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FEDERAL RESERVE BANK OF CHICAGO
Research Department
Financial Markets Group
230 South LaSalle Street
Chicago, Illinois U.S.A.
Working Paper No. PDP 2016-1 *
September 2016
Resolving central counterparties after Dodd–Frank:
Are they eligible for “orderly liquidation”?
Robert S. Steigerwald, senior policy advisor, Federal Reserve Bank of Chicago, and
David W. DeCarlo, policy and markets analysis associate, Federal Reserve Bank of
New York
[Summary: The disorderly failure of a central counterparty clearinghouse (CCP) could
lead to severe systemic disruptions, potentially impairing the effective operation of
financial markets. To avoid such disruptions, we need effective mechanisms to provide
for the resolution of a failing clearinghouse if recovery is not possible.]

The payment, clearing, and settlement systems that support financial markets are
critical to the efficient functioning of the financial system. Although sometimes referred
to as the “plumbing” of the financial system, these little-appreciated infrastructures may
be more accurately described as “the central nervous system” of a market economy.

*

This paper is preliminary and should not be cited or quoted without the authors’
permission. The views expressed in this paper are solely those of the authors and do
not necessarily reflect the views of the Federal Reserve Bank of Chicago, the Board of
Governors of the Federal Reserve System or their staff. David DeCarlo co-authored this
article while he was an intern in the Financial Markets Group at the Federal Reserve
Bank of Chicago. He now works at the Federal Reserve Bank of New York. The authors
welcome all comments.

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[Page 1 pullout: “When the crisis hit, regulatory options for responding to distress in
large, non-bank financial companies left policymakers with a no-win dilemma: either
prop up failing institutions with expensive bailouts or allow destabilizing liquidations
through the normal bankruptcy process” -Sheila C. Bair, former chair, Federal Deposit Insurance Corporation. i

A specialized form of financial market infrastructure—the central counterparty (or CCP)
clearinghouse—is widely used in modern securities and risk transfer markets. Central
counterparty clearing provides a foundation for centralized risk management (including
multilateral netting, collateralization, and loss mutualization) and efficient data
processing (such as trade registration, reporting, and risk monitoring). However, central
clearing also concentrates risk. Interposing a CCP as the “buyer to all sellers” and
“seller to all buyers” in a market may make the CCP a single point of failure that could
propagate systemic shocks through global financial markets in a crisis.

What if a CCP fails? Paul Tucker, a former Deputy Governor of the Bank of
England, recently noted that this “is a huge issue.” ii The disorderly failure of a CCP
could lead to severe systemic disruptions, potentially impairing the effective operation of
financial markets. To avoid such disruptions, we need effective mechanisms to provide
for the resolution of a failing clearinghouse if recovery is not possible.

BOX
International policy developments
In the wake of the 2009 Financial Crisis, the Group of Twenty charged the Financial
Stability Board (FSB) with responsibility for monitoring and assessing the
implementation of internationally agreed regulatory reforms. Among other things, the

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FSB has issued standards for the resolution of financial institutions, including specific
guidance regarding the application of those standards to financial market infrastructures
(see http://www.financialstabilityboard.org/publications/r_141015.pdf).
In addition, the Committee on Payments and Market Infrastructure (CPMI), formerly
known as the Committee on Payment and Settlement Systems (CPSS), and the
International Organization of Securities Commissions (IOSCO) recently published a
report on the resolution of financial market infrastructures, including clearing and
settlement infrastructures (see http://www.bis.org/cpmi/publ/d121.pdf).
END BOX

In 2010, Congress enacted the Dodd–Frank Wall Street Reform and Consumer
Protection Act. Title II of Dodd–Frank provides for a new “orderly liquidation authority”
for the resolution of certain non-bank financial companies. In this paper, we discuss
whether a systemically important CCP would be eligible for orderly liquidation. If a failing
U.S. CCP qualifies as a “financial company” and meets the other requirements of Title II,
it may be resolved by the Federal Deposit Insurance Corporation (FDIC) under the new
resolution authority. If not, it would be resolved under the Bankruptcy Code or other
applicable law.

