Out-Law News 2 min. read

Without resolution plans, clearing houses could become 'too big to fail', warn industry bodies


The growth of mandatory clearing during derivatives trades has "significantly increased concentrations of risk" within the largest clearing houses, with the result that their failure could risk financial stability, financial services industry bodies have warned.

Trade bodies The Clearing House and the International Swaps and Derivatives Association (ISDA) have produced a report setting out some of the biggest issues involving clearing houses (24-page / 1.75MB PDF), with the intention that it be used as a reference by international watchdogs as they develop a resolution framework for these institutions. The report identifies potential approaches to resolution, from the perspective of clearing houses, traders and other participants in the clearing process.

"Having devoted considerable thought and resources to ensuring the resolvability of the world's largest banks, it is now time to take the lessons learned in that process and ensure that CCPs [central counterparties] - where much risk has been concentrated by the post-crisis regulatory regime - are equally resolvable," said Greg Baer, president of The Clearing House, which acts as both a banking association and a payments company which is owned by some of the largest commercial banks in the US.

As a result of new rules implemented in response to the financial crisis of 2008 more than 70% of global swap transactions now take place through a third party rather than being traded directly, according to the report. Clearing houses act as 'central counterparties' (CCPs) between buyers and sellers to a particular trade, meaning that neither party to the trade itself is exposed to the risk of the other defaulting.

In their report, the trade bodies backed improvements to the resilience of CCPs, as well as the use of appropriate recovery tools, as the best way of mitigating the risks of CCP failure. However, the orderly winding up of CCPs may be required in certain circumstances. For this reason, they welcomed the work of the likes of the Financial Stability Board (FSB) on CCP resolution, noting that the FSB is due to publish plans for CCP resilience and recovery later this year.

All 'systemically important' CCPs should be required to prepare resolution plans, in line with the FSB's 'key attributes' for such plans, according to the report. Regulators responsible for resolution should also prepare 'action plans' for the orderly resolution of CCPs generally, and for individual CCPs where appropriate to the jurisdiction. These plans should be designed to "facilitate both continuity and resolvability should the CCP be placed in resolution", it said.

The report also sets out factors that resolution authorities should consider when developing their general action plans, with a particular emphasis on cross-border issues. "CCP viability" should be the main trigger for the resolution process, in line with the FSB's key attributes, according to the report.

The trade bodies conclude that many of the features and tools of financial resolution generally will be of relevance to CCPs, although they do not provide a "complete solution" due to the "unique characteristics" of these institutions. Resolution authorities would also face "significant and unique challenges" in the event of CCP failure, as this was likely to occur during "a period of unparalleled market stress and instability not limited to the affected CCPs", according to the report.

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