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 Replumbing Our Financial System:
Uneven Progress *
  Abstract: The financial crisis of 2007-2009 has spurred significant ongoing changes in the "pipes and valves" through which cash and risk flow in the center of our financial system. These include adjustments to the forms of lender-of-last-resort financing from the central bank and changes the
infrastructure for the wholesale overnight financing of major dealer banks. Significant changes in the regulation of money market funds are under consideration. The Dodd-Frank Act mandates the central clearing of standardized over-the-counter derivatives, although a pending exemption of
foreign-exchange derivatives remains to be decided. The vulnerability of major dealers to runs by prime brokerage clients is also an issue to be addressed. I focus on U.S. financial plumbing and on areas where financial stability remains a concern.
  1 Introduction Weaknesses in the "plumbing" of the financial system that came to light during the financial crisis of 2007-2009 have prompted reforms that are ongoing. On this path toward greater financial stability, progress has been uneven. My objective here is to focus on some weaknesses that remain. "Plumbing" is a common metaphor for institutional elements of the financial system that are fixed in the short run and enable flows of credit, capital, and financial risk. This institutional structure includes some big "valves and pipes" that connect central banks, dealer banks, money market
funds, major institutional investors, repo clearing banks, over-the-counter (OTC) derivatives central clearing parties, and exchanges. The connectors include lending facilities offered by central banks to each other and to dealer banks, tri-party repo and clearing agreements, OTC derivatives master
swap agreements, prime-brokerage agreements, and settlement systems arranged through FedWire, CHIPS, CLS Bank, DTC, the two main clearing banks for tri-party repurchase agreements, and other major custodians and settlement systems. The institutional framework depends significantly on regulations. Largely because of changes in financial regulation, we are heading toward a safer financial system. Of primary importance in this progress are improvements in capital and liquidity requirements for regulated banks, although these
are not my main focus here. Improvements in the plumbing of the financial system, however, have in some areas been partial or halting. Just as the wider economy depends on an effective financial system for allocating credit, capital, and risk among ultimate economic actors, the internal effectiveness of the financial system depends on the proper functioning of financial infrastructure. At the onset of a financial crisis,
institutional arrangements that are fixed in the short run determine the scope for discretionary action, of both harmful and risk-reducing types. Some of these arrangements, such as central-bank emergency liquidity facilities, are only activated during a crisis. Plumbing elements should not only be
resilient to stresses such as the defaults of interacting entities, they should also be placed and designed so as to permit the sorts of transfers that may be needed in a crisis. Typical approaches to financial risk management that balance failure risk against away-from-failure operating efficiency should, in my view, be fully re-calibrated for applications to certain key financial market infrastructure. Although regulators are working toward a world that can more easily
tolerate the failure of large financial institutions, I doubt that we should view some of the key financial infrastructure in the same way. Obviously there should be effective failure-management plans for all key financial market infrastructure, such as repo clearing facilities and OTC derivatives
central clearing parties (CCPs), but the public interest suggests that these kinds of utilities should be designed, regulated, and managed with the objective that it is extremely difficult for them to fail catastrophically. The expected spillover costs of the failure of large financial utilities
such as these are significant relative to the costs of safer designs. Moreover, the threat of their potential failure can lead financial market participants to react defensively in ways that destabilize markets. Considering as well the narrow scope for moral hazard associated with dedicated
financial market utilities, my view is that we can afford to design and regulate some of these utilities as though they are "too important to fail." If that is the case, the operations and capital structure of these utilities should not be entangled with those of larger and more complex financial
institutions, especially if there is an intention to let those financial institutions fail whenever they cannot meet their obligations. In the course of this overview, I will focus on the following policy issues: The emergency plumbing available to the Fed has changed. We are now in an environment in which the importance of emergency access to a secured lender of last resort is widely recognized, but is available for a systemically important non-bank financial institution under a limited and potentially
shrinking set of circumstances. Events could some day arise in which it would be difficult for the central bank to provide effective emergency liquidity.
Given the systemic importance of tri-party clearing agents, and given their high fixed costs and additional economies of scale, tri-party repo clearing services for U.S. dealers and cash investors should probably operate through a dedicated regulated utility. Although this would likely increase
operating costs for market participants, it would enable investment in more advanced clearing technology and financial expertise, allowing greater resilience of the tri-party repo market in the face of financial shocks such as the default of a major dealer. The moral hazard associated with lending
of last resort to a dedicated utility is much reduced relative to the case of a financial institution with a wide scope of risk-taking activities.
Large institutional investors in money market funds are prone to run in the face of losses. Systemically important borrowers such as dealer banks remain dependent on short-term financing from money market funds, among other key lenders, particularly through tri-party repos. The Securities and
Exchange Commission (SEC) is considering new regulatory requirements for money market funds, such as capital buffers and redemption gates, with the goal of lowering the risk of runs by money market fund investors. Further reform of money market funds is indeed necessary for financial stability. The
unintended consequences of the reform of money market funds, however, may include a shift to other forms of run-prone wholesale short-term lending to critical borrowers. Close principles-based supervision of systemically important short-term wholesale financing will also be needed.
Central clearing parties for OTC derivatives are proliferating. This risks a significant and unnecessary rise in counterparty exposures as well as the dilution of regulatory oversight across many CCPs. Competition among CCPs could lead to reduced demands on members for default management
resources such as margin. Fewer CCPs, each closely supervised, should be a goal. To this end, arrangements should be made for the cross-jurisdictional regulatory supervision of CCPs wherever possible, with clear assignment of regulatory responsibilities and lines of access to central-bank liquidity
support. Regulatory minimum margin standards should be strong and harmonized. Effective plans for dealing with the failure of a CCP are yet to be established, to my knowledge.
