Bank of England tells clearing houses to put stability before profit

LONDON Tue Dec 18, 2012 8:03am EST

Busses pass the Bank of England in the city of London November 26, 2012. REUTERS/Olivia Harris

Busses pass the Bank of England in the city of London November 26, 2012.

Credit: Reuters/Olivia Harris

LONDON (Reuters) - Clearing houses hoping for a rich pickings from stricter derivatives rules face spot checks to make sure they are investing enough money in risk management, the Bank of England said.

World leaders have agreed that the $650 trillion markets for credit default swaps, interest rate swaps and other derivatives traded among banks should be centrally cleared from next year to improve transparency.

Central clearing ensures transactions are backed by a default fund in case one side of a deal goes bust.

The prospect of large swathes of derivatives having to be cleared has prompted clearing companies such as NYSE Euronext NYX.N, CME (CME.O), and others to bulk up.

The BoE, outlining how it will supervise clearing houses from April, said on Tuesday its key concern will be to ensure financial stability was maintained in the public interest.

"If financial market infrastructures are operated only in the private interests of their managers, owners, or even their members, they may under invest in the mitigation of risks to the wider system," the BoE said.

Clearing houses should make sure that senior management pay did not "create pressure to prioritize revenues, market share and profit over systemic risk management objectives".

The BoE will have powers to force clearing houses to take a specific action, impose requirements and penalties and even to revoke their license to operate.

While clearing house ran into difficulties during the 2007-09 financial crisis, there are concerns that clearers becoming bigger on derivatives will be new risk centers.

Thomas Huertas, when he was a senior regulator at Financial Services Authority last year, said that unless carefully thought through, centralizing trillions of dollars of derivatives would be like "putting a Chernobyl in the back yard".

The BoE said it will fully enforce European Union and new global standards on supervising clearing houses, which will require them to hold enough capital to withstand two of their biggest customers going bust.

The London Stock Exchange (LSE.L) is renegotiating its purchase of a controlling stake in LCH.Clearnet, one of Europe's biggest clearers which now faces a regulatory capital shortfall of 300-375 million euros ($395-$494 million).

The BoE said clearing houses will have to show plans for dealing with their own demise and how key services would continue if they got into trouble.

Supervision will look for "strong user" representation and independent directors at clearing houses, the BoE said.

It said clearing houses should not cut margin requirements on contracts to win business. "A better solution for the system is for margins to remain at higher levels in good times even if this may be above the minimum level required by regulation."

Clearing houses will also have to satisfy themselves that their members are managing their risks properly too.

(Editing by Dan Lalor)