Following in the footsteps of nine major banks doing business in the United States, clearing houses will be required to create detailed plans to be followed in the event that they need to be rescued or liquidated, global regulators said on Tuesday.
The so-called “living wills” are intended to prevent a chain reaction such as those caused by the bailout of AIG and the collapse of Lehman Brothers in 2008. Those events led to new rules, coming into effect at the end of this year, stipulating that most Over-the-counter (OTC) derivatives be processed through clearing houses.
Clearing houses, also called central counterparties (CCP) are an important part of the regulatory reforms called for under the Dodd-Frank Act. Instead of trading directly with one another, counterparties to a derivatives transaction place their trades with the CCP, which has a default fund to guard against the risk that one of the counterparties cannot meet its obligations. This reduces risk in most situations, but the concentration of risk can make the CCP a “too big to fail” entity in the event that many counterparties default simultaneously. Taxpayers could then be forced to cover the shortfall, as they did in 2008.
By creating living wills, clearing houses such as the Depository Trust & Clearing Corp. (DTCC), LCH.Clearnet and Eurex Clearing would increase the likelihood that such events will minimally impact the market as a whole.
“The vital role of the financial system’s infrastructure makes it essential that credible recovery plans and resolution regimes exist,” said Paul Tucker, deputy governor of the Bank of England and chairman of the Committee on Payment and Settlement Systems (CPSS).
Proposals on what to include in living wills are out for public consultation until September.