Derivatives traders may take losses on the margins they post at clearinghouses during a crisis, as global plans to eradicate the dangers of too-big-to-fail financial institutions gather pace.
Losses on so-called variation margin and conversion of creditor claims into equity are among options proposed by a group of regulators last week to protect taxpayers from future financial catastrophes when other buffers are depleted. Clearinghouses act as central counterparties in derivatives contracts to spread the risk of default.
Central counterparties “are the nuclear power plants of the financial system,” Jesper Berg, senior vice president at Nykredit A/S, Denmark’s biggest mortgage bank, said in a telephone interview. “For the financial industry it’s absolutely crucial we don’t have discontinuities” in their functions. “You can’t stop the clock.”
The proposals are part of a global overhaul of rules governing derivatives contracts, mandating the use of central counterparties by derivatives traders. Regulators have sought tougher rules for over-the-counter derivatives since the collapse in 2008 of Lehman Brothers Holdings Inc. and the rescue of American International Group Inc. (AIG), two of the largest traders of credit-default swaps.
Regulators won’t permit “the tragedy of central counterparties becoming too big to fail,” Paul Tucker, deputy governor at the Bank of England and chair of the global committee developing the standards, said in an interview with Risk magazine last week.
The market “will adapt” to the risk of haircuts on their collateral for derivatives trading, Nicolas Veron, analyst at Breugel, a Brussels-based advisory group, said in a telephone interview.
Tucker has seen the consequences of a clearinghouse failure first-hand, having worked on an overhaul of Hong Kong’s securities market after its futures exchange collapsed during the global stock market crash in 1987.
“The effects were devastating,” he said in a speech last year. “The upshot was that Hong Kong’s main capital market shut down.”
Members of a clearinghouse post margin to the central institution, which can be cash, securities or other financial assets, when trading derivatives. So-called variation margin sees that amount change on a daily or intraday basis depending on the price movements in the derivatives contracts.
LCH Clearnet Ltd., Europe’s biggest clearing house, raised the extra margin it demands from clients to trade some Spanish government bonds last month. The margin for trading Spain’s securities maturing in seven to 10 years increased to 12.2 percent from 11.8 percent, the company said.
Losses imposed on creditors “should be no worse than they would be in insolvency” if the clearinghouse’s creditor hierarchies are respected in write-downs, according to the proposals published by the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions on July 31.
“What becomes extremely difficult is deciding who will take decisions on resolution given that some of these firms are global,” Veron said. “Allocating gains and losses is one of the definitions of executive power.”
Madrid-based IOSCO brings together national market regulators from more than 100 countries to coordinate rules and share information. The CPSS, which is part of the Basel, Switzerland-based Bank of International Settlements, is made up of central bankers from developed and emerging economies and sets standards for payment, clearing and settlement systems.
The proposals mirror those in the pipeline for big lenders. The European Commission proposed measures in June for creditors to take losses in the event of failure to avoid the type of taxpayer bailouts seen in the wake of the 2008 financial crisis.
Clearinghouses would also be required to submit so-called living wills to regulators, much like banks, which outline how the institution can be resolved in an orderly way in a crisis.
The CPSS paper “arguably misses the real issue” of low capital, Patrick Fell, director at PricewaterhouseCoopers, said in a telephone interview. “The volumes of business going through clearinghouses are huge and the owners’ capital is very small by comparison.”
Another regulator, the European Banking Authority, proposed earlier this year that clearinghouses hold enough capital to cover credit risk from their activities, as well as to cover operational expenses during a wind-down.
Regulators can either impose losses, based on existing creditor hierarchies at clearinghouses, or try to unwind unmatched trades, Simon Gleeson, financial regulation lawyer at Clifford Chance LLP, said in a telephone interview in London. “Of course, the third option is for the government to pony up the cash.”
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