Isda AGM: dealers, CCPs debate risks of lowering bar to entry

Weaker clearing members could be overstretched by a crisis, dealers warn - but LCH.Clearnet and CME differ on the risk of wider access

Allowing smaller firms to become clearing members of multiple central counterparties (CCPs) could create a hidden vulnerability in the system, a trio of senior clearing figures from big banks warned during the International Swaps and Derivatives Association's annual meeting in Prague yesterday. Regulators are pushing for CCPs to lower their barriers to entry, letting weaker firms into clearing's inner circle – but these firms could be overwhelmed in a crisis, the larger banks argued.

"Let's say you're a clearing member with $75 million in capital, and your cost of entry to a CCP is $25 million for the guarantee fund – and you join two CCPs. But those CCPs also have the right to call on you for an additional $25 million if they run out of money," said Athanassios Diplas, global head of counterparty portfolio management at Deutsche Bank, at a press briefing. "They can't both get it, they don't know about each other – and the assessment will come at the worst point in time – the day after the Lehman Brothers collapse, for example."

Tom Benison, managing director for credit trading at JP Morgan, echoed the point. "If one CCP has to make a call for more funds, it's likely to mean we're really far out in the tail when it happens – which means every CCP is really far out in the tail. So how many CCPs are calling for funds?"

These could look like self-serving arguments. In recent months there has been a public battle between large, incumbent clearing members and smaller, would-be clearers – with the latter arguing they are being denied access to the growing market for over-the-counter clearing by arbitrarily high membership criteria. As an example, LCH.Clearnet's SwapClear sets a minimum capital requirement of $5 billion for clearing members – in December, the Commodity Futures Trading Commission proposed capping the capital requirement at $50 million.

But the incumbents might have an ally in the form of Federal Reserve chair Ben Bernanke. Delivering a speech on CCPs and financial stability on April 4, he warned stress could be transmitted through the financial system by CCPs with overlapping membership. "The same globally active banks participate in all the major clearing houses, and the major clearing houses often rely on similar sets of banks for payment services, funding, settlement and emergency liquidity. In such a world, problems at one clearing house could have significant effects on others, even in the absence of explicit operational links," he said.

If one CCP has to make a call for more funds, it's likely to mean we're really far out in the tail when it happens - which means every CCP is really far out in the tail. So how many CCPs are calling for funds?

In the absence of a system for monitoring these risks, Deutsche's Diplas proposed a simple solution – keep the entry criteria high. Stephen O'Connor, the incoming Isda chair and global head of over-the-counter client clearing at Morgan Stanley, raised a different possibility – different tiers of membership, with weaker clearers facing either volume restrictions or tougher margin requirements. "The current model is agnostic about members, but if you want to start lowering the bar in terms of size, capitalisation or other factors, then you get into territory where a member can join, but the amount of business they can do is capped or they're on a different margin multiplier. It gets complicated very quickly," he said.

Earlier, attendees in the main hall saw CCPs debating the same issue – with a sharp difference of tone between LCH.Clearnet, which is industry-owned, and CME, which is privately owned and is seen as being more sympathetic about broader access for smaller clearing members.

"The challenge is that we're going to see more defaults in the membership of CCPs – and that is concerning," said Simon Grensted, head of business development at LCH.Clearnet. "We used to say it's quite good that our risk staff have worked through a default once in their lifetime at LCH – but we don't want defaults every year and that's the challenge that wider access is sending us towards."

Kim Taylor, president of CME Clearing, begged to differ: "I'm going to challenge that a little, Simon – saying that a broader membership base results in more defaults ignores the fact we all actively risk-manage clearing members on an ongoing basis and have the ability to set additional risk requirements for any that we think are in trouble."

But Grensted stuck to his guns: "Completely. But the central question is whether we're going to see more defaults in CCPs – and the answer has to be yes."