Dudley Says Central Counterparties Must Be ‘Bullet Proof’

Federal Reserve Bank of New York President William C. Dudley said tougher standards are needed in overseeing financial-market infrastructure for over-the-counter derivatives.

Clearinghouses, also known as central counterparties or CCPs, “will be central to the system” as regulators create “strong incentives” for financial institutions to standardize derivatives trades and clear them through the CCPs, Dudley said today in the text of remarks given in Armonk, New York.

“Global CCPs will be systemically important,” Dudley said. “Thus, for the system to be safer it is not sufficient to ensure that trades are standardized and that they are mandated to be cleared through CCPs, but also it is necessary that CCPs be bullet proof.”

Dudley said the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions are nearing completion of new standards called the Principles for Financial Market Infrastructures, which are scheduled to be published next month.

The Financial Stability Oversight Council, led by Treasury Secretary Timothy F. Geithner, is determining which clearinghouses should face heightened supervision, examination and reporting requirements, and it hasn’t yet announced its designees. The body also includes Federal Reserve Chairman Ben S. Bernanke.

‘Potential Disruptions’

Clearinghouses must “be prepared to handle even greater potential disruptions and more extreme market conditions,” Dudley said. While current rules require a clearinghouse to be able to withstand the default of its largest bank member, the principles would require them to “collateralize its current credit exposures to all of its participants.”

CCPs must also “have their own liquidity resources as the first line of defense” in the event of the failure of a “major market participant,” he said. In addition, they need “a viable resolution regime,” Dudley said.

Under the Dodd-Frank Act, designated utilities such as clearinghouses may be required to open an account at a Fed branch and the central bank may provide access to the central bank’s discount window in “unusual and exigent” circumstances.

“A resolution regime is necessary to ensure that a central bank that might lend to a CCP in extremis will be repaid,” Dudley said. No major derivatives clearinghouse has ever failed.

Oversight of global CCPs must be “cooperative” across international regulators and central banks, and there needs to be “fair, open and safe access” to financial market infrastructures, or FMIs, around the world, Dudley said.

Degree of Stress

CCPs must “have the ability to perform and meet their obligations regardless of the degree of stress in the financial system and even if one or more of their participants were to fail in a disorderly manner,” Dudley said. “Hence, there is a compelling need for tougher principles that are broadly enforced.”

Dudley said in response to audience questions that while we’re “not there yet” in terms of coordinating rules across the U.S. and Europe, regulators “really do want to achieve a harmonized system.” One of the challenges in doing so is to get regulators more “comfortable” sharing information, he said.

“We have a system where the regulators aren’t used to sharing confidential information that freely across borders,” Dudley said. “This is the tension between a global financial system and a system of national regulators.”

To contact the reporters on this story: Caroline Salas Gage in New York at csalas1@bloomberg.net; Matthew Leising in New York at mleising@bloomberg.net.

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net

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