First loser

Finance's new plumbing better safe than efficient

Finance's plumbing should be efficient, but not at the expense of stability. Global regulators' latest thinking on so-called central counterparties raises the risk that these massive new derivative clearing houses could have to hold further reserves of capital. Given their centrality in the new financial architecture, this may be a risk worth taking.

In 2008, the financial system crashed in part because banks' trading arms were stuffed full of derivative trades that turned out to be insufficiently backed with collateral. Post-crisis reforms requiring these instruments to be centrally cleared are a big step forward. But, if the clearing entities themselves are insufficiently robust, the next crisis could be worse.
 
The Financial Stability Board's (FSB) latest consultation, published on August 16, is structured as a series of leading questions. An important one is how much notice regulators should give to the financial institutions that back a clearing house, if it is going to be wound up. An even more vital one is whether the central counterparties should be required to hold pre-funded resources over and above the margin posted by the client doing the trade, plus the buffers and funds provided by the clearing house and the banks that are its so-called members.

For some market participants, this is overkill. Existing buffers may well be adequate - no central counterparty has ever gone through its so-called "waterfall". If one gets into difficulty because some of its members go bust, the situation could in theory be swiftly remedied via an auction of the affected parties' derivative positions. Higher reserve requirements would push up the cost of clearing and thus derivatives trades, since clearing houses need to make a profit. So, might giving regulators too much discretion.

These are all risks. But if the worst that happens is that corporate clients do less hedging, that sounds a more acceptable risk than a bust clearing house that causes a systemic financial collapse. Given that all consultations usually end up somewhere in between the two positions, the FSB would be advised to start its negotiations at the tough end.