Battle rages over clearing house reform

IFR 2345 - 08 Aug 2020 - 14 Aug 2020
4 min read
Christopher Whittall

Some of the world’s largest financial institutions have urged the Financial Stability Board to recommend sweeping reform of derivatives clearing houses, including a significant increase in the amount of losses these entities must absorb in the most stressed market scenarios.

The recommendations from a group of 15 banks and money managers, including Citigroup, JP Morgan, T Rowe Price and Vanguard, represent one side of a battle brewing in a crucial area of finance: how much of the burden should different parties have to bear in the event of large-scale losses in derivatives markets?

Regulators forced trillions of dollars worth of derivatives through central counterparties, or clearing houses, after the 2008 financial crisis to help avoid repeats of that meltdown. The focus has shifted in recent years to what would happen if one of these vital institutions ran into trouble – or collapsed altogether.

The FSB, which helps coordinate global financial regulation, asked for comments on guidance it issued on the financial resources available for CCP resolution in May. CCPs argue they have sound risk-management procedures and warn against the kind of substantive overhaul that they say could harm financial stability.

But a large group of banks and investors argue that CCP shareholders must shoulder a greater burden of losses in worst-case scenarios, not only to ensure incentives between clearers and market participants are fully aligned, but also to avoid saddling healthy firms with hefty losses that could trigger a broader crisis.

"We think there needs to be a line drawn so that the resources of non-defaulting clearing members and participants are not accessed in an almost limitless manner, while clearing house shareholders are protected,” Bill Thum, principal at Vanguard, told IFR.

“There really needs to be more CCP skin in the game so that their shareholders are impacted if the CCP’s risk and product decisions are incorrect."

CCPs act as middlemen in derivatives trades to prevent losses cascading through the financial system if one of the parties involved defaults. Over three-quarters of the nearly US$450trn interest-rate swap market is now cleared, compared with a fifth in 2009, according to data from the Bank for International Settlements.


CCP12, a global association of clearing houses, said in response to the FSB’s consultation that CCPs have established risk-management frameworks to reduce systemic risk and rejected calls for their shareholders to be exposed to greater losses.

“CCP equity ... is not designed to serve as a financial backstop for the default of its clearing members or for non-default losses that are not caused by the CCP,” said Kevin McClear, president of ICE Clear US in a statement. “Changing the treatment of CCP equity ... could have negative effects on financial stability."

The group of banks and investors disagree.

"It seems very odd that clearing house shareholders could be protected even in the event of a resolution. That’s a really hard case for clearing houses to make,” Marnie Rosenberg, global head of clearing house risk and strategy at JP Morgan, told IFR.

“There’s also no reason why equity shouldn’t be on the line in recovery. That would be inconsistent with basic corporate finance principles."

Banks and investors are particularly worried they could be called on to absorb additional losses that had nothing to do with them after the CCP’s main financial resources were exhausted in extreme scenarios.

For example, they balk at the idea that a CCP could use up some of the initial margin – money that is posted upfront on derivatives trades – of non-defaulting clearing firms as part of a mutualisation of losses.

”Initial margin hair-cutting for non-defaulting members or customers should certainly be prohibited,” Jon Siegel, senior legal counsel at T Rowe Price, told IFR.