LONDON — Regulators should scrutinize clearing houses and banks together to spot financial stability threats from the world’s multi-trillion dollar derivatives market, the Bank for International Settlements (BIS) said on Sunday.
Almost two-thirds of interest rate swaps pass through clearing houses like LICH and Eurex, ensuring the safe completion of trades even if one side of a transaction goes bust.
This compares with a fifth in 2009, before new rules were introduced in the aftermath of the financial crisis that require banks to clear trades to improve safety and transparency.
Banks and clearing houses are now regularly “stress tested” on an individual or sector-wide basis to check their resilience to defaults and extreme market stresses, but the BIS paper called for checks to be coordinated.
Clearing has cut risk in the financial system overall, but banks and clearing houses, also known as central counterparties (CCPs), could create a “destabilizing feedback loop” that amplifies stresses in markets, said the BIS, a forum for central banks from across the world.
“Hence, the risks of banks and CCPs should be considered jointly, rather than in isolation,” it said in its quarterly review.
Mandatory clearing has built up large exposures between a small number of banks and CCPs, or what the BIS calls a CCP-bank nexus that regulators should now be studying more closely.
Clearing houses are processing large notional values of interest rate and credit default swaps equivalent to 4.4 times the world’s economic output, up from 2.8 times in 2008 when Lehman Brothers bank went bust.
Rules for clearing houses have already been tightened, and they must now be able to hold enough default funds to survive their two largest members going bust.
“However, given the complex web of incentives, spanning different institutions and markets, what might transpire under some stress scenarios is less than fully understood,” the BIS said.
Only three clearing houses have failed in the past 50 years, though some have come under severe stress.
A Norwegian power market trader racked up losses he could not cover in September, leaving commodities companies part of the Nasdaq clearing house and the exchange itself to plug a €114-million hole in a contingency fund. — Reuters