BIS paper says broader approach needed to supervise clearers

LONDON (Reuters) - The consequences of forcing more derivative trades through clearing houses are not fully understood and regulators should take more of a system-wide approach to assessing risks, a Bank for International Settlements (BIS) paper said on Sunday.

A long-time exposure shows traffic flowing in front of a building (R) of the Bank for International Settlements (BIS) in Basel December 5, 2013. REUTERS/Arnd Wiegmann

When Lehman went bust in 2008, regulators found it hard to see who was on the other side of its derivatives contracts, creating uncertainty which rattled markets.

Policymakers decided large chunks of the $552 trillion market for derivatives like credit default swaps should pass through a clearing house, a third party that ensures a transaction is completed even if one side goes bust.

Only this week European Union regulators said interest rate swaps must pass through a clearing house from next June.

Yet the BIS paper looks at how clearers form a web of links between themselves and their customers such as banks, raising the risk of a “domino effect” if one clearer went bust without the resources to contain the fallout.

Regulators worry that clearers, also known as central counterparties or CCPs, could become a new generation of “too big to fail” firms, a concern which the BIS paper supports in part, saying more needs to be done to supervise them.

“While progress in these vital areas has been impressive, the interaction between CCPs and the rest of the financial system remains, at best, imperfectly understood,” it says.

So far, regulators have focused on ensuring individual CCPs, like Eurex Clearing, part of Deutsche Boerse DB1Gn.DE, ICE Clear, part of Intercontinental Exchange ICE.N, and LCH.Clearnet, owned by the London Stock Exchange LSE.L, hold enough capital and follow robust methods for assessing and covering risks from trades.

This approach may not be too narrow.

It was possible that while clearers can buffer the financial system from relatively small shocks, this could be at the risk of potentially amplifying larger ones, the paper said. “Certain challenges stand in the way of designing and implementing sound CCP risk management,” it notes.

Clearers may underestimate the initial margins required to back transactions, and competition between CCPs may result in weaker risk management standards, the paper said.

“Further analysis of the implications of central clearing ... should help authorities to consider a macroprudential perspective to the regulation and supervision of financial systems that rely on central clearing,” it adds.

Macroprudential policy refers to intervention by central banks on a system-wide basis, such as requiring all clearers to collect more margin to cool down the derivatives market if it becomes overheated.

Editing by David Holmes