If it is agreed that the central clearing of standardized OTC derivatives is an important source of financial stability, there is every reason to include foreign exchange (FX) derivatives in the requirement for central clearing, or some effective substitute. It is currently proposed that FX
derivatives should be exempted from clearing and other major new regulations for OTC derivatives markets, which include collateral standards for uncleared positions, trade execution in swap execution facilities, and post-trade transaction reporting. Regulators abroad are likely to follow the lead
of the United States in this area.
Prime brokerage was revealed to be an important weak link in the financial system immediately after the failure of Lehman Brothers in 2008. Rule 15-c-3 of the U.S. Securities Exchange Act of 1934 had appeared to safely limit the dependence of a U.S. dealer for liquidity on its prime-brokerage
business. It did not. The United Kingdom had almost no regulatory standards on this dimension. Morgan Stanley suffered a firm-threatening loss of liquidity due to a sudden run by its prime brokerage hedge-fund clients in both the United States and the United Kingdom after the failure of
Lehman Brothers. An in-depth forensic analysis of the mechanics of this run is warranted. The lessons learned should be published and used to revise Rule 15-c-3 and to improve the regulatory treatment of prime brokerage in London and emerging global financial centers.
 2 Changes in Central Bank Plumbing Before the financial crisis of 2007-2009, central bank liquidity was provided to financial markets mainly through normal monetary operations conducted through primary dealers, and through limited forms of lender-of-last-resort financing. The latter included secured lending through the discount
window to regulated banks as well as the potential for emergency secured lending to essentially any market participant under Section 13(3) of the Federal Reserve Act. The Dodd-Frank Act now restricts "13(3)" emergency financing to a "program or facility with broad-based eligibility." Thus,
individual non-bank firms can no longer obtain emergency financing directly from the central bank. Because of the extreme stresses of the financial crisis, the Federal Reserve set up a range of broad lender-of-last-resort programs and facilities, such as the Primary Dealer Credit Facility (PDCF), the Term Auction Facility (TAF), the Money Market Investor Funding Facility (MMIFF), the
Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Term Securities Lending Facility (TSLF), the Commercial Paper Funding Facility (CPFF), and the Term Asset-Backed Securities Loan Facility (TALF). Many of these facilities would presumably have met the statutory
criterion, had it applied at the time, of "broad-based eligibility." They played a crucial role in mitigating the severity of the financial crisis of 2007-2009. Versions of these facilities could be resurrected in a future crisis. **Figure 1:** Lines of emergency liquidity provision by a central bank, through the discount window to domestic banks, indirectly to foreign banks through central-bank currency swap lines, through a "program or facility with broad-based eligibility" such as
the Primary Dealer Credit Facility, and to a financial market utility under Title VIII of the Dodd-Frank Act.
Figure 1: Lines of emergency liquidity provision by a central bank, through the discount window to domestic banks, indirectly to foreign banks through central-bank currency swap lines, through a (program or facility with broad-based eligibility) such as the Primary Dealer Credit Facility, and to a financial market utility under Title VIII of the Dodd-Frank Act. This figure is a flow chart with the central bank (CB) in the middle and multiple arrows going outward to other entities. All arrows are double-sided. There are arrows from CB to separate entities surrounding it, including B1, B2, B3, which are colored with a blue square. Also there is an arrow between the CB and the CCP, which is labeled with a red triangle. There is an arrow between the CB and a large circle, which contains 5 small unlabeled purple squares in its space. Finally, there is an arrow from CB to FCB, which is designated as a green pentagon. From the FCB, there are two sided arrows in two different directions, one pointing to FB1 and the other to FB2, both of which are represented as green squares. There is one dotted one-way arrow from FB1 to space, while there are two dotted one-way arrows from FB2 into space.
 In addition, as illustrated in Figure 1, in 2007 the Fed set up "currency swap lines" that provided dollar liquidity to foreign central banks.1 These currency swap lines enable a foreign central bank to provide lender-of-last-resort financing in dollars to banks within in its own jurisdiction, and in principle allowed the Fed to give U.S. banks access to foreign currencies. Because of the "reserve-currency"
status of the U.S. dollar, global financial stability depends on global access to emergency secured loans of last resort in dollars. With the innovation of these currency central-bank swap lines, the U.S. central bank has improved financial stability while allowing foreign central banks to monitor
and absorb the credit risk of the banks to which the dollars ultimately flow. That these currency swap lines have been a useful addition to the plumbing of the financial system was demonstrated during the 2007-2009 crisis and more recently during the Eurozone debt crisis. Title VIII of the Dodd-Frank Act allows the central bank to provide liquidity support to financial market utilities such as central clearing parties. The ability to take advantage of this emergency secured lending to stabilize a financial market utility (FMU) depends in part on the default
management plan of the FMU. Because of the nature of its balance sheet, a CCP may have a limited sets of assets to post as collateral to the central bank by the time of its near failure or failure. As opposed to the case of a large bank, there would be no large class of unsecured creditors to
absorb losses. The counterparties of a CCP are typically systemically important themselves. Because of these concerns, Duffie and Skeel (2012) point to the potential importance of a short stay2 on the OTC derivatives of a CCP at its bankruptcy, or at its resolution under Title II of the Dodd-Frank Act. **Figure 2:** A schematic of access of a bank affiliate, such as a broker dealer, to indirect lender-of-last-resort secured financing through its bank affiliate, as limited by sections 23A and 23B of the Federal Reserve Act.
