LCH.Clearnet 'shocked' at Dodd-Frank capital requirement

Firm might not be able to live with 99% reduction in minimum capital requirement under Dodd-Frank Act, says chief executive

The row over minimum capital requirements for clearing members of central counterparties (CCPs) intensified this week, with London-based clearing firm LCH.Clearnet claiming it might not be able to work with the $50 million minimum proposed by regulators.

The limit was put forward by the US Commodity Futures Trading Commission (CFTC) on December 16 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It has since provoked a dispute between firms that believe the level is too low and smaller market participants eager to gain direct access to CCPs as clearing members.

“We were shocked, frankly, when the CFTC proposal to have a net capital requirement of $50 million came out,” said LCH chief executive Roger Liddell, speaking during a panel discussion at a conference hosted by consultancy firm Tabb in New York on January 25.

Compared with requirements for the firm’s interest rate swap clearing platform SwapClear, such a level would represent a drop of 99%, he emphasised. Current net capital requirements for SwapClear are $5 billion.

In response to a question from the audience about what the minimum capital requirement should be, Liddell answered: “I don’t think there’s any right answer. It’s a question of judgement.” However, he said the firm did not agree with an approach of “the more, the merrier”, noting that clearing members needed to have the financial strength and operational capability to help mutualise risk.

To take on a defaulting client’s portfolio requires resources, expertise and access to markets

Most importantly, clearing members had to have the resources to bid on the portfolios of defaulted firms. “To take on a defaulting client’s portfolio requires resources, expertise and access to markets,” he insisted.

Having a lower minimum capital requirement for clearing members would make the business of clearing much more difficult, he suggested. Instead of relying on the ability of clearing members to deal with risky clients, CCPs could be forced to keep a sharper eye on the activity and creditworthiness of market participants. Consequently, it was “unclear whether we could live in a world with a $50 million requirement”, he said.

The comments come as LCH.Clearnet prepares to launch a US-based clearing effort. In June, the company lodged an application with the CFTC to allow US clients to clear using a futures commission merchant model, with margin held onshore and transactions governed under New York law. On January 6, the firm announced the appointment of Floyd Converse, who previously worked at Bank of America Merrill Lynch, as its new head of sales and marketing in the US.

Liddell’s concerns were reflected in comments from other panel participants. Ray Kahn, global head of over-the-counter derivatives clearing at Barclays Capital, noted clearing members would have to manage bilateral counterparty risk with many buy-side market participants – something that could prove tough for inexperienced firms to handle. Dealing with a multitude of individual OTC trades from inception to maturity would also be challenging from an operational and legal perspective.

“At Barclays Capital we have more than 200 people working on clearing in one way or another. In addition, you need a lot of legal resources. When you build it all up, it’s incredibly operationally intensive,” he said.