LONDON, July 31 Clearing houses must plan for an orderly rescue and even their own demise to prevent their growing importance in the financial system from becoming a source of market disruption when things go wrong, global regulators said on Tuesday.
The clearers, which stand behind trillions of dollars of derivatives contracts, have become an important part of reforms to the financial services industry after the collapse of U.S. bank Lehman Brothers and near failure of insurer AIG.
It took so long to untangle the derivatives contracts held by these two companies during the crisis that world leaders agreed in 2009 that much of the $650 trillion over-the-counter (OTC) derivatives traded among banks must pass through clearing houses from the end of this year.
The clearing houses, such as the Depository Trust & Clearing Corp (DTCC), LCH.Clearnet and Eurex Clearing, keep electronic records and are backed by a default fund used when one side of a trade goes bust. But the increase in the volume of contracts they will have to handle could make them "too big to fail" in a crisis, leaving taxpayers footing the bill to rescue them.
To try to tackle this problem regulators set out on Tuesday how the clearing houses must prepare "death plans" or "living wills" for an orderly rescue or demise.
"The vital role of the financial system's infrastructure makes it essential that credible recovery plans and resolution regimes exist," said Paul Tucker, deputy governor of the Bank of England and chairman of a global central bankers' committee on payment and settlement systems (CPSS).
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Written jointly with global markets supervisory body IOSCO, the proposals include tearing up unmatched derivatives contracts held by a failed clearing house whose default fund has run dry.
The contract would be valued and closed out, with any profit or loss handed back.
The proposals make it clear that regulators are looking for ways to share out losses from a bust clearing house on the private sector.
But there is already criticism from the industry.
"For a while the idea of tear-ups were considered to be a helpful way forward, you would have certainty, but the mood is changing in some quarters of the market and there is a live debate right now," said Damian Carolan, a partner law firm at Allen & Overy.
"The disruption it would cause to be cut adrift and having to build up new positions from scratch in the OTC (over-the-counter) space is hard to imagine," Carolan said.
He recommended an array of tools, such as voluntary recapitalisation of a clearing house's default fund from contributions from its members, rather than pre-set actions that could be inflexible.
Clearers will have to hold far more capital in future, enough to withstand the collapse of their two biggest clients. But critics argue the largest clearing houses in the sector will always be too big to fail.
The proposals on what to include in living wills are out for public consultation until September and the feedback will be used to help supervisors check that clearers have properly prepared plans.