Figure 2: A schematic of access of a bank affiliate, such as a broker dealer, to indirect lender-of-last-resort secured financing through its bank affiliate, as limited by sections 23A and 23B of the Federal Reserve Act. This figure is a flow chart from left to right. On the left is a light blue pentagon labeled with CB. There is a two-sided arrow between CB and a blue square labeled B1 which is in the middle. Then there is a two-sided arrow (itself labeled Section 23A) between B1 and BD1, which is prepresented by a red square. Finally, there is a one-sided dotted arrow leading from B1 into space, and the same for BD1.
 The ability of the Federal Reserve to provide indirect liquidity to affiliates of regulated banks, such as broker-dealers, is limited by section 23A of the Federal Reserve Act, which restricts transactions between a bank and its affiliates, as illustrated in Figure 2. Omarova
(2011) argues that during the financial crisis of 2007-2009 section 23A included sufficient exemptive power for the Fed to provide substantial emergency liquidity.3 The Dodd-Frank Act, however, has placed significant additional restrictions on "23A transactions." Section 23A and section 23B still provide some scope for exemptive liquidity provision, subject however to a finding by the Federal Deposit Insurance Corporation that the
exemption does not place the Deposit Insurance Fund at risk, among other requirements. In summary, if a systemically important non-bank market participant is threatened by a liquidity crisis, lender-of-last-resort secured financing from the Fed can now be obtained only under broad programs or indirectly via the new version of section 23A, which is generally more restrictive. Even
assuming that a broad program could be arranged quickly enough in an emergency situation, the design of such a program places a central bank under some stress. Depending on the breath of eligibility of such a program, the central bank could be accused of exceeding its mandate. If the program is
aimed broadly but few borrowers ultimately participate, the same concerns could be raised, whether or not they are legitimate. Some of the targeted market participants might hold back in the face of concerns over stigma regarding their need for funding or over the potential for expectations by the
public or some public officials of quid-pro-quo behavior by the borrower. Among other implications, the new and more limited scope for lender-of-last-resort financing to non-banks merits attention given the potential for new regulations such as the Volcker Rule to incite the emergence of large broker-dealers that are not affiliates of bank holding companies.4 If that were to occur, significant quantities of collateral would be placed further from access to lender-of-last resort financing. These assets may include, for
example, over-the-counter derivatives and foreign assets held on the balance sheets of U.S. banks and bank subsidiaries. Section 23A provides an exception for derivatives. Of the five major U.S. bank holding companies operating OTC derivatives dealers, J.P. Morgan, Bank of America, Goldman Sachs,
Citigroup, and Morgan Stanley, all but Morgan Stanley keep most of their OTC derivatives on the balance sheets of the respective regulated banks. The Edge Act allows classes of foreign assets to be held by subsidiaries U.S. banks, where 23A restrictions are less onerous. For a broker-dealer
unaffiliated with a bank, access to a lender of last resort through transactions allowed under Section 23A (and its exemptions) is irrelevant, and only broad programmatic emergency lending would be available. This issue also elevates the importance of strong capital and liquidity standards for
non-bank financial firms, which do not fall under the scope of the Basel III process.
 3 Tri-Party Repo, Dealer Liquidity, and Money Market Funds A repurchase agreement, or "repo," is in essence a secured loan.5 A delivery-versus-payment (DvP) repo is arranged through direct transfers between
borrower and lender of cash and securities. A substantial quantity of repos are instead arranged in the tri-party market, which is serviced by two clearing banks, JP Morgan Chase and Bank of New York Mellon. The tri-party repo market is the source of over $100 billion in overnight financing to each of several major U.S. dealer banks. The aggregate quantity of repos handled by this market was $1.74 trillion in February, 2012.6 Money-market funds and securities lenders are major sources of cash lending. Most of these cash lenders lack the operational or regulatory capability to conduct DvP repos. As illustrated in Figure 3, in order to
obtain this form of financing, a dealer bank places collateralizing securities in the clearing-bank account of its cash lender. Each dealer depends crucially on the willingness of its clearing bank to facilitate this lending. In particular, when the repos mature each day, the clearing bank offers
intra-day financing to the dealer for its securities until the dealer and clearing bank have completed the allocation of the dealer's collateral into new repo financing from cash lenders. Reforms of the tri-party market infrastructure have been slow. The senior industry task force charged with implementing these reforms brought their work to a halt in February 2012, incomplete. In its "Statement on the Release of the Tri-party Repo Infrastructure Reform Task Force's Final
Report," released on February 15, 2012, the Federal Reserve Bank of New York, the primary regulator of the try-party repo market, stated that "the amount of intraday credit provided by clearing banks has not yet been meaningfully reduced, and therefore, the systemic risk associated with this
market remains unchanged." Among the upgrades of tri-party infrastructure that remain to be implemented are more automated collateral substitution and collateral allocation processes. These would allow a smoother and safer rolling of maturing repos into new repos.7 The objectives of the reforms undertaken by the tri-party repo industry task force are illustrated in Figure 4. The main accomplishment to this point is to
reduce the portion of the day over which the clearing banks provide secured credit to dealers. These reforms are still hampered by insufficient automation and by timing of repo unwinds relative to the completion of transfers of collateralizing securities through FedWire, the DTCC, and the Fixed
Income Clearing Corporation. **Figure 3:** A schematic of a tri-party repurchase agreement between a cash investors, such as a money market fund, and a dealer bank. A clearing bank acts as an agent for the trade.
