This Article challenges the academic and policy consensus that clearing- houses adequately mitigate the risks of trading credit derivatives. The Article advances two arguments. First, scholars have devoted little attention to the risks posed by underlying assets (such as mortgage loans) that the credit derivative references and the impact that these risks have on the clearinghouse. Credit derivatives enable the economic risk of debt to be separated from the legal rights attaching to that debt. This separation affects the clearinghouse profoundly. As a contract party to each trade it processes, the clearinghouse can be saddled with the economic risk of underlying debt without the legal rights necessary to mitigate its exposure. If a clearinghouse cannot manage its risks, the consequences are invariably systemic and enormously costly to the taxpayer. Second, the Article shows that the clearinghouse’s structure ex- poses its members to complex incentives that (1) encourage risk taking by subsidizing and mutualizing default losses; (2) shift the private costs of monitor- ing to the clearinghouse and thereby allow members to underinvest in due diligence; and (3) cause members to place undue reliance on information pro- vided by third parties that is often colored by the strategic motives of the parties providing it.

This Article concludes with a proposal for a new paradigm for the clearing- house. This new model seeks to repair the consequences of separating economic risks from legal rights, which are caused by the use of the credit derivative. It also seeks to mitigate the distorted incentives affecting clearinghouse members. With reforms in place that allow for improved policing of its exposures, the clearinghouse will become a more robust institution that is better positioned to control lax underwriting standards accompanying the extension of credit.