Clearinghouses should have detailed explanations how they will assign losses to members in the event of a default that depletes the company’s emergency funds, according to a Bank of England paper on financial stability.
Central counterparties can’t rely on voluntary agreements between members to absorb losses and there may be “coordination problems or practical difficulties in arranging this within a short period of time,” David Elliott, an analyst in the BOE’s Financial Stability department, said in the report published in London today.
So-called loss-allocation rules offer clearinghouses “a way to protect their participants from the additional costs, disruption and uncertainty of an insolvency, and allow continuity of systemically important clearing services,” said Elliott, an analyst in the BOE’s Financial Stability department.
The Group of 20 nations has ordered a global overhaul of rules governing derivatives contracts, mandating the use of CCPs by traders. Regulators have sought tougher rules for over-the-counter derivatives since the collapse of Lehman Brothers Holdings Inc. and the rescue of American International Group Inc., two of the largest traders of credit-default swaps.
Plans for assigning losses could include provisions for tearing up open contracts between members, according to the BOE paper. The move would help the clearinghouse to stem potential losses by “limiting the gains otherwise payable by the central counterparty to the clearing members with positions opposite to those of the defaulter.”
Clearinghouses such as London’s LCH.Clearnet Ltd. and Eurex Clearing operate as central counterparties for every buy and sell order executed by their members, who are required to post collateral, reducing the risk that a trader defaults on a deal.
Bank of England Deputy Governor Paul Tucker said in an article this month that regulators need legal powers to allow them to commandeer clearinghouses that are close to failure.
Watchdogs responsible for financial stability “need the power to take control of a central counterparty that is no longer viable, or doomed to become unviable, and where there is no reasonable prospect of its recovery,” he said.