LCH highlights challenge in derivatives regulation

May 18, 2010

By Huw Jones

LONDON, May 18 (Reuters) – LCH.Clearnet moved to reassure markets on Tuesday that its capital base was adequate despite a ratings downgrade at a time when regulators are finalising laws to force banks to clear vast numbers of derivatives.

Standard & Poor’s placed LCH.Clearnet’s rating on “negative credit watch” last week after one of its biggest customers, the transatlantic exchange NYSE Euronext said it would stop using the Anglo-French clearer from late 2012.

“The clearing activity itself is not dependent upon the creditworthiness of the clearing house,” LCH.Clearnet Chief Executive Roger Liddell told an industry conference.

LCH.Clearnet has more than 3 billion euros of capital and this is dwarfed “into almost insignificance” by the 55 billion euros put up the company’s users, Liddell said.

“So the risk of the system is effectively underwritten by all of its participants who have a lot of their capital on the line,” Liddell said.

The downgrade comes as the European Union and the United States are thrashing out new rules that will force banks to centrally clear as much of the $615 trillion off-exchange derivatives market as possible with operators like LCH.Clearnet.

It is part of a global drive to learn from the financial crisis and create a less risky system.

Regulators are anxious that clearers of vast amounts of derivatives are soundly capitalised in order to withstand any “financial armageddon”, so that if one goes belly up, it won’t threaten the whole system.

“It’s very important we work on risk management standards for central counterparties so we don’t create new too big to fail institutions,” said Athanassios Diplas, global head of systemic risk management at Deutsche Bank.


The EU’s executive European Commission is due to come out with a draft law to oblige central clearing of derivatives in July, mirroring similar efforts underway in the United States.

But regulators face the twin challenge of ensuring clearers can manage risks from derivatives and that users have enough choice in the market.

So far ICE has the field to itself in clearing credit default swaps in Europe.

Germany’s Eurex Clearing has failed to make inroads and the CME Group of the United States has just announced it was delaying its launch of clearing CDS in Europe.

Industry officials say LCH.Clearnet’s loss of a key customer could also dent its plans to clear CDS transactions.

Liddell was seeing signs of clearing houses competing with each other by “relaxing risk standards” and urged regulators to get involved.

“We do not want competition between central counterparties on risk, we believe that is unacceptable for the stability of the system,” said Patrick Pearson, a senior Commission official who is drafting the measure.

“But we will act if we see anticompetitive behaviour,” Pearson said.

David Bailey, manager of OTC derivatives policy at Britain’s Financial Services Authority and Theo Lubke, a senior vice prsident at the Federal Reserve Bank of New York, said no clearer should be forced to clear a derivatives contract.

But underlying all this is whether central banks would step in if a clearing house threatened to go under, industry officials said.

Daniela Russo, a director of market infrastructure at the European Central Bank, said making clearers eligible for central bank liquidity would give a “very dangerous” incentive for them not to manage risks properly.

Governance mechanisms would help deal with issues raised by any lack of competition among clearers, she added.

Industry officials fear that the United States and the EU could end up with significant differences in their derivatives rules and create competitive disadvantages for some players.

“I am quite sure the end result will be pretty similar and very equivalent,” Pearson said.

(( Reporting by Huw Jones, editing by Jason Webb; + 44 207 542 3326;

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