Orderly liquidation of non-bank financial companies under Dodd–Frank
Title II of Dodd–Frank authorizes the Secretary of the Treasury to appoint the FDIC as
receiver for a non-viable financial company under the conditions set forth in the statute
and applicable regulations. Among other things, Dodd–Frank section 203(b) requires
the Treasury Secretary to initiate orderly liquidation proceedings if, after consultation
with the President, the Secretary determines that:
•

A financial company is “in default or in danger of default”;

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•
•
•
•
•

The failure of the company and its resolution under the Bankruptcy Code (or
other applicable law) “would have serious adverse effects on financial stability in
the United States”;
A “viable private sector alternative” to orderly resolution is not available to
prevent the company’s default;
The effect on “creditors, counterparties and shareholders of the financial
company and other market participants” of a Title II resolution is “appropriate
given the impact . . . on financial stability in the United States”;
Orderly resolution of the company “would avoid or mitigate . . . adverse effects”
on the company’s stakeholders, taking into consideration financial stability
concerns, the cost to the U.S. Treasury and other factors; and
The company qualifies as a “financial company.”

To determine whether a company qualifies as a financial company for this purpose, we
look to the definition set forth in Dodd–Frank Act section 201(a)(11) and related
provisions of U.S. law.

With certain exceptions not relevant to our discussion, a company is defined as a
financial company under Title II only if it is incorporated or organized under U.S. law
(federal or state) and is: a bank holding company as defined in section 2(a) of the Bank
Holding Company Act of 1956; a nonbank financial company supervised by the Board of
Governors of the Federal Reserve System (the Federal Reserve); or a company that is
“predominantly engaged in activities” that the Federal Reserve has determined are
financial in nature or incidental thereto for purposes of section 4(k) of the Bank Holding
Company Act of 1956. In addition, certain subsidiaries of the foregoing entities may
themselves be financial companies. We consider each of these possibilities in turn.

General conditions for orderly liquidation under Title II
First, no systemically important U.S. CCP is a bank holding company or a subsidiary of
a bank holding company. Second, no U.S. CCP is a nonbank financial company

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supervised by the Federal Reserve under Dodd–Frank section 201(a)(15). This result
arises from the statute’s incorporation by reference of the definition of “U.S. nonbank
financial company” under Dodd–Frank section 102(a)(4)(B), which expressly excludes
“derivatives clearing organizations” (the term for CCPs regulated by the Commodity
Futures Trading Commission [CFTC]) and “clearing agencies” (the term for CCPs
regulated by the Securities and Exchange Commission [SEC]). Therefore, no
derivatives clearing organization or clearing agency is a nonbank financial company
supervised by the Federal Reserve for purposes of either Title I or II of Dodd–Frank.
This is consistent with the general regulatory framework of Dodd–Frank, which assigns
primary supervisory authority over U.S. CCPs to the CFTC and SEC, not the Federal
Reserve.

Consequently, a U.S. CCP may qualify as a financial company only if it is
“predominantly engaged in activities” that the Federal Reserve has determined are
“financial in nature or incidental thereto for purposes of section 4(k) of the Bank Holding
Company Act of 1956.” Moreover, according to Dodd–Frank section 201(b), a company
may not be considered a financial company for purposes of Title II “if the consolidated
revenues of such company from [activities that are financial in nature or incidental
thereto] . . . constitute less than 85 percent of the total consolidated revenues” of the
company.” This proviso turns out to be relevant to at least one U.S. CCP because of its
corporate structure, but we do not discuss the complicated issues that may arise under
the revenue test of section 201(b) in this article.

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Is central clearing an activity that is “financial in nature”?
To determine whether a CCP qualifies as a “financial company” for purposes of Title II,
we must identify the activities that the Federal Reserve has determined are financial in
nature or incidental thereto for purposes of section 4(k) of the Bank Holding Company
Act. That turns out to be no simple task. As an initial matter, the reference to section
4(k) of the Bank Holding Company Act in Dodd–Frank Title II is ambiguous when
applied to companies – such as CCPs – that are not bank holding companies. iii

The Federal Reserve, which has primary responsibility for interpreting and applying
section 4(k), has resolved that ambiguity by adopting a regulation defining the activities
that are considered financial in nature for purposes of Title I of Dodd–Frank. Title I
imposes enhanced prudential standards on certain “nonbank financial companies,” as
separately defined in section 102(a)(6), and subjects those companies to supervision by
the Federal Reserve for financial stability purposes. iv The Federal Reserve essentially
incorporated the list of Congressionally authorized activities added by the Gramm–
Leach–Bliley Act and activities previously approved by the Board for bank holding
companies under sections 4(c)(8) and (13) of the Bank Holding Company Act in its Title
I determination.

