16 February 2017

Financial Times: Clearinghouses saddled with ‘too-big-to-fail’ tag

The institutions have been at the forefront of efforts to reform the financial system since the crisis of 2007-2008. Centralising the trading of derivatives into clearing houses has reduced risks to the financial system from the failure of an individual bank, but magnified the importance of clearing houses. That, for some, has made clearing houses the new “too-big-to-fail” institutions of the post-crisis financial system. Earlier this month, the Basel-based Financial Stability Board, an umbrella group of central bankers and regulators, became the latest regulator to lay out a blueprint for how to prevent taxpayer bailouts of clearing houses such as London-based LCH, which is controlled by the LSE. [...]

All the proposals from regulators’ start with the assumption that a clearing house’s normal business — standing between two parties in a trade, and managing the credit risk if one side defaults — has gone badly wrong. The contentious part of the debate revolves around who bears the pain to replenish a clearing house’s funds used up during a “stress event”. There are only four possible parties on the hook: the clearing house’s shareholders, normally big exchanges; the clearing house’s members, usually the big banks; customers of the clearing house members, like fund managers; or the government or taxpayer. Policymakers are united that it will not be the taxpayer.

[...] clearing houses are exposed if a counterparty defaults on outstanding contracts. This would potentially leave their book “unmatched”. There are plenty of guards to cushion against the effect of that scenario. A clearer, for example, demands more margin from counterparties to the trades it clears. If that fails to cover the losses from the party that has defaulted, there is also capital from the clearing house itself and, finally, a mutual default fund that is made up of contributions from members. The lack of clarity lies in what happens once these defences are burnt through. Regulators’ proposals consider at what point the authorities can and should step in, and whether the clearing house should be saved. The consensus among them is that a failing clearing house should be rescued because of its systemic importance.

The FSB has called for national authorities to establish “crisis management groups” to co-ordinate planning and information sharing for clearing houses that are systemically-important in more than one jurisdiction. All very well except that regulators can only oversee their own markets. For example, the EU’s plans — which came out before the FSB’s own guidelines — are designed to safeguard the financial stability of the EU and its member states.

Full article on Financial Times (subscription required)

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