Figure 3: A schematic of a tri-party repurchase agreement between a cash investors, such as a money market fund, and a dealer bank. A clearing bank acts as an agent for the trade. This is a flow chart. There are two red boxes on the left and right, one labeled Cash Investor (CI) and the other Dealer (D). In between these two red boxes is a blue circle labeled Tri-Party Clearing Bank (TPCB). From CI to TPCB there is an arrow labeled Cash. From TPCB to D there is an arrow labeled Cash. From D to TPCB there is an arrow labeled Securities.
 **Figure 4:** Ongoing adjustments in the daily unwind and rewind of try-party repos, with the main objective of lowering the exposure of a clearing bank to a intra-day credit risk.
Figure 4: Ongoing adjustments in the daily unwind and rewind of try-party repos, with the main objective of lowering the exposure of a clearing bank to a intra-day credit risk. This chart is a flow chart separated into two parts - on the top is Pre-Reform and on the bottom is Post-Reform. First Pre-Reform will be described. There is a long arrow segmented into three categories. The left and right parts of the arrow are labeled Cash Investors, and are colored in blue. In the middle is a red segment labeled Clearing Banks. Right below the junction between the left and middle parts of the arrow, there is a label of 8:30 AM. Right below the junction between the middle and right parts of the arrow, there is a label of 5:30 PM. Under this arrow, there are three lines labeled FICC GCF Repos Settle (which is under 5:30PM), DTCC Equities Available(which is under and to the left of 5:30PM), and Fedwire Securities Interbank Open (which stretches from 8:30AM to 3:30 PM. Now Post-Reform. There is a long rectangle segmented into three columns. The first column, which takes up about half the rectangle, is labeled Cash investors. The second column, which takes up the next quarter of the rectangle, is split into two parts. A small slice on the top is labeled Goal < 10 \%, and is red. The bottom larger slice is labeled Cash Investors. Then the third column is labeled Cash Investors. Right above the junction between the first and second columns, there is a label of 3:30 PM
 Institutional investors in money-market mutual funds, in the face of any concerns over the exposures of their money-market funds to dealers, are apt to immediately redeem their money-market fund shares. Institutional investors treat their money-market fund shares as though cash; any loss
relative to the normal price of one dollar per share is viewed by these investors as essentially unacceptable. Indeed, when the Reserve Primary Fund "broke the buck" in 2008 through its exposure to Lehman Brothers, there was a general industry-wide run by institutional investors in prime money
market funds, amounting to roughly 40% of their funds over a two-week period.8 This run would have continued but for the prompt action of the U.S. Treasury to
guarantee all money market funds. Such a guarantee by the government is considered to be no longer permissible, absent congressional action. Since the financial crisis of 2007-2009, Rule 2a7 of the Securities Exchange Act significantly tightened the quality and liquidity requirements of
money-market funds. In my opinion, Rule 2a7 should be further improved by diversification requirements. For example, in the summer of 2010, the top 5 exposures of U.S. prime money market fund assets were all to European banks, with each of the five banks representing an exposure of at least 2.5% of
aggregate fund assets.9 As illustrated in Figure 5, the Squam Lake Group (2011) recommended that money market funds be required to have their shares marked to market, or alternatively that money market funds have loss buffers of some form, such as third-party insurance or
over-collateralization.10 The SEC is preparing a recommendation for further regulation of money market funds. **Figure 5:** An illustration of the recommendation of the Squam Lake Group to have money market shares trade at a price that is marked to the current market value of the fund's assets, or alternatively for money market funds to be buffered against loss.
Figure 5: An illustration of the recommendation of the Squam Lake Group to have money market shares trade at a price that is marked to the current market value of the fund's assets, or alternatively for money market funds to be buffered against loss. This is a figure with two vertical bars (a bar chart without its axes). The bar on the left is divided into two parts, the bottom part being labeled Market Value and going up to 99.60 and the top part being labeled Accounting NAV, which goes up to 100. The right bar is also split in two, with the bottom being labeled Market Value and going up to 100, and with the top being labeled Buffer and going up to 100 + b.
 The tri-party repo market infrastructure, the heavy reliance of major dealers on short-term financing, and the current design of money market funds, collectively present several sources of systemic risk: A dealer whose solvency or liquidity come into question may be unable to find cash lenders that are willing to roll over a sufficient quantity of its repos. In that case, concerns over a dealer's liquidity might be self-fulfilling. The dealer could fail, or its securities might need to be
liquidated in a fire sale, or both. Figure 6 illustrates the rapid reduction of Lehman's tri-party repo book around the time of its failure, based on data from the Federal Reserve Bank of New York.
A fire sale of a dealer's securities caused by the dealer's inability to roll over its repo financing on a given day could temporarily depress the prices of some of the affected classes of securities, particularly those securities that lack transparency or whose credit-worthiness depends on the
stability of the financial sector. This could have spillover effects to other dealers and more broadly.
Between the unwinding of the previous day's repos and the roll into the next day's repos, money market funds and other cash investors claims are in the form of demand deposits at the clearing bank. In extreme scenarios and in the absence of sufficient transparency, cash investors could become
concerned that a clearing bank could be destabilized by its intra-day secured-lending exposure to a dealer. A run of these intra-day demand deposits could indeed destabilize the balance sheet of a clearing bank in the worst case. Access to intra-day lender-of-last-resort financing to the clearing
bank from the Fed could depend in part on the mix of collateralizing assets.
In light of such concerns, a clearing bank could fail to provide intra-day financing to a dealer. At current magnitudes, the loss of this financing could be life threatening to a dealer.
