Clarity on Clearinghouse Default

Derivative users want regulators to write rules for unwinding a failing clearinghouse.

Regulators need to finish writing the rules on how to unwind a swaps clearinghouse if it fails, derivatives industry users and observers said at a conference today.

“It’s very important that sooner rather than later regulators make sure we get these things written down so they’re respected,” John Williams, a partner in the derivatives and structured products finance group at law firm Allen & Overy LLP, said today at an over-the-counter derivatives symposium at the Federal Reserve Bank of Chicago. He called a default by a clearinghouse “the worst worst scenario,” and said more research on how to handle such an event is needed.

Clearinghouses are required to process most swaps in the $708 trillion OTC derivatives market under both U.S. and European regulations. The Financial Stability Oversight Council, led by U.S. Treasury Secretary Timothy F. Geithner, is determining which clearinghouses should face heightened supervision, examination and reporting requirements, and it hasn’t yet announced its designees. The body also includes Federal Reserve Chairman Ben S. Bernanke.

The Dodd-Frank Act in the U.S. allows the Fed to bail out a clearinghouse if it has been deemed systemically important. The law also allows regulators to take over a clearinghouse if it’s not bailed out, said David Skeel, a professor of corporate law at the University of Pennsylvania Law School.

“We really do need to be thinking of the implications of financial failure in this area,” he said at the symposium, which was attended by members of the dealer banks that dominate the swaps market, asset managers, lawyers, regulators and academics.

Clearinghouses, capitalized by their members, seek to reduce the effect of a member default by collecting daily margin and ensuring users can meet their obligations. If they can’t, their positions are liquidated. They also provide regulators with access to derivatives positions and pricing.

Speakers at the Fed event debated how derivatives trades should be treated when a counterparty defaults. Under current bankruptcy law, swaps and futures trades don’t face a “stay,” or a freeze in activity, if the bank or money manager that owns the trades defaults.

A stay of a few days may give the defaulted user time to value the transactions, Skeel said. Derivatives are live contracts, however, with their value changing constantly through a bankruptcy process, and should be allowed to be settled or transferred as soon as possible, said Athanassios Diplas, global head of systemic risk management at Deutsche Bank AG.

 

‘Added Uncertainty’

“The market will only move against you” in the time that any trades were stayed, he said.

Not allowing trades to be settled or moved would also add to systemic risk, said representatives of clearinghouses.

A stay would cause “a tremendous amount of added uncertainty” in the time of default, said Dale Michaels, a managing director in credit and market risk management at CME Group Inc. A delay could “even cause more systemic risk or even the default of a central counterparty,” or clearinghouse, he said.

Chris Edmonds, president of ICE Clear Credit, Intercontinental Exchange Inc.’s credit-default swap clearinghouse, agreed.

“You’re increasing systemic risk if you limit our ability to act,” he said. Clearing members are required to bid on and take over positions from a defaulted fellow member, and are under stress in such scenarios, Edmonds said. “Those who have the most amount to lose are the ones we have to go to first,” he said.

 

 

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