LONDON, Feb 26 (Reuters) - Britain's race to shield taxpayers from a potentially new breed of "too big to fail" financial firms is pitting investors against banks over who pays the bill if one of the clearing houses handling the trillions of dollars of trades made each year in financial markets runs into trouble.
Investors in the form of pension funds and asset managers who buy financial assets like derivative instruments which pass through clearing houses, say they should not have to bail out a clearer in danger of going bust.
The banks, who sell the products, say investors have little choice but to bear some losses as they would take a hit in any case if the clearing house went under.
This month the Bank of England became the first regulator in the EU to require clearing houses to have a system for allocating losses once funds available from trading collateral and other contributions have been drained.
Investors argue they should not be made to bear losses after this point has been reached.
"Client monies must not act as 'lenders of last resort' for clearing houses as this could involve unlimited liability," the UK Investment Management Association (IMA) said.
The row is especially topical because clearers, are set to grow as mandatory clearing for large parts of the $700 trillion worth of financial derivatives which are currently traded each year off-exchange starts in the coming months, to help make those markets more transparent for regulators.
The Financial Stability Board, a regulatory task force for the world's leading economies, estimates that 80 percent of the $385 trillion interest rate swaps market could be cleared, but only $163 trillion is currently.
But the BoE wants to avoid clearers becoming like the sinking banks in the financial crisis when there was no clear plan to deal with failure and as a result taxpayers had to bail them out.
"What the UK is saying is that it's more important that we never get to the resolution point and that we must be able to tap investors," said Jonathan Herbst, global head of financial services at Norton Rose Fulbright lawfirm.
Large amounts of derivatives traded in the EU will pass through four clearers in London: LCH.Clearnet, CME and ICE Clear, and LME Clear.
A "waterfall" of pre-paid money, such as funds deposited by a defaulting member of the clearing house and margins posted by all members, is already in place under new EU derivatives market rules.
But the new BoE rule forces clearers to spell out how losses would be covered if this money is not enough to plug a hole left if, for example, several clearing house members defaulted at once.
Some clearers have decided that investors who have trading positions at the clearer should, along with banks and owners of the clearing house, bear these remaining losses.
This has sparked fierce opposition from investors.
"We strongly believe that private sector failure must not be borne by ordinary savers and pensioners," the IMA said.
Investors are now campaigning against being hit by a second BoE rule from May as well which is aimed at plugging losses from routs in markets such as massive falls in government bond prices.
Banks say such a stance is unrealistic.
"The thrust of all this regulatory reform is that public money is not used," said George Handjinicolaou, deputy chief executive of the International Swaps and Derivatives Association, which represents big banks that trade swaps.
"No one wants to be on the hook for losses, but that's not reality because when a counterparty fails, everyone should be prepared for the possibility of losses," he added.
Britain is moving first, as it did with bank capital and liquidity rules, in a bid to encourage others to copy it.
The European Union is due to propose a draft law on dealing with struggling clearing houses later this year and Britain hopes it will follow the lines of its own new rule. Global regulators are also due to come out with recommendations in this area in the coming months.
The BoE said without a mandatory plan to raise extra money to keep a clearing house operating, it would become insolvent and investors would be hit regardless.
"Having a plan for how to allocate losses should this remote risk materialise can help make sure that all creditors are better off than they would have been in insolvency," a BoE spokesman said.