The Lynch amendment has to be one of the most bizarre pieces of legislation relating to derivatives I've ever seen—and that's saying something. Really, the amendment is just illogical. Introduced by Rep. Stephen Lynch, the amendment prohibits swap dealers and "major swap participants" from owning more than 20%, collectively, of a derivatives clearinghouse. Here's how Rep. Lynch justified his amendment on the House floor:
[T]he problem is—and in my view, this is a huge problem with the bill—the bill would allow these same big banks to purchase the clearinghouses that are being created to police the big banks in their derivatives trading. The big banks would be allowed to own and control the clearinghouses and to set the rules for how their own derivatives deals are handled. My amendment would prevent those big banks and major swap participants, like AIG, from taking over the police station—these new clearinghouses.This makes absolutely no sense. Rep. Lynch appears to be deeply confused about both clearinghouses and the derivatives market. Unfortunately, the Lynch amendment has been cheered on by the blogosphere, which now reliably swoons at any mention of hurting "Wall Street," seemingly without regard for the merits of the proposal.
Honestly, what do supporters of the Lynch amendment think clearinghouses are? The purpose of a clearinghouse is risk mutualization. If one clearing member defaults on a cleared contract, the other members—via the clearinghouse—will pick up the tab. That's why the clearinghouse, as the central counterparty (CCP), interposes itself between counterparties to contracts cleared through the clearinghouse, serving as the buyer to every seller and the seller to every buyer. The whole purpose of this set-up is to put all the clearing members on the hook for one clearing member's default. (If after applying a defaulting member's margin account, the money the other clearing members have contributed to the clearinghouse's guaranty fund still isn't sufficient to cover the losses from a member's default, the clearinghouse can generally force the other clearing members to make one-time contributions to cover the remaining losses.)
Why on earth would we want to discourage the dealer banks—who, for better or worse, are the only ones capable of being market-makers in OTC derivatives—from mutualizing losses? That's what the Lynch amendment would do. The clearing members are the ones who are ultimately on the hook for a default in a clearinghouse model, so of course they're going to want to have a say in the kinds of contracts the clearinghouse accepts, and in the clearinghouse's risk management practices. A dealer is unlikely to trade through a clearinghouse if it's prohibited by law from having a say in the kinds of contracts that it—as a clearing member—is being put on the hook for. Clearing members should have a say in those kinds of matters—it's exactly the kind of aligning of economic interests that we're looking for!
The Lynch amendment would effectively prevent a given clearinghouse from having more than 2 or 3 dealers as clearing members. This would make the clearinghouse much less effective in mitigating the systemic risk of OTC derivatives. When a clearing member defaults, the clearinghouse can generally transfer big chunks of the defaulting member's open positions to other clearing members—like the FDIC does when it resolves commercial banks—minimizing the disruption to counterparties and preventing contagion from spreading. If a clearinghouse only has 2 or 3 dealers as clearing members, and one of those dealers defaults, the clearinghouse wouldn't be able to transfer most of the defaulting member's open positions to other clearing members, because there would only be a couple other clearing members who, under the best of circumstances, have the balance sheet capacity to assume significant chunks of the defaulting member's derivatives book. This would greatly increase the strain on the clearinghouse's guaranty fund. By contrast, if all of the dealers are clearing members and one of the dealers defaults, there's a good chance the clearinghouse will be able to transfer most of the defaulting member's derivatives book to other clearing members, smoothing the resolution of the defaulting dealer and minimizing the strain on the guaranty fund.
Another major problem with the Lynch amendment is its potential effect on the liquidity of cleared OTC derivatives. As the name implies, "swap dealers" are the market-makers in OTC derivatives. There's already a question as to whether a lot of standardized OTC derivatives are liquid enough to be centrally cleared. I personally think they are, but the Lynch amendment would make it a very close call. You have to think about why clearinghouses only accept liquid derivatives for clearing — in order to collect the right amount of collateral (or "variation margin") from counterparties, cleared derivatives need to be liquid enough to accurately mark-to-market every day. If mark-to-market prices aren't available, a clearinghouse won't be able accurately value the contract, and it won't know how much collateral to demand from counterparties. If a clearinghouse only has 2 or 3 dealers as clearing members — which, again, would be the ultimate effect of the Lynch amendment — then its access to the (real-time) pricing information it needs to accurately set mark-to-market values will be severely constrained. A clearinghouse needs several dealers to be clearing members (at least 7 or 8) in order to accurately mark-to-market standardized OTC derivatives on a daily basis.
Finally, Rep. Lynch is wrong to say that the clearinghouses "are being created to police the big banks in their derivatives trading." Uh, no Congressman, they're not. There's a reason we often say that standardized derivatives should be forced onto "regulated clearinghouses" — it's because the clearinghouses would be "regulated" by the CFTC and SEC! The CFTC and SEC will be the ones policing the OTC derivatives markets, as they'll have nearly unfettered access to clearinghouse data, as well as the authority to impose pretty much whatever standards they want on the clearinghouses. A regulated clearinghouse can only make rules for its members within the confines of CFTC/SEC regulations. Warning that the big banks will be allowed to police themselves without the Lynch amendment is a pure straw man.
Let's hope the Senate takes a second to think through the Lynch amendment before it takes up financial regulatory reform.