July 31, 2012 3:13 pm

Creditors should face clearing failure hit

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Creditors of clearing houses facing collapse should accept losses rather than demand full contractual repayments from default funds, global regulators proposed on Tuesday.

The suggestions were made in a series of proposals intended to create a road map for regulators to unwind failed financial institutions and avoid bailouts or systemic risk for key financial markets infrastructures (FMI) – so-called “living wills”.

It was compiled jointly by the Bank for International Settlement’s Committee on Payment and Settlement Systems and the International Organisation of Securities Commissions, the umbrella body for the world’s securities regulators.

CPSS-Iosco said that losses imposed on creditors “should be no worse than they would be in insolvency and are likely to be better than in circumstances where the FMI’s operations cease and its assets are liquidated”.

Clearing houses have moved to the forefront of the regulatory push to shore up the financial system in the wake of the 2008 crisis. Authorities want to move more of the vast but opaque over-the-counter derivatives market on to electronic trading platforms, with deals processed through clearing houses.

A clearing house stands between two parties in a trade, taking on the financial risk if one party defaults. It uses funds posted by members of the clearing house – known as margin, or collateral – to ensure deals are completed in the event of default. Regulators are anxious to prevent the failure of a clearing house from infecting the rest of the financial system but so far have lacked a clear set of principles to follow.

The CPSS-Iosco proposals, the “living wills”, for systemically important financial market infrastructure operators – set out potential paths for their recovery or resolution.

“The vital role of the financial system’s infrastructure makes it essential that credible recovery plans and resolution regimes exist,” Paul Tucker, deputy governor for financial stability at the Bank of England said. Clearing houses “need to be a source of strength and continuity for the financial markets they serve”.

Many clearing houses have default funds, held in reserve, as well as the margin posted by customers for trading but CPSS-Iosco said it may be better to use both sources to cover losses.

“It may be preferable to haircut the creditor’s claims to them and give these creditors equity in the FMI through the mechanism of bail-in, in resolution, rather than resort to liquidation,” it said.

Clearing houses that do not take on credit risk, a key part of their operations, may have their powers transferred to one or more third parties. CPSS-Iosco acknowledged that given the lack of alternatives, “it may increase the reliance on transfer to a bridge institution pending an eventual sale to private hands”.

The regulators also suggested that the FMI could be placed into public administration but said the administrator may need powers similar to an insolvency practitioner to suspend or renegotiate contracts to allow the institution to recover.

David Wright, IOSCO’s new secretary-general, acknowledged last month that resolution regimes for systemically important financial institutions were “our most important area of work”.

The consultation period for the proposals will run until the end of September.

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