Institutional investors in money market funds, harboring any concerns about losses, could run indiscriminately as in 2008, forcing the managers of even those money market funds that are in good financial condition to sharply reduce their cash lending to even the safest dealers. Through a
combination of the other effects mentioned above, this could "spiral" into a severe lack of liquidity at the center of the financial system. These weaknesses point to the importance of the liquidity of collateral used in the tri-party repo market. Currently, approximately 80% of the collateral used in the tri-party repo market consists of treasuries or agencies (including agency debentures, agency MBS, and agency collateralized
mortgage obligations) that are eligible as collateral for financing from the Federal Reserve. The largest classes on non-Fed-eligible assets used in the tri-party market are corporate bonds and equities, which each constitute approximately 5% of the total, as of February 2012.11 The new Basel III requirements for liquidity coverage ratios are likely to be effective at forcing regulated financial institutions to maintain a reduced dependence on short-term repos for financing their securities inventories. Some consideration should be given to parallel regulatory
requirements for non-bank systemically important wholesale cash borrowers. **Figure 6:** Quantities of assets of various classes financed by Lehman Brothers through tri-party repos, in the days surrounding Lehman's failure. Source: Copeland, Martin, and Walker (2011), from data provided by the Federal Reserve Bank of New York.
Figure 6: Quantities of assets of various classes financed by Lehman Brothers through tri-party repos, in the days surrounding Lehman's failure. Source: Copeland, Martin, and Walker (2011), from data provided by the Federal Reserve Bank of New York. This figure is a time-series representation of the components of the total assets. The x-axis is time, from 7/18/12 to 9/26/12. The y-axis is billions of dollars, from 0 to 200. There is a vertical line slightly to the right of 9/12/12 labeled Lehman Bankruptcy. At the start in 7/18, the total assets of \$180 billion is split fairly evenly between US Treasuries and Strips, Agency Debentures, Agency MBS, and Non-Fed Eligible. There are two negligible categories, Cash and Other Fed-Eligible. These ratios vary slightly but stay relatively the same until around 9/12, when they all plunging. By the Lehman Bankruptcy line, almost all the categories are negligible except for Non-Fed Eligible, which reaches up to around \$60 billion. A few days after bankruptcy, all values are zero except cash, which is about \$10 billion, and then drops to 0 by 9/26.
 Given the systemic importance of tri-party repo clearing, and its high fixed costs and other sources of economies of scale, tri-party repo clearing services for U.S. dealers and cash investors should probably operate as a regulated utility. Although this would likely increase operating costs for
market participants, it would enable the investment in more robust clearing technology and lead to a more resilient wholesale funding market for dealer banks. It is not yet clear whether the better design is based on a clearing agent that facilitates bilateral repos, or based on a central clearing
facility that acts as a direct counterparty to each member participant. The current market for access to tri-party repo services seems to have lead to a level of investment in infrastructure that reflects a significant wedge between costs that can be captured through pricing by the service
providers and total costs to the broader economy including those associated with systemic risk. A dedicated utility acting as a regulated monopoly could improve this situation. Further, the possibility that risks unrelated to repo clearing could threaten one of the banks currently operating
systemically crucial repo facilities is not a good choice, in my opinion. As unlikely as such a failure may be, the systemic importance of a tri-party repo clearing facility unnecessarily raises the systemic importance of the bank that operates the facility. This could increase moral hazard, and in
any case runs counter to suggestions by some that the U.S. is now in a position to safely force any large financial institution into failure resolution. A dedicated tri-party repo utility would also be relatively more transparent to its users and its primary regulator.
 4 Central Clearing of Over-the-Counter Derivatives A derivatives contract is "cleared" when the performance of the buyer and the seller is effectively guaranteed by a special purpose financial utility known as a central clearing party (CCP). A CCP becomes the buyer to each seller, and the seller to each buyer. Central clearing is suitable for
standardized derivatives, those which are sufficiently widely traded to be safely and efficiently handled by a CCP. A key element of the new regulatory approach to financial stability is the central clearing of standardized derivatives, which is mandated (with exceptions) by Title VII of the Dodd-Frank Act and by comparable regulation in most G20 countries. Effective clearing mitigates systemic risk by
lowering the risk that defaults propagate from counterparty to counterparty. Such a chain reaction did not occur during the financial crisis of 2007-2009, but this may be partly due to a decision to "bail out" AIG over its losses on OTC derivatives positions. (In any case, the AIG derivatives
were too customized to be handled safely by a CCP.) Clearing also reduces the degree to which the solvency problems of a market participant are suddenly compounded by a flight of its OTC derivative counterparties, such as when the solvency of Bear Stearns and Lehman Brothers was in question.
Central clearing further promotes financial stability through improved transparency into counteparty credit risk. With a well regulated CCP, market participants and regulatory supervisors should be in a better position to judge counterparty risk and default-management capabilities. They can better
monitor the uniform application of collateral requirements on all members. The scope of potential forms of risk taking and failure mechanisms of CCPs are limited relative to those of a large dealer bank, the main alternative type of counterparty, given that essentially all over-the-counter
derivatives are first negotiated with a major dealer. Central clearing, if it covers a sufficient amount of derivatives trade and is conducted at sufficiently few CCPs, also lowers average counterparty risk through the effect of netting, as illustrated in Figures 7 and 8, and as modeled by Duffie and Zhu
(2011).12 **Figure 7:** A simple illustration of reductions in counterparty exposure through the effect of netting at a central clearing party.
Figure 7: A simple illustration of reductions in counterparty exposure through the effect of netting at a central clearing party. This figure is separated on the left and right. On the left, there are three circles arranged in a triangle labeled A, B and C. From A to C there is an arrow labeled 80, from C to B there is an arrow labeled 90, and from B to A there is an arrow labeled 100. On the right, the circles are arranged in the same triangular manner, but in addition there is a small red triangle centered in the triangle between the three circles. From C and B, there is an arrow labeled 10 going into the red triangle. From the red triangle to A, there is an arrow labeled 20.
