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EU takes action on 'too-big-to-fail' risks in financial clearing

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By Reuters
EU takes action on 'too-big-to-fail' risks in financial clearing
FILE PHOTO: A European flag is seen outside the EU Commission headquarters in Brussels, Belgium November 6, 2019. REUTERS/Yves Herman   -   Copyright  YVES HERMAN(Reuters)
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By Francesco Guarascio

BRUSSELS (Reuters) – European Union governments on Wednesday agreed new rules for handling failures of clearing houses raising the financial burden on them in a rescue, in a move aimed at preventing contagion risk in the global financial system.

The rules could set a global standard for regulators, which put clearing houses at the centre of trading in over-the-counter derivatives and interest rate swaps after the 2008 financial crisis but did not agree on how to wind them down safely.

The deal, which confirms a preliminary agreement struck last week, concerns 16 EU-based clearing houses which stand behind a significant proportion of the 640 trillion euros (£549.81 trillion) of derivatives traded globally, the EU said.

Most of this clearing is done by houses owned by the London Stock Exchange <LSE.L> and International Exchange Inc <ICE.N>, which are based in Britain. It is not clear how the new rules will be applied to these firms after Britain leaves the EU.

The clearing houses stand behind both sides of a transaction and ensure its completion even if one side goes bust. Large investment banks are their main customers.

But in a crisis, there are fears that a clearing house might not have the resources to meet all its commitments which could rock the financial system and force governments to step in.

As a result, like large global banks, the clearers have become as analysts describe it “too big to fail,” meaning that taxpayers’ money would have to be used to rescue them.

The rules, which need approval by the European Parliament and are still subject to change, are meant to close this gap.

They “will help to address interconnectedness and contagion risks, while encouraging less risky behaviour by clearing houses and other market participants,” Finland’s Finance Minister Mika Lintila, who chairs the EU council, said.

In a major regulatory shift, EU governments agreed a clear procedure to address clearing house failures, putting a higher financial burden on them and reducing costs for banks and other clients, which are known as “clearing members”.

The industry’s European trade association, EACH, said the rules would increase financial stability, but urged higher contributions from banks to make sure taxpayers would not be required to foot the bill. They also warned about the impact on clearers from the additional contributions required by the rules.

Under the draft deal, clearing houses should use their own resources to cover losses “before resorting to other recovery measures requiring financial contributions from clearing members.”

This would double clearing houses’ contributions in a crisis to 50% of the capital they are required to set aside by regulators against losses.

Under existing rules, when one party in a transaction, whether a bank or fund, cannot meet its commitments, it is the first to pay for its failure by using backstop capital set aside before the transaction.

If that is not enough, the clearing houses contribute up to 25% of their capital, before a default fund financed by banks and other clearing clients is used.

The new rules would force clearing houses to put up more of their own capital if the default fund was not sufficient to cover losses. Banks would need to pay extra cash only if this was not enough.

But the new draft rules do not explicitly require the clearing houses to raise more capital after a recovery, leaving it unclear how they would fill any shortfall created by their crisis contributions.

Under the agreement, the new rules would be applied two years after the date of entry into force of the regulation.

(Reporting by Francesco Guarascio. Editing by Jane Merriman)