The FDIC, in turn, has determined that the Federal Reserve’s interpretation of the
parallel (but not identical) language of Dodd–Frank Title I is “appropriate and consistent
with the purposes and goals of Title II” and that “the definition of ‘financial activities’ for
purposes of Title II [should] remain as similar as practicable to the definition of ‘financial

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activities’ for purposes of Title I.” v The FDIC’s decision to adopt the Federal Reserve’s
interpretation of the statutory language in Title I, however, does not completely resolve
the problems that arise in determining which activities are "financial in nature or
incidental thereto" for purposes of Title II. In particular, the list of activities that are
considered financial in nature under the Bank Holding Company Act “evolved piecemeal
over the years and reflects both regulatory and statutory political and policy decisions
made during those times.” vi

The defining characteristic of central counterparty clearing is counterparty substitution,
by means of which the CCP is interposed as a principal to all contracts that are
accepted for clearing. Can we find this function listed as an activity that the Federal
Reserve has determined to be financial in nature under the Bank Holding Company
Act? Not in simple or obvious terms. The list includes “[e]ngaging in investment
transactions as principal, including underwriting and dealing in government obligations
and money market instruments, investing and trading as principal in foreign exchange
and derivatives, and buying and selling bullion.” A CCP, as we have noted, does
become a principal to each trade it accepts for clearing. But serving as a central
counterparty does not involve underwriting or dealing, as those terms are ordinarily
understood. Moreover, central counterparty clearing is a special form of market
infrastructure, not the kind of activity that can easily be conceived of as “engaging in
investment transactions.” Given these doubts, we think the list of financial activities
under section 4(k) is not dispositive, as the other activities on the list are even further
from sounding like descriptions of central clearing. While Lubben (2014) concludes that

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central clearing is not on the list of financial activities, there is separate precedent
supporting the conclusion that clearing is an activity that is financial in nature. vii

The Federal Reserve has previously determined that a CCP for foreign currency
transactions performed functions that are permissible for bank holding companies under
section 4(c)(8) of the Bank Holding Company Act. viii As we have noted, activities that
have been approved by the Federal Reserve for bank holding companies pursuant to
section 4(c)(8) are included in the list of activities that are financial in nature for
purposes of Title I, and the FDIC has adopted that list for purposes of Title II.
Consequently, it appears that CCPs may be eligible for resolution by the FDIC in orderly
liquidation proceedings, assuming that the other requirements of Title II are satisfied.
Nevertheless, there are some other reasons to question that conclusion, as we discuss
next.

Other issues of statutory construction
Lubben (2014) notes that the CFTC has been given no role in triggering an orderly
liquidation under Title II. That certainly seems odd, given that section 203(a)(1) of
Dodd–Frank explicitly provides for the SEC to play a key role in determining whether to
recommend to the Treasury Secretary that a failing broker-dealer should be subject to
orderly liquidation by the FDIC. Dodd–Frank section 203(a)(1) also explicitly provides
for the Director of the Federal Insurance Office to play a similar role in determining
whether to recommend orderly liquidation of a failing insurance company. The omission
of authority for the CFTC or SEC—the primary supervisory authorities for U.S. CCPs—

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to play any role in determining whether a failing CCP should be resolved by the FDIC
under Title II suggests, as Lubben argues, that Congress may not have intended for
CCPs to be resolved in orderly liquidation proceedings.

What, if anything, should we make of the fact that certain CCPs have been designated
by the Financial Stability Oversight Council (FSOC) as systemically important
“designated financial market utilities” (DFMUs) under Dodd–Frank Title VIII? To date,
FSOC has identified five CCPs as DFMUs—the Chicago Mercantile Exchange, Inc.,
Fixed Income Clearing Corporation, ICE Clear Credit LLC, National Securities Clearing
Corporation, and The Options Clearing Corporation. Some commentators have
concluded that a failing DFMU would be subject to orderly liquidation under Title II
because the FSOC has made a systemic risk determination as a prerequisite for
designation under Title VIII that is effectively identical to the systemic risk determination
required under Title II.

That conclusion, however, is not consistent with the language of Dodd–Frank section
203(b), which explicitly requires the Secretary of the Treasury to determine that a failing
company qualifies as a financial company. To be sure, a systemic risk determination by
FSOC under Title VIII is persuasive evidence that the Secretary of the Treasury would
conclude that the failure of a DFMU “would have serious adverse effects on financial
stability in the United States,” but that alone is not sufficient to trigger a Title II
proceeding, as we have argued here.

