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The Risks of Clearing Houses

Following the financial crisis, the leaders of the G20 nations agreed to a series of measures to increase the transparency of the over-the-counter (OTC) derivatives market and to reduce systemic risk. Regulations have fundamentally altered the structure of the OTC derivatives markets, significantly impacting the business models, profitability, legal entity structures, operations, data and technology of financial institutions' derivatives businesses. In the aftermath of the financial crisis, clearing houses have moved to the forefront of this global regulatory push to reform derivatives market and reduce the risks posed by big banks.

A clearing house has been best described by the London Clearing House: "As a clearing house, we stand in the middle of capital markets, acting as a buyer to every seller and a seller to every buyer. Put simply, we make financial markets safer." Investopedia builds on this definition: "clearing houses take the opposite position of each side of a trade which greatly reduces the cost and risk of settling multiple transactions among multiple parties. While their mandate is to reduce risk, the fact that they have to be both buyer and seller at trade inception means that they are subject to default risk from both parties. To mitigate this, clearing houses impose margin requirements."

The usage of clearing houses is set to expand sharply in the coming years as regulators make central clearing compulsory for over-the-counter trades in financial derivatives such as interest rate swaps. As trading volumes through lowly capitalised clearing houses rise, banks increasingly fear this counterparty risk: central clearing houses are providing insufficient data on their risks and demanding lower-quality collateral for swaps transactions. New regulations imply that all clearing houses for securities trading in the European Union will be required to comply with new rules aimed at managing their financial collapse in a way which does not jeopardise the smooth working of markets. Moreover, a clearing house would have to file for a Chapter 7 bankruptcy in the event of a default.

Amidst uncertainty surrounding Brexit, the London Clearing House (LCH) is losing business to newly established European counterparts. Current rules would leave the EU with little say how clearing houses in the UK are policed, likely resulting in the introduction of new LCH regulation. The draft bill proposed by the European Commission could allow Brussels to stop EU banks using non-EU clearing houses and calls on EU regulators to check on "systemic" foreign clearing houses that handle large amounts of euro-denominated assets like interest rate swaps. If a clearing house’s home regulator, which would be the Bank of England in the case of LCH, failed to cooperate with the EU supervisors, the bloc would demand that clearing for EU customers be relocated to the EU. Eurex, the German clearing house, has launched a scheme to entice London’s prized business clearing a notional €7tn in over-the-counter deals this year compared with more than €117tn processed by LCH. This awards its 10 most active participants (including JP Morgan, Citi, Morgan Stanley HSBC, BNP Paribas, Barclays, Commerzbank, Deutsche Bank and Bank of America Merrill Lynch) with a significant profit share of the multi-currency interest rate swap business.

Banks should consider these new opportunities that emerge, but must equally consider the wider risk and implications of new clearing houses to the financial industry. Clearing houses, which act as the processing centres for trillions of dollars of global trading, could pose the biggest risk to the world’s financial system in a future crisis and need further regulation to ensure sufficient data provision and a standard quality of collateral demanded for swaps transactions.