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October 11, 2022

BETTER MARKETS COMMENTS ON CLEARING AGENCY GOVERNANCE AND CONFLICTS OF INTEREST

Better Markets filed a comment letter with the Securities and Exchange Commission in response to a proposed rule to reform governance and conflicts of interest at financial clearing agencies.

Why It Matters. Clearing agencies are a vital, if largely forgotten, component of the financial system.  They ensure that the innumerable stock, bond, option, and derivatives trades that occur each day are settled according to the terms of the deal, and, when one party to a trade defaults, the clearing agency helps absorb the loss and spread the risk across financial participants.  Clearing agencies are therefore key components to managing systemic risk and enduring market stresses like the 2008 financial crisis, the COVID pandemic, and the recent “meme” stock frenzy.  However, clearing agencies face a number of cross-pressures in performing this task thanks to the competing interests of their ownership, the financial institutions that participate in their settlement services, and even the clearing agency’s own senior management.  When one of these groups has too much influence over the clearing agency, its ability to manage and distribute risk might be compromised, thereby putting the wider financial system at risk of cascading defaults.

What We Said. The SEC has proposed a thoughtful, multi-layered solution to these governance concerns. In brief, the proposed rule requires a majority of the clearing agency’s board of directors to be independent from (i.e., not have a conflicting relationship with) the clearing agency or its corporate affiliates.  Plus, each clearing agency must nominate new directors through a special committee itself compose of a majority of independent directors, and its must set up a special risk management committee with representatives of both the ownership and the participating financial institutions.  Finally, the board of directors must seek out and consider views from all of its key constituents.

This proposal is a good start, and it will go a long way to ensuring that directors exercise business judgment free from any excessive influence of the clearing agency’s ownership or its senior officers.  But the proposal could and should go further.  The ownership of a clearing agency will always have some power over the board, so removing some extra financial conflicts isn’t enough.  The SEC should require the owners to have some “skin in the game” by providing funds when a participating entity defaults on a trade; this will give the ownership incentives to choose directors who have a healthy respect for risk management and systemic stability, not just short-term profits.  Perhaps more importantly, clearing agencies operating in some highly concentrated financial markets, particularly certain derivatives, are at greater risk of bending to the will of a dominant group of participating dealers.  These powerful players have every incentive to undermine healthy competition by pushing cost and risk onto smaller institutions—or even denying them clearing services entirely.  Unless and until the SEC moves to check this dominance through limits on these dealers interests in or deals with the clearing agency, even a majority of independent directors won’t counteract their monopolistic power.  The SEC has to look at tougher controls.

Bottom Line. The SEC is doing important work here, but not work that is likely to garner much attention.  We applaud the agency for proactively reforming clearing agencies before another crisis occurs.  But much more work needs to be done on this front, and the SEC should not rest at its current proposal.

Read our full Comment Letter here or click the button below.

Securities
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