 **Figure 8:** An illustration of the increase in counterparty exposures that arises from a proliferation of CCPs.
Figure 8: An illustration of the increase in counterparty exposures that arises from a proliferation of CCPs. This figure is separated on the left and right. On the left, there are three circles arranged in a triangle labeled A, B and C. From A to C there is an arrow labeled 80, from C to B there is an arrow labeled 90, and from B to A there is an arrow labeled 100. On the right, the circles are arranged in the same triangular manner, but in addition there two small small red triangles centered in the triangle between the three circles. One triangle is labeled CCP1 and the other CCP2. From A to CCP2 there is an arrow labeled 80. From C to CCP there is an arrow labeled 10. From CCP2 to B there is an arrow labeled 90. From B to CCP1 there is an arrow labeled 100. From CCP1 to A there is an arrow labeled 100.
 The U.S. Treasury Department has proposed to exempt foreign exchange derivatives from recent regulatory requirements for over-the-counter derivatives, including clearing, trade competition, and minimum collateral requirements. In my opinion, the arguments that have been made for such an
exemption are not sufficient. Major participants in the FX derivatives market have strongly resisted the clearing of counterparty default exposures. They correctly emphasize that, as opposed to derivatives that are settled by a payment of only the net market value of the contract, a large fraction of FX derivatives are
settled when each of the two parties pays the gross amount of the currency due on its side, through a payment-versus-payment procedure at CLS Bank. A conventional approach to clearing FX derivatives might therefore entail some special operational risks or costs. For example, if CLS were to clear
counterparty default exposures and as a result be exposed to the failure of one or more clearing members, then CLS Bank might at some point become unable to complete crucial deliveries of large amounts of currencies. This could lead to a significant disruption of financial markets or international
commerce. Arguably, this may suggest that CLS Bank should not provide clearing services in combination with its settlement services. On the other hand, the claim by some market participants that FX derivatives exposures are small, thus representing little benefit from clearing, is not well
supported by my review of the publicly available data on FX volatilities, gross market values of positions, volumes of derivatives trading by maturity, and total outstanding notional amounts of FX derivatives.13 If clearing is indeed an important mitigant of systemic risk, then a failure to further regulate counterparty risk in the foreign exchange derivatives market could be a significant mistake. The component of counterparty risk that is not treated by settlement at CLS could be covered by a parallel
system of contracts by which a separate margin-holding financial utility offers protection against losses in the net market value of FX derivative caused by counterparty defaults. This parallel financial utility would maintain a default guarantee fund and collect initial and variation margin based
on the daily revaluation of the FX derivatives, in essentially the same manner as a normal central clearing counterparty (CCP). This would not provide a backstop for the gross deliveries of currencies through CLS, but would insulate original counterparties (some of whom are systemically important)
from potentially important losses in market value due to counterparty failure. In order to obtain both operating efficiencies as well as the benefit of netting gains against losses on other classes of derivatives, the financial utility could be encompassed within an existing CCP. According to data provided by the financial industry organization known as the "Foreign Exchange Committee," and available through the web site of the Federal Reserve Bank of New York,14 more than 40% of the monthly volume of new FX forward contracts have maturities over one month. These longer-maturity forwards have a total notional monthly volume of $1.4 trillion. Roughly 30% of the monthly volume of new FX
swaps have maturities of over one month. These longer-maturity swaps have a total monthly volume of about $1.8 trillion.15 Even larger than these new-trade
volumes are the total outstanding notional amounts of these derivatives that exist at maturities over one month. Disclosure of the outstanding amounts by maturity is not provided by the Foreign Exchange Committee. In my opinion, the outstanding amounts, by maturity, should be publicly disclosed in
order to facilitate an analysis of market-wide counterparty risk. In its own survey, the Bank for International Settlements (BIS) reports a total outstanding notional amount of foreign exchange swaps and forwards (not including ISDA-style currency swaps) of roughly $31 trillion, as of June 2010.16 There are no publicly available data bearing on the effective average maturity of FX forwards and swaps, a critical gap in our knowledge of whether the risks from this class of derivatives are systemically
important. Based on the BIS data as well as the monthly volume data provided by the Foreign Exchange Committee, the total outstanding notional amount of FX forwards and swaps with maturities over one month could be of the order of $10 trillion. The BIS survey indicates that the total gross market value of outstanding FX forwards and swaps was $777 billion in June 2011. (The gross market value of a derivatives contract is the amount that would be lost in the event of default, before considering the effect of netting gains against losses
on other derivatives, and before considering recoveries, for example through the application of collateral.) The total gross value of FX forwards and swaps is more than that of equity derivatives ($708 billion) or commodity derivatives ($471 billion). Equity and commodity derivatives were not
exempted from the clearing and other requirements of the Dodd-Frank Act. Further, the total gross market value of FX forwards and swaps is about 60% of the total gross market value of credit default swaps ($1.35 trillion). The market values of credit default swaps (CDS) may have lower volatility,
on average, than those of FX derivatives. Absent the disclosure of data allowing a proper quantitative analysis, the total effective amount of counterparty risk in the FX derivatives market could be of a magnitude similar to that of the market for credit default swaps. The importance of clearing
credit default swaps figured prominently in legislative discussions preceding the Dodd-Frank Act. Taken together, the above data do not support the view that foreign exchange derivatives represent a small amount of counterparty risk. The volatilities of currency prices are significant, and could increase dramatically in certain types of financial or currency crises, or dramatic currency
realignments such as that following the "Plaza Accord" of September, 1985. The tail risks of counterparty exposure on FX contracts can be quite large, particularly in situations with significant sovereign risk, which may plausibly arise in coming years. Volumes in FX markets have been growing
rapidly. Within a decade, the Chinese currency, the Renminbi, is likely to add significantly to the volume of FX markets and to total FX counterparty risk. The FX market also exhibits substantial concentration to specific currencies, particularly the U.S. dollar and the Euro. According to the most
recent data provided by the Foreign Exchange Committee, FX derivatives for the delivery of dollars against Euros account for over 25% of the total volume of FX derivatives trading. By comparison, the market for credit default swaps has a far lower concentration of trade on a single underlying risk
factor. **Figure 9:** A schematic of the provision of margin on foreign exchange derivatives contracts to a financial market utility.
Figure 9: A schematic of the provision of margin on foreign exchange derivatives contracts to a financial market utility. This figure is a flow chart with four entities organized in a diamond shape. On the left is a blue circle labeled A, on the top is a red triangle labeled CLS, on the right is a blue circle labeled B, and on the bottom is a purple triangle labeled Margin Custodian(MC). Between A to CLS there is a double-sided arrow labeled USD-EUR. Between B to CLS there is a double-sided arrow labeled USD-EUR. Between A and MC there is a double-sided arrow labeled Margin. Between B and MC there is a double-sided arrow labeled Margin. Between MC and CLS there is a double-sided arrow labeled DATA.
 Figure 9 illustrates a potential approach that I have proposed for obtaining an economic effect similar to that of clearing for those FX derivatives that are settled at CLS Bank. As the dollar-Euro contract increases in market value to Bank A through fluctuations in
currency prices, variation margin payments are collected from Bank B by a special-purpose financial utility. The financial utility could be operated by a traditional central clearing party (CCP) or by CLS Bank. The margin payments are made in an agreed standard margin currency, such as U.S.
dollars. If the market value of the position of Bank A subsequently declines, a corresponding amount of the margin that had been posted by Bank B is returned to Bank B.17 In order to lower operational costs, FX contracts with a sufficiently short maturity, for example under one week, could be exempted from a clearing requirement. Likewise, exemptions could be provided for FX derivative contracts in relatively illiquid currency pairs, or for customized financial
products with small notional amounts. Finally, one could exempt from clearing those market participants whose total notional derivatives positions are below some reasonable quantity threshold. One must be cautious, of course, to avoid regulations that unintentionally encourage the migration of
trade to exempted products or participants. International standards established by CPSS-IOSCO18 for the central clearing of derivatives do not contemplate
the elimination of delivery settlement risk at one financial utility (in this case, CLS Bank) and the indemnification of losses of net market value due to counterparty failure in a separate financial utility. The CPSS-IOSCO standards call for this combined effect of clearing to be obtained instead
by a single financial utility that becomes the legal counterparty to the original buyer and seller. Thus if the U.S. Treasury wishes to adopt an alternative approach such as that proposed here, it may find it necessary to issue an exemption with respect to the manner in which the effect of clearing
is to be obtained. The proposed exemption of FX derivatives from the requirements of the Commodities Exchange Act as "swaps" would also exempt uncleared FX derivatives from minimum bilateral collateral requirements. To exempt both cleared and uncleared FX derivatives from minimum regulatory standards for
collateralization or margin would, in my opinion, be a mistake. **Figure 10:** A schematic of assets pledged to a prime broker and repledged to the third party.
Figure 10: A schematic of assets pledged to a prime broker and repledged to the third party. This is a flow chart with four entities. There is a green box labeled investor. There is a larger blue box labeled Dealer Bank (Prime Broker), with a small subsection within the blue box that is divided by a dotted line. The subsection is labeled Cash and Securities. Finally, there are two red boxes labaled Hedge Fund A and Hedge Fund B. There is a line from each of the hedge funds to the Cash and Securities subsection in the blue box. Between Investor and Cash and securities there is a double-sided arrow labeled Securities. Between Investor to Dealer Bank (Prime Broker) there is a double-sided arrow labeled Cash.
 5 Prime Brokerage and Dealer Liquidity Several large dealers are active as "prime brokers" to hedge funds and other large investors. A prime broker provides clients a range of services, including custody of securities, clearing, cash management services, securities lending, financing, and reporting. A dealer also frequently serve
as derivatives counterparty to its prime-brokerage clients. In the United States, Rule 15c3 of the Securities Exchange Act of 1934 protects brokerage clients from exposure to a broker-dealer failure. During the financial crisis of 2007-2009, however, it appears that this rule did not prevent large
broker dealers from being de-stabilized by the departure of their prime brokerage clients. **Figure 11:** Securities pledged to Morgan Stanley that were available to be repledged to third parties. Data source: Aitken and Singh (2009), from SEC filings. Figure source: Duffie (2010).
Figure 11: Securities pledged to Morgan Stanley that were available to be repledged to third parties. Data source: Aitken and Singh (2009), from SEC filings. Figure source: Duffie (2010). This is a bar chart. The x-axis is labeled as Time, from Nov 05 to Mar 09. The y-axis is the number of securities. In Nov 05 the number was 798 before rising to 953 in May 08, then down to 877 in Aug 08 before dropping dramatically to 295 in Nov 08, and 283 Mar 09.
 In the United Kingdom, securities and cash in prime brokerage accounts are generally mingled with the prime broker's own assets, and thus available to the prime broker for its business purposes, including secured borrowing. As far as regulatory requirements, cash in London-based prime brokerage
accounts can be held in a form equivalent to uninsured demand deposits, a source of concern. Prime brokers operating under United States rules may or may not fully segregate their clientÕs cash, depending on the situation, according to Rule 15c3-2 of the Securities and Exchange Act of 1934
governing the treatment of Òfree credit balances.Ó19 These balances are the amounts of cash that a client has a right to demand on short
notice. Under Rule 15c3-3, a U.S.-regulated prime broker must aggregate its clients' free credit balances Òin safe areas of the broker-dealer's business related to servicing its customersÓ or otherwise deposit the funds in a reserve bank account to prevent commingling of customer and
firm funds. If prime brokerage clients pull cash from their free credit balances, then this cash is no longer available to meet the demands for cash of other clients on short notice, so the prime broker may be forced to use its own cash to meet these demands. **Figure 12:** Sources of loss to Morgan Stanley's liquidity pool during the period September 10-22. Source: Disclosure by Morgan Stanley to the Federal Reserve Bank of New York.
Figure 12: Sources of loss to Morgan Stanley's liquidity pool during the period September 10-22. Source: Disclosure by Morgan Stanley to the Federal Reserve Bank of New York. This figure is made of two parts. On the left is a bar chart. The first bar is labeled \$176.8 billion. The second bar is labeled \$91.5 billion, and has a large red arrow on top of it pointing downward labeled \$85.3 billion. On the right is a single bar divided into different colors. The main portion of the bar is taken up by a color labeled Prime Broker \$56.4 billion. Next to this bar are two bullets that label the prime brokerage liquidity loss as \$44.8 billion from New York and \$17.6 billion from London. The rest of the bar is taken up by Conduit Finance Roll off (\$8.8 billion), Derivatives Collateral Loss (\$7.3 billion), Debt Maturing/Buyback (\$5.4 billion), Repo Haircut Widening (\$4.0 billion) and Other (\$3.4 billion).
 Further, hedge funds may post securities with their prime brokers with permission given to the prime brokers to repledge those securities to third parties so as to obtain cash financing for the prime broker itself. In this way, the prime broker can act as a conduit for secured lending to its
prime brokerage clients. Rule 15c3 places strict limits on the reliance of client investors on prime brokers to obtain leverage in this manner, and thus puts a brake on the leverage that the prime broker can itself obtain through repledging. Nevertheless, any difference between the haircuts
(over-collateralization) applied to prime brokerage clients and the haircuts applied to prime brokers represents an effective source of additional cash financing to the prime broker. Figure 11 shows data collected by Singh and Aitken (2009) on the amounts of securities pledged to Morgan Stanley, during the reporting periods surrounding the failure of Lehman, that Morgan Stanley was able to pledge to others.20 The sudden drop in repledgeable assets shortly after the failure of Lehman represents a substantial run of Morgan Stanley's prime brokerage clients. A failure of
Morgan Stanley would have left the hedge funds that had not run with a claim against their assets, but no guarantee of quick or complete return of the assets. Figure 12, based on data provided by Morgan Stanley to the Federal Reserve Bank of New York,21 illustrates sources
of reductions in the liquidity pool of Morgan Stanley in the period of days surrounding the failure of Lehman Brothers. The dominant source of loss in liquidity was through an effective run by Morgan Stanley's prime brokerage clients. In response to the financial crisis of 2007-2009, it has been anecdotally reported that many hedge funds have arranged for additional prime brokers. As illustrated in Figure 13, this allows a hedge fund to quickly port its assets from a prime broker whose stability is of
concern to a "safer" prime broker. Clearly, this represents a heightened run risk for a prime broker whose stability comes into question. An alternative and more stable approach is illustrated in Figure 14. A three-way legal agreement, involving a hedge fund, its prime
broker, and a custodian, allows the hedge fund's collateral to be placed in the custodian. The collateral is available to cover the losses of the hedge fund, but can be returned safely to the hedge fund (provided is obligations to the prime broker have been met), in the event that the prime
broker's performance becomes suspect. The three-way agreement reduces away-from-failure efficiency gains associated with the ability of the prime broker to re-pledge the hedge fund's assets as collateral, as a source of financing. **Figure 13:** A hedge fund with two prime brokers.
Figure 13: A hedge fund with two prime brokers. A red box labeled Hedge Fund is connected via two separate lines to two blue squares labeled Prime Broker One and Prime Broker Two. A small lower subsection of each blue squares is separated by a dotted line and is labeled Assets. Under each blue square is a green square labeled Investor, and there are two double-sided arrows running from each Assets to each Investor, and the arrows are labeled Cash and Securities.
 **Figure 14:** A schematic of a three-way collateral agreement, involving a hedge fund, a prime broker, and a custodian.
Figure 14: A schematic of a three-way collateral agreement, involving a hedge fund, a prime broker, and a custodian. There are three entities in this flowchart. A red box labeled Hedge Fund, a green box labeled Cash and Securities, and a blue box labeled Dealear Bank (Prime Broker). There are doubles-sided arrows between the red and green box and the green and blue box.
 6 Concluding Remarks By treating the financial system as a network of interacting nodes and links, one may be in a better position to design and supervise the financial system so as to safeguard its resiliency to large financial shocks. Significant improvements in financial stability are ongoing, the most important
of which are increases in the capital and liquidity requirements of regulated financial institutions, and new tests of their individual abilities to withstand stresses. I have focused here on some of the key "plumbing" at the core of the financial system, paying special attention to some
remaining or new systemic weaknesses.
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