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FSB says initial margin, derivatives could be wiped out in clearing house crisis

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FSB says initial margin, derivatives could be wiped out in clearing house crisis

Watchdogs should have the power to wipe out the cash guarantees posted by members of clearing houses or cancel derivative contracts in an emergency, the Financial Stability Board said Feb. 1.

Clearing houses, or central counterparties, have grown in importance within the global financial infrastructure since the 2008 crash, when the collapse of Lehman Brothers triggered the need for some $500 billion in contracts to be settled. But that increasing importance means that CCPs have themselves become a source of systemic risk, prompting the FSB to begin fashioning a framework for dealing with the fallout of a clearing house failure.

Launching a consultation on its proposals, the FSB urged national and supranational authorities to clearly designate the authority that would be primarily responsible for managing the recovery or resolution of a CCP; design action plans for various adverse scenarios; and put in place any necessary collaboration agreements between agencies when a "systemically important" CCP operates across jurisdictions.

The ability to write down initial margin is unpopular among many market participants, which argue that such an action could impose unfair losses on investors and potentially worsen the systemic impact if a clearing house runs into trouble. The FSB said the power to write down initial margin, where granted, "should only be applied to initial margin that is not bankruptcy-remote and be limited to use as a last-resort-tool. In considering including such a power in their legal framework, jurisdictions should take into due account the impact on financial stability and on incentives to centrally clear."

The FSB also advised that regulators ought to be able to demand cash from members, up to a specific limit, to recapitalize a CCP and prevent a wider financial crisis. It also said that where losses stem from the default of one or more clearing house members, the resolution authority should be able to take steps to return the CCP to a "matched book" — a situation in which all counterparty positions are offset through an opposite position with a second counterparty.

This should be done wherever possible through voluntary or market-based actions, such as auctions or direct liquidations of positions into the market, the FSB said. But where that fails or is likely to fail, the resolution authority should be able to "tear up" contracts as a last resort.

The FSB also recommends that resolution authorities should be able to demand cash from members, up to a specific limit, to recapitalize a CCP and prevent a wider financial crisis. Where a CCP default results from an event other than a participant default, such as investment losses, operational failures or fraud, authorities should be able to write down unsecured liabilities and, if necessary, convert them into equity or other ownership instruments.

Elke König, chair of the FSB Resolution Steering Group and chair of the European Single Resolution Board, said: "CCPs have grown substantially over the last years. The failure of a CCP would have a significant impact on financial stability. It is essential that authorities have effective resolution planning arrangements in place, including legal powers and tools to take action in a crisis. Once finalized the guidance will provide an internationally agreed standard for CCP resolution."

The guidelines are under consultation until March 13.

Almost €500 trillion in over-the-counter derivatives are held in the world's clearing houses at any given moment, according to the European Commission, which introduced a legislative proposal in November 2016 aimed at resolving clearing houses along the lines of the Bank Resolution and Recovery Directive, or BRRD.

There are 17 clearing houses in the European Union.