Swaps Clearinghouses Face Tougher Rules

Global regulators proposed tougher standards for clearinghouses at the heart of the US$493 trillion derivatives market, taking some of the biggest steps yet to prevent the platforms from becoming too big to fail.

The Financial Stability Board (FSB) and other securities regulators published guidelines on Tuesday for clearinghouses to bolster their assessments of risks and improve plans for how they'd recover after the default of major bank members. The recommendations came after regulators found some clearinghouses negligent in complying with existing standards.

The Basel-based FSB, whose members include the Bank of England and U.S. Federal Reserve, also began to lay out how regulators could resolve a clearinghouse if its own recovery plan fails.

“Although the risk of default cannot be entirely eliminated from the global financial system, we aim to limit potential systemic risks arising from any default by a central counterparty member as much as possible by applying a robust but balanced approach to reinforce financial buffers and risk control,” Ashley Alder, board chair of the International Organization of Securities Commissions, said in a statement.

Derivatives Clearinghouses Come Under Greater Scrutiny

In the aftermath of the 2008 financial crisis, regulators around the world mandated that more derivatives be settled at clearinghouses that collect collateral from buyers and sellers to limit the risk to the system from a trader's default. Many transactions were previously conducted directly between traders without a third party requiring collateral. Swaps trading—when it was largely unregulated—amplified the meltdown and prompted a $182 billion U.S. rescue of American International Group Inc.

As a result of regulators' post-crisis rules, clearinghouses operated by the London Stock Exchange Group Plc, CME Group Inc., and Intercontinental Exchange Inc. have grown in importance. That has led to calls from regulators, as well as from JPMorgan Chase & Co., BlackRock Inc., and other large traders, for greater scrutiny of the companies.

To protect against defaults, banks deposit collateral at clearinghouses, which also contribute some of their own capital. If both of these funding sources are exhausted in a time of stress, a clearinghouse could then require banks and other members to pick up the tab.

“It is clear to us that the risk of default cannot be eliminated from the global financial system—to do so would imply unsustainable costs and severely restrict or even prevent businesses from using derivatives to manage commercial and financial uncertainty,” Alder and Benoit Coeure, chair of the Committee on Payments and Market Infrastructures, said in an op-ed first published in the Financial Times. “So the aim is to limit the potential systemic risks arising from any default as much as possible by encouraging central clearing and then applying a robust but proportionate approach to back up financial buffers and risk control.”

In a 160-page report assessing current oversight, securities regulators said clearinghouses have made “meaningful progress” to comply with standards put in place since 2008. Still, they found “gaps and shortcomings” and said some clearinghouses haven't yet fully put in place recovery plans required by regulators.

“These CCPs, and their supervisors, regulators, and overseers, should consider this to be a serious issue of concern that should be addressed with the highest priority,” according to the report from IOSCO and the Committee on Payments and Market Infrastructures.

Where CCPs Are Falling Short

The report, which reviewed 10 clearinghouses in nine jurisdictions, found that some have failed to put in place policies to ensure they have sufficient financial resources and lack robust tests of their liquidity. Regulators said they expect the firms to fix the problems by the end of the year, though they didn't disclose which clearinghouses were at fault. The report relied on data as of June 30, 2015.

The organizations proposed additional guidance for clearinghouses' credit and liquidity resource requirements, margin, contribution of own financial resources to losses, and recovery plans. The guidelines suggest that clearinghouses' recovery plans should have a clear description of arrangements to obtain additional liquidity, such as cash or pre-arranged funds, in the event of a crisis.

“It's crucial that CCPs put in place clear, transparent, and comprehensive recovery plans that disclose the steps a CCP would take if its default resources are exhausted,” Scott O'Malia, chief executive of the International Swaps and Derivatives Association, said in a statement. ISDA's membership includes Citigroup Inc., JPMorgan, and Deutsche Bank AG, among other large swaps dealers.

In addition, the authorities have started work on a common system for supervisors to stress-test clearinghouses. The report stopped short of providing guidance to clearinghouses on how they should determine members' financial contributions to funds that can be tapped in the event of a default.

The FSB, which under BOE Governor Mark Carney has made oversight of clearinghouses a top priority, also published a paper on Tuesday seeking industry feedback on how authorities might step in to oversee a failing firm if the recovery process isn't working. The effort is meant to ensure clearinghouses can be resolved without taxpayer-funded bailouts or losses spreading throughout the financial system.

“CCPs form a central part of the post-crisis reforms of OTC derivatives markets to help reduce risk in the financial system,” Elke Koenig, chair of the FSB's resolution steering group and head of the European Single Resolution Board, said in a statement, referring to central counterparties. “But we must also ensure that CCPs are themselves robust and this includes appropriate resolution regimes.”

The paper, open for comment until October 17, asks for feedback on criteria regulators should use to determine when to step in to resolve a firm, whether clearinghouses should have additional funds available for resolution, and how losses should be allocated among defaulting and non-defaulting members. The FSB said it will propose more specific guidance on resolution early next year, which it plans to complete later in 2017.

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