Insight - Derivatives exchanges prove resistant to regulatory change

By David Henry

NEW YORK (Reuters) - In December 2013, Hanmag Securities Corp, a small South Korean brokerage firm, lost 46 billion won (26.77 million pounds) in a day after a stock option trading algorithm went bad. It was a fatal blow for a company that had just 15 billion won of capital — Hanmag went bust.

What happened next rattled regulators around the world: Hanmag defaulted on its obligations, forcing the Korea Exchange's clearinghouse to tap its emergency funds.

Clearinghouses are a critical part of regulators' efforts to fix the financial system after the crisis, and they have grown much larger in recent years. Seen as a way to ensure that banks are not too connected to fail, clearinghouses can guarantee that if one party in a derivatives trade can't meet its obligations, other banks it trades with will still get the money they are owed.

During the financial crisis, regulators were reluctant to let wobbly traders such as Bear Stearns go bust, fearing that a failing bank would default on derivatives trades with other market players, which in turn would default on obligations with others, potentially spiralling into a systemic meltdown.

For clearinghouses to work, they need to be rock solid when the world is crashing around them. If they aren't, they may make any unfolding financial crisis much worse, by spreading panic instead of tamping it down.

While regulators have recently talked about efforts to make clearinghouses stronger, they are finding it's not easy, according to bankers and former regulators who are working with global rulemakers on this issue.

Clearinghouses force banks to post collateral to support their trades, but it is hard to be sure that parties have always posted enough, in part because during crises the value of collateral may drop. The derivatives contracts that banks trade may also behave unpredictably, potentially leaving the clearinghouse with too little collateral.

There are by one measure about $700 trillion of derivatives that trade off exchanges, which are the types of products regulators are most concerned about, though that number is far bigger than the actual potential losses from these contracts.

Figuring how much capital different parties should pony up when a failing bank doesn't have enough collateral is also difficult. Forcing other banks or the clearinghouse itself, for example, to put up a lot of cash when a member has failed could further destabilise the financial system.

To be sure, clearinghouse failures are rare - four have happened in the last 40 years. Still, regulators have been late to design risk management standards for clearinghouses, given how big they are, said Darrell Duffie, a finance professor at Stanford University who has consulted with regulators on the matter.

For example, clearinghouses handle more than two-thirds of over-the-counter interest-rate derivatives, which are the most common type of derivatives that trade off exchanges, according to an analysis of data by clearinghouse operator LCH.Clearnet. That's about four times as much as before the financial crisis.

LCH.Clearnet's SwapClear, one of the biggest clearinghouses in the market, has cleared some $400 trillion of outstanding interest-rate derivatives known as swaps.

The actual market risk from those swaps is much lower, but even so some bankers complain that most clearinghouses have low levels of their own capital available to absorb losses. SwapClear has just 44.6 million euros ($55.45 million) of capