* Will not tolerate "race to the bottom"
* Says cheap clearing is false economy
* Sees no sign of collateral crunch
By Huw Jones
LONDON, April 24 (Reuters) - Britain's new regulator for market operators warned clearers of tougher policing of fees to stamp out cut-throat competition that risks undermining financial stability.
World leaders agreed during the financial crisis to reshape the opaque $640 trillion off-exchange derivatives market for interest rate, credit default and other swaps by requiring many of the contracts traded between banks to be cleared by a third party that has a default fund to cover losses.
Clearing stands between two sides of a trade to cut risks by monitoring the transactions and making sure the default fund is strong enough.
The new derivatives rules are part of a wider set of reforms to make markets safer, including higher capital requirements on banks.
Investors were left guessing who was exposed to uncleared derivatives at Lehman Brothers when the bank collapsed in 2008, with the uncertainty sending markets into near meltdown.
The prospect of vast amounts of new clearing business has prompted exchanges to acquire or set up clearing houses in the hope of generating fresh cash streams to offset depressed trading volumes.
"We are not in the business of preventing competition but what's important is the terms of that competition," Britain's new clearing supervisor, Edwin Schooling Latter, told Reuters in an interview.
The Bank of England became the regulator for clearing houses this month and Schooling Latter said in his first media interview he will not tolerate "a race to the bottom" such as clearers allowing banks to post too low margins against trades.
Margins refer to traders of derivatives posting government bonds or other high quality collateral to help cover any losses and the level of margins is determined by the clearing house.
"We want a world where the clearing houses compete on the quality of their risk management and not on how low their margins are," Schooling Latter said.
He also supervises settlement houses that exchange legal ownership of securities for cash, and the UK payments systems, with all three components key to financial stability.
He said clearers stayed resilient in the financial crisis but he wants to make sure they have enough capital to avoid needing taxpayer help in any future crisis.
He said he is checking if default funds can withstand the two biggest customers collapsing and whether clearers are asking for enough initial margin from users to back trades.
The final and new line of defence is for clearers to have a recovery plan on how losses would be allocated.
"This is a big change. The recovery plan is not a complete task but I don't want to be moving into 2014 with lots of uncertainty over how those recovery and loss allocation plans would work." Schooling Latter said.
He supervises four clearers based in Britain serving the EU.
Chicago-based derivatives exchange CME and its Atlanta rival ICE have set up clearing operations in London to compete with LCH.Clearnet, in which the London Stock Exchange is taking a controlling stake.
Andrew Lamb, CEO of CME Clearing Europe said the primary focus of any clearing house should be on the quality of risk management to meet the needs of customers.
LCH.Clearnet said the margin should be an accurate reflection of the risk involved in clearing a trade, with no standards compromised for commercial gain. ICE declined to comment.
The central bank will also supervise EuroCCP, which clears share trades, and a planned clearer at the London Metal Exchange.
Schooling Latter warned banks about pressuring clearers for lower margin requirements.
"They need to be wise. There is no free lunch in central clearing. If you've got low margin requirements then probably other participants do and you've got to think about what that means for the risks that you are bearing," he said.
Greater risks means that the banks would more likely bear losses under the new recovery plans, he said.
Banks say tougher margin requirements will create a collateral crunch and make lending to the economy harder.
"I don't think we are in a place where it's case proven that there isn't enough collateral," Schooling Latter said.