A senior Bank of Canada official has warned against the danger of concentrating market risk in the hands of the big banks which control dealing in the world’s largest clearing houses for over-the-counter derivatives.

The comments, in a speech by Tim Lane, the bank’s deputy governor, highlight growing concern beyond the US that reform of the $600,000bn OTC derivatives markets could end up creating new structures, including clearing houses, dominated by the same banks, mainly the biggest on Wall Street, that have long controlled that market.

Banks in smaller countries such as Canada are keen not to be squeezed out of the business opportunities arising from the G20’s commitments in 2009 to shift OTC derivatives on to trading platforms and to require that such instruments be processed through clearing houses to help safeguard the financial system against further defaults.

A clearing house, or central clearing counterparty (CCP), stands between parties to a trade, stepping in if one side defaults to ensure the transaction is completed.

Mr Lane said given that OTC markets were global, clearing through “large offshore CCPs has important advantages”, such as economies of scale. “A key concern, however, is access. Until recently, access was limited to the largest financial institutions with global reach. Access now is being broadened, but the global dealers have considerable entrenched advantages in settlement costs.”

He said any institutions without direct access to offshore CCPs would have to clear indirectly through a direct clearing member. While acknowledging arguments in favour of restricting access to a CCP to large banks, because they were more able to handle financial wind-downs in case a CCP member defaulted, he said this involved “an important challenge”.

“In carrying out the G20 mandate requiring all OTC derivatives to be centrally cleared, it is essential to ensure that we do not unduly concentrate risk in a relatively small number of institutions that are direct clearing members of global CCPs,” he said.

These were the very institutions that spread and amplified contagion through the global financial system in 2008, Mr Lane told the annual Sibos settlement and payments conference.

He added non-Canadian dealers may be able to use their dominance in direct clearing to heighten their competitive edge in other financial market activities, such as trading and other investment banking services. That in turn could lead to “greater concentration of business, and of risk, across a whole range of activities”.

His comments come as the Bank of Canada is considering whether to support the building of a Canadian CCP for OTC derivatives, to avoid Canadian banks having to rely on overseas CCPs and to give Canada its own clearing infrastructure. The Reserve Bank of Australia is debating the same thing. Both initiatives have raised concern that clearing of OTC derivatives, which was supposed to be harmonised globally, may end up being “Balkanised” across the globe, making it harder for regulators to track risks in the system on a global basis.

Mr Lane said creation of a Canadian CCP for OTC derivatives would make it easier for Canadian authorities to oversee such systemically important financial infrastructure, as well as provide liquidity in an emergency. It also could, in some situations, reduce the impact on Canadian markets of financial shocks from abroad.

“In assessing the best clearing strategy for Canadian OTC derivatives, [we] are working with our domestic and international counterparts to ensure that global CCPs, particularly those of systemic importance to Canada, are able to deliver the intended benefits of financial stability. Second, we are actively exploring the possibility of developing a Canadian-domiciled CCP, in collaboration with the financial industry and other public policy institutions. We must choose the arrangements that best support the stability and efficiency of Canada’s financial system,” Mr Lane said.

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