd-Frank's mandatory clearing requirements both in terms of the manner in which the requirements were adopted and in terms of the result of the requirements. As to the former, the author notes that "it has never been clearly articulated [why there] is a need for mandatory client clearing." As to results, the author points out that the end result of the mandatory clearing requirement has been to substantially increase concentration of the business. Consequently, if a large clearing firm were to shut down, it is unlikely that market disruption could be avoided. This outcome is completely contrary to the effect that Dodd-Frank was intended to achieve (although the result was not unpredictable; see, e.g., Peirce, Derivatives Clearinghouses: Clearing the Way to Failure; Perice & Soliman, Rethinking the Swaps Clearing Mandate; Pirrong, A Bill of Goods: Central Counterparties and Systemic Risk and The Clearinghouse Cure; Levitin, Response: The Tenuous Case for Derivatives Clearinghouses.)
The real subject of Mr. Murphy's paper is much broader than a review of mandatory central clearing as a case study. The questions are fundamental. How should rules be made and how should the government evaluate the quality of those rules? On one level, the paper's suggestions seem so simple and straightforward as to be undeniable; e.g., the government should clearly state the goal of any rulemaking and an independent party should conduct an after-the-fact assessment of whether that goal has been achieved and at what cost.
Unfortunately, while those recommendations may seem like "common sense," the reality is that after many financial regulatory measures are taken (e.g., Dodd-Frank), regulators and elected officials of one party tend to put out a steady stream of reports as to the success of the rules, while regulators and elected officials of the other party tend to put out a steady stream of reports as to the failures of the rules. As to the conclusions drawn in the study concerning central clearing, assuming even the possibility that consensus could be reached that the requirement went too far and that (at least that portion of) Dodd-Frank should be revised, it is not likely that the damage could be undone. The numerous firms that exited the business do not stand ready to jump back into this activity.
These are not academic concerns. The SEC has recently adopted Regulation Best Interest, which may do significant damage to the business of full-service brokerage. Notably, SEC Commissioner Peirce, who supported the adoption of the rule, has called for an eventual review of the rule's merits. It seems likely, however, that any such review would be too late to matter: if the regulation damages the full-service brokerage business, how could it possibly be restored?
Primary Sources
Originally published 14 May 2020
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