The New Too-Big-to-Fail Plan for Clearing Crisis Readied by EU

To prevent derivatives clearinghouses’ failure from wreaking havoc throughout the financial system, the European Union plans to give authorities sweeping powers to tackle ailing the clearinghouses.

Rules on saving or shuttering clearinghouses that would apply to firms such as London-based LCH, have been laid down in the draft EU legislation, reported the media. From the powers they would have when winding a company down, including writing down shares, debt and collateral to the creation of resolution authorities have been covered by the proposals.

The EU will come out with recovery and resolution proposals by year-end, having forced most clearing to go through central counterparties to manage risk in the financial system. After emerging as a pawn in the post-Brexit battle for London’s financial-services industry, clearing has come into focus.

“If we are going to rely more on CCPs, we need to have a clear system in place to resolve them if things go wrong,” Valdis Dombrovskis, the EU’s financial-services chief, said last month.

The damage inflicted by derivatives trades that went awry during the financial crisis had spooked governments around the world. Steps to ensure trading in the contracts is reported and centrally cleared have since been taken. Clearinghouses hold collateral, known as margin, from both in case a member defaults and thus stand between the two sides of a derivative wager.

Previously many transactions were conducted without a third party requiring collateral and directly between traders. A $182 billion U.S. rescue of American International Group Inc. was prompted and the 2008 meltdown was amplified by swaps trading, when it was largely unregulated.

To bolster the clearing houses’ assessments of risks and improve plans for how they’d recover after the default of major bank members, the Financial Stability Board and other securities regulators pu8blished guidelines in August at the global level. Before the FSB issues guidance early next year, the EU proposals will probably be published.

According to the summary of an EU impact study, the plan’s upfront costs for clearinghouses “are estimated to be in the millions for the largest institutions and in the thousands for smaller entities.” Costs for “better planning and prevention of failure” will vary by firms’ “size, interconnectedness, substitutability and complexity.”

Clearinghouses, which might get into difficulty after the default of a clearing member — typically a major bank — or after some operational failure that inflicted major losses, could face increased risk even as the process is taking risk out of the banking system. In both cases the authorities would act amid a looming crisis and would need to do it quickly.

Creation of authorities with a standard set of powers that would override national regimes have been called for in the EU draft law. The new authorities would draw up resolution plans and operate separately from supervisors, similar to the framework created for the bloc’s banks and could be part of a central bank, ministry, supervisor or other public body.

European Central Bank, which oversees the currency bloc’s banks, do not supervise euro-area clearinghouses at present, but it is done by national authorities.

(Adapted from Bloomberg)

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