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Conclusion
Under current circumstances, a U.S. CCP may qualify as a financial company only if it is
“predominantly engaged in activities that the Board of Governors has determined are
financial in nature or incidental thereto for purposes of section 4(k) of the Bank Holding
Company Act of 1956. ...” The Federal Reserve has previously determined that central
clearing is an activity that is permissible for bank holding companies and FSOC has
designated certain CCPs as systemically important. However, as we have noted, the
omission of authority for the CFTC or SEC to play any role in determining whether a
failing CCP should be resolved by the FDIC under Title II may suggest that Congress
did not intend for CCPs to be resolved in orderly liquidation proceedings. If so, this casts
doubt as to whether CCPs are eligible for orderly liquidation and raises the possibility
that Chapter 7 of the Bankruptcy Code provides the only mechanism under U.S. law for
resolving a systemically important CCP.

Does the Bankruptcy Code provide an adequate procedure for resolving systemically
important financial market infrastructures, such as CCPs? Former FDIC Chair Sheila
Bair argues that policymakers faced a “no-win dilemma” in responding to financially
distressed non-bank financial companies and were forced to “prop up failing institutions
with expensive bailouts or allow destabilizing liquidations through the normal bankruptcy
process” (see note 1) In response, Congress enacted Dodd–Frank Title II to provide for
the orderly liquidation of systemically important non-bank financial companies. For the
reasons discussed in this article, however, there is some lingering uncertainty whether
U.S. CCPs are eligible for orderly resolution under Title II. As Duffie (2014) notes,

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“[r]esolution procedures should be transparent and predictable . . . so that the attendant
risks can be better managed and priced into contracts.”ix Moreover, because the
disorderly failure of a systemically important clearinghouse could lead to severe
systemic disruptions, we should have reasonable certainty about the tools policymakers
have to respond to such a crisis.

i

Shelia C. Bair, 2011, “Testimony on Implementation of the Dodd-Frank Wall Street Reform and
Consumer Protection Act,” before Committee on Banking, Housing, and Urban Affairs, U.S. Senate,
February 17, available at: https://www.fdic.gov/news/news/speeches/archives/2011/spfeb1711.html.
ii

Paul Tucker, 2014, “Are Clearing Houses the New Central Banks?,” Remarks at the Federal
Reserve Bank of Chicago, Symposium on OTC Derivatives, Chicago (April 11), p. 2, available at:
http://www.chicagofed.org/digital_assets/others/events/2014/annual_over_the_counter_derivatives_symp
osium/tucker_clearinghouses_new_central_banks_tucker_2014.pdf.
iii

Federal Deposit Insurance Corporation, 2013, Definition of ‘‘Predominantly Engaged in Activities
That Are Financial in Nature or Incidental Thereto,’’ Federal Register, Vol. 78, No. 111, p. 34716 (June
10, 2013), available at: https://www.fdic.gov/regulations/laws/federal/2013/2013-06-10_final-rule.pdf.
iv

Board of Governors of the Federal Reserve System, 2013, Definitions of ‘‘Predominantly
Engaged In Financial Activities’’ and ‘‘Significant’’ Nonbank Financial Company and Bank Holding
Company, Federal Register, Vol. 78, No. 66, pp. 20756 et seq. (April 5, 2013), available at:
www.gpo.gov/fdsys/pkg/FR-2013-04-05/pdf/2013-07688.pdf.
v

FDIC (2013), p. 34717. We note that Dodd-Frank section 102(a) requires the Federal Reserve to
determine which activities "are financial in nature" for purposes of Title I; by contrast, section 201(a)(11)
requires a determination regarding activities that are "financial in nature or incidental thereto" for purposes
of Title II. However, this distinction has no significance for the discussion in this article.

vi

Davis Polk & Wardwell, LLP, 2011, Summary of Federal Reserve Proposed Rule on
Definitions Related to Nonbank Financial Companies and Interconnectedness of Systemically Important
Firms (February 9), p.1, available at:
www.davispolk.com/publications/list?&field_pb_related_services_target_id=49361.
vii

Lubben, Stephen J., 2014, “Nationalize the Clearinghouses!,” Seton Hall Public Law Research
Paper No. 2458506 (June 24), p. 23, available at: http://ssrn.com/abstract=2458506 or
http://dx.doi.org/10.2139/ssrn.2458506.
viii

Board of Governors of the Federal Reserve System, 1996, Order Approving a Notice to Engage
in Certain Nonbanking Activities and Application to Become a Member of the Federal Reserve System
(December 4, 1996), available at:
www.federalreserve.gov/boarddocs/press/bhc/1996/19961204/#f9/.

ix

Duffie, Darrell, 2014, “Resolution of Failing Central Counterparties,” (December 17), available at:
www.darrellduffie.com/uploads/working/DuffieCCP-ResolutionJan2015.pdf.


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