The Dodd-Frank Act recently celebrated its 10th anniversary, with commentators, policymakers, and scholars joining the celebration by discussing the achievements of the sweeping post-crisis financial reform. Yet Dodd-Frank left a critical unfinished business that, if not addressed, could erode the structural foundations of the post-crisis markets: the regulation of clearinghouses.

In a new article, I identify the flaws in the current regulatory framework for derivatives clearinghouses. These flaws polarize rather than align the incentives of clearinghouses’ major stakeholders: the owners—companies such as the Chicago Mercantile Exchange Group, Intercontinental Exchange, and the London Stock Exchange Group—and the members and users of the firms’ services, such as Deutsche Bank, Goldman Sachs, JPMorgan Chase and other financial institutions.

Derivatives markets were deemed one of the major catalysts of the 2008 financial crisis and underwent a radical makeover. Legislators required financial institutions to process derivatives through clearinghouses. Clearinghouses have been building blocks of modern financial markets, serving as central counterparties between buyers and sellers and guaranteeing each party’s performance. Policymakers embraced these ‘too-important-to-fail’ financial market infrastructures as systemic risk managers and systemic stability buffers and trusted their resilience and internal risk management to effectively reduce and control risk in the markets.

However, clearinghouses’ guaranty function, which made them so appealing to post-crisis policymakers, is also the source of a few critical and yet unsolved issues. Clearinghouses act as systemic risk managers because of their unique risk-management tools and economic structure. Clearinghouses do not guaranty the performance of processed transactions with their own capital. Instead, they rely on the financial resources provided by the financial institutions—clearing members—that Dodd-Frank required to use clearing services for eligible derivatives. Clearing members, once admitted, are bound by a contractual rulebook for the management and allocation of risk between the clearing firm and its members.

Members agree to provide different layers of resource to the clearinghouse. They pledge collateral to cover the exposures of their open positions. They contribute to a ‘default fund’ that serves a loss-mutualization function. If one or more clearing members were to default, the surviving members agree to share the outstanding losses in the interest of market stability. Members even agree to provide additional contributions if losses are too large to cover with the default fund. To show confidence in their own risk management practices, clearinghouses contribute their own layer of loss-absorption resources, which serves as the ‘skin in the game’ in their guaranty-function mechanism. In theory, this measure could be an effective structure to align owners’ and members’ incentives. In practice, however, it is not enough. In CME Clearing, which processes interest rate swaps, for instance, members contribute $3.6 billion to the guaranty fund, while the holding firm—the owner of CME Clearing—contributes only $150 million (approximately 4.1 percent of the total guaranty fund) to the firm’s ‘default waterfall’—the ensemble of dedicated loss-absorption resources. In ICE Clear Credit, the credit default swaps clearinghouse of the Intercontinental Exchange group, members contribute $3.1 billion, and the firm contributes only $50 million (approximately 1.6 percent of the total guaranty fund). The imbalance in skin in the game between the clearinghouse (and indirectly its owners) and its members can create serious tensions.

The situation is even more troubling in Title VII and Title VIII of Dodd-Frank. As I analyzed in a previous article, when regulating clearinghouses, lawmakers overlooked the evolution in their ownership structure and the costs and benefits of different ownership and governance models. Historically, clearinghouses were mutual firms, where clearing members shared the losses of the business but also retained control rights over them. Today, the major derivatives clearinghouses are not owned by their members (in other words, they are demutualized in structure) but still operate with loss-mutualization mechanisms. The incomplete demutualization of clearinghouses was embraced by lawmakers as a feature, not a bug, in the economic structure of clearinghouses, and clearing members, the derivatives dealers whose derivatives exposures were blamed as accelerators of the crisis, have received no formal protections nor voice in the risk management or governance of clearinghouses.

My article identifies a critical misalignment of incentives in the existing loss allocation structure of clearinghouses, which potentially polarizes the interests of the members and the clearinghouse, increasing the risk of moral hazard by the clearinghouse. After analyzing the current regulatory landscape and the inadequate safeguards built by lawmakers and regulators to align the incentives of members and owners of clearinghouses, the article presents some policy proposals to reduce moral hazard and make clearinghouses more resilient. While remutualization could be an effective (but also the most costly) mechanism to align the incentives of risk takers and risk bearers, addressing clearinghouses’ internal governance and financial structure is a more practical strategy. Lawmakers could encourage or require clearinghouses to adopt a multi-stakeholder board with clearing members representatives while also strengthening the role and decision-making authority of their risk committees (where members are represented). In addition, the financial structure of clearinghouses should be revisited. For instance, clearinghouses could post, or be required to post, more substantial amounts of financial resources to their loss mitigation mechanisms or, as also recently and similarly proposed by the Systemic Risk Council, clearinghouses’ owners should underwrite convertible contingent bonds to be used once members pre-funded contributions are exhausted.

Clearinghouses might not arouse the passions of academics and other commentators as much as too-big-to-fail banks do, but all those banks are connected and exposed to clearinghouses. And the collapse of one side could mean the collapse of the other.

This post first appeared on the Columbia Law School Blue Sky Blog here.

Paolo Saguato is an Assistant Professor of Law at George Mason University.