(Bloomberg) -- The European Union plans to give authorities sweeping powers to tackle ailing derivatives clearinghouses to prevent their failure from wreaking havoc throughout the financial system.
Draft EU legislation seen by Bloomberg sets out rules on saving or shuttering clearinghouses that would apply to firms such as London-based LCH. The proposals cover everything from the creation of resolution authorities to the powers they would have when winding a company down, including writing down shares, debt and collateral.
Having forced most clearing to go through central counterparties to manage risk in the financial system, the EU will come out with recovery and resolution proposals by year-end. Clearing has come into focus after emerging as a pawn in the post-Brexit battle for London's financial-services industry.
“If we are going to rely more on CCPs, we need to have a clear system in place to resolve them if things go wrong,” Valdis Dombrovskis, the EU's financial-services chief, said last month.
Governments around the world were spooked by the damage inflicted by derivatives trades that went awry during the financial crisis. Since then, they've taken steps to ensure trading in the contracts is reported and centrally cleared. Clearinghouses stand between the two sides of a derivative wager and hold collateral, known as margin, from both in case a member defaults.
Many transactions were previously conducted directly between traders without a third party requiring collateral. Swaps trading, when it was largely unregulated, amplified the 2008 meltdown and prompted a $182 billion U.S. rescue of American International Group Inc.
At the global level, the Financial Stability Board and other securities regulators published guidelines in August for clearinghouses to bolster their assessments of risks and improve plans for how they'd recover after the default of major bank members. The EU proposals will probably be published before the FSB issues guidance early next year.
The plan's upfront costs for clearinghouses “are estimated to be in the millions for the largest institutions and in the thousands for smaller entities,” according to the summary of an EU impact study. Costs for “better planning and prevention of failure” will vary by firms' “size, interconnectedness, substitutability and complexity.”
Clearing Member
While the process is taking risk out of the banking system, it has increased it in the clearinghouses, which might get into difficulty after the default of a clearing member -- typically a major bank -- or after some operational failure that inflicted major losses. In both cases the authorities would need to act quickly and would be doing so amid a looming crisis.
A spokeswoman for the Brussels-based commission declined to comment on the undated document.
The EU draft law calls for resolution authorities to be created with a standard set of powers that would override national regimes. The new authorities, which could be part of a central bank, ministry, supervisor or other public body, would draw up resolution plans and operate separately from supervisors, similar to the framework created for the bloc's banks.
Elke Koenig, head of the Single Resolution Board for euro-area banks, said last month that she'd make a case for creating a European resolution authority for clearinghouses.
‘Logical Argument'
At present, euro-area clearinghouses are supervised by national authorities, not the European Central Bank, which oversees the currency bloc's banks. “There is a very logical argument that resolution should also be on the EU level,” she said.
Once the authorities decide that a platform is beyond repair, the proposal gives them the option of selling the whole thing, or just its critical functions, to a viable competitor; of creating a publicly owned “bridge” company to take those functions over; and of imposing losses and allocating positions to clearing members, according to the proposal. The tools to be employed, and how they are used, would be set out in the resolution plan.
The authorities would be able to recapitalize the clearinghouse by seizing variation margin, exercising cash calls defined in recovery or resolution plans and writing down capital and converting debt securities. They would also be able to auction off the defaulters' positions, tear up some or all contracts and access default funds. The relevant central bank would be able to facilitate resolution by supplying temporary liquidity.
“Should these options be unavailable or be demonstrably insufficient to safeguard financial stability, government participation in the shape of equity support or temporary public ownership could be considered as a last resort,” according to the proposal. Those steps would need to comply with EU rules on state aid.
--With assistance from John Detrixhe To contact the reporters on this story: Boris Groendahl in Vienna at bgroendahl@bloomberg.net, John Glover in London at johnglover@bloomberg.net. To contact the editors responsible for this story: Patrick Henry at phenry8@bloomberg.net, Trista Kelley
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