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Clearing Amp Settlement
Clearing at a cost
From the Financial Times of Thu, 11 Dec 2014 10:56:31 GMT

Positions are being taken ahead of the next big lobbying battle — deciding where to apportion the losses from failing clearing houses.

Clearing houses, their members, the members’ customers and regulators all have strong views in this vital and yet, in some ways, strange debate.

While the result will be formal laws to cover procedures to resolve the futures of these new systemically-important institutions, one hopes they will never be needed. Nor should they be if the welter of banking and markets legislation over the past five years does its job.

But avoiding the issue would be a terrible abdication of responsibility.

Even so, tougher rules — as Europe will propose next year — could also require clearing house operators to find real pots of money, and that is far from an abstract exercise.

Last week the LCH.Clearnet, the world’s largest clearer of over-the-counter derivatives, added its voice to the debate in a paper. It is a must-read whether one agrees with the conclusions or not.

For all the talk of discord between clearing houses and their main users, it is worth noting the issues that both sides agree on, such as global harmonisation of stress tests and consistent regulation across jurisdictions.

The faultline is the call for clearing houses to hold more of their own funds in the mutualised default fund that pays out when a counterparty fails — the so-called “skin in the game”.

So far the loudest calls have come from JPMorgan, one of the world’s largest swaps traders, but others, such as the International Swaps and Derivatives Association, Pimco and BlackRock, have expressed the same view.

JPM argues that the clearing house is responsible for setting minimum eligibility requirements for collateral and membership. That, too, introduces risk to the system, it says, and therefore needs to be incentivised to manage its risk.

LCH, controlled by the London Stock Exchange Group, says that while aligning incentives is important, increasing the skin in the game could bring the clearing house directly into the credit risk structure. As LSE chief Xavier Rolet argued this week: “The clearing house risk to which members are exposed is different from the members’ risk.”

The biggest difference appears to be whether the amount of skin in the game should be absolute (as happens in many clearing houses), or a fixed percentage of the default fund (the view of many users).

JPMorgan has estimated that total skin in the game (defined as both the funded and unfunded default funds) of the world’s four largest operators — ICE, CME, LCH and Eurex — is less than 2 per cent of their overall default waterfalls. A woeful amount, the bank says.

But what would be the quantifiable effect of a fixed percentage, or even just more capital?

Morgan Stanley’s London research team has just made a helpful first stab at an answer. Using one International Swaps and Derivatives Association suggestion — a fixed percentage of 5-12 per cent of a default fund — it estimated a hefty €100m-€450m of additional capital for the LSE and €100m-€350m for Deutsche Börse.

That worked out at roughly 10-15 per cent of each group’s estimated net income from between 2015-17 or roughly a couple of retained earnings from relevant subsidiaries, LCH.Clearnet and Eurex Clearing.

While it called the scenario “manageable” for the clearing houses, the broker warned of potential market consequences: “For example, greater capital or higher costs for clearing houses could potentially be passed on to users and thus could lower market liquidity as economics deteriorate for market participants.”

Indeed. The full impact may still be years away.

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