December 6, 2010 / 4:54 PM / 9 years ago

Analysis: U.S. may toughen scrutiny of tiny clearers

CHICAGO (Reuters) - Even small clearinghouses may find themselves subject to heightened scrutiny as the United States prepares to identify firms that could threaten the financial system.

This past summer’s Wall Street reform law creates a special class of non-bank firms deemed “systemically important.” Those chosen will face both increased supervision and financial support from the Federal Reserve.

The idea is to avoid a repeat of the 2007-09 financial crisis when non-bank firms such as insurer AIG wreaked havoc on markets and forced the government to prop it up with billions of dollars in taxpayer funds.

Yet declaring small clearing houses systemically important could raise costs for operators and lead to expensive bailouts, analysts warn. Regulators say the designation should help avoid failures in the first place.

A council of regulators, the Financial Stability Oversight Council (FSOC), is in charge of identifying systemically important firms and mitigating potential risks to financial markets.

With much of the $593 trillion derivatives market to be forced through clearinghouses, some of the biggest, including those run by CME Group Inc and IntercontinentalExchange Inc, are expected to get the designation.

But the line of questioning the Council is pursuing as it seeks input on what criteria to use to decide which utilities need higher policing suggests regulators are casting a wide net.

The FSOC is posing a series of questions that suggest a broad range of financial firms — big to small, domestic to foreign-owned — could qualify.

Craig Pirrong, a finance professor at the University of Houston who studies market structure, expects the Council ultimately to designate only the biggest firms. Still, he said, “It does look like they are starting from ground zero.”

“What is the best approach for measuring potential aggregate monetary values for start-up financial market utilities?” the Council asks in a preliminary list of questions for public comment. “Should certain payment systems that transfer relatively low aggregate values be considered?”

The possibility that many clearinghouses could be classified as systemically important is raising some red flags.

“I think we should be careful in designating institutions that way because we then get into the trap of having to bail them out,” said Hans Stoll, a finance professor at Vanderbilt University.

For their part, regulators say heightened supervision should help prevent clearinghouses from getting into trouble. Those that get the designation can count on extra support, including the ability to stash cash in interest-bearing accounts at the Fed, and to borrow from the central bank in a liquidity crunch.

One of the Council’s questions suggests it may seek to designate all clearers owned by a single parent company as “important.”

That could mean greater scrutiny not only of IntercontinentalExchange’s ICE Trust — whose $8 trillion in cleared credit default swaps make it an obvious candidate — but also of a sister firm that does a brisk business in sugar and cocoa, commodities not usually seen as central to financial stability.

ICE has a total of five clearinghouses. A spokeswoman declined to comment.

“What is interesting is that this list will not be just a ‘bad boy’ list, but a list of everyone who is systematically important, even if their systems and controls are top of class,” said Gary DeWaal, a lawyer for futures brokerage giant Newedge. “Depending what responsibilities the council imposes on designees, this could add extra costs even to a ‘star’ performer.”

Reporting by Ann Saphir and additional reporting by Rachelle Younglai; Editing by Andrew Hay

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