In an article published in this journal in 2012, the author challenged the conventional wisdom that a major feature of Dodd-Frank—the mandated clearing and required margining of OTC derivatives—could be expected to achieve a material reduction of the risk of another financial crisis. In this article, the author views the dramatic financial fallout from the spread of COVID-19 in March 2020, when the economic infrastructure of the U.S. was threatened by extreme disruptions in its stock and bond markets, as providing the first major test of this theory.
The author’s main conclusion from this episode is that the very mechanism that advocates of Dodd-Frank claimed would reduce systemic risk—the clearing of and imposition of margin requirements on derivatives—played a major role in this acute market dislocation by amplifying stresses on and dramatically reducing market liquidity.
One major implication of this analysis is that protecting important pieces of the system, such as clearinghouses, is not the same as protecting the entire system; indeed, these two goals are likely to prove to be antithetical under conditions of stress. It was only massive injections of liquidity by the Federal Reserve, and not the autonomous operation of the market infrastructure mandated by Dodd-Frank, that succeeded in stemming the crisis. And as this case is meant to suggest, despite clearing mandates and other major regulatory changes designed to minimize systemic risk, the net effect has been to substitute possibly greater liquidity risks for credit risk. As a consequence, the soundness of the U.S. financial system continues to depend on the prompt and effective intervention of the Fed as lender of last resort, with all the attendant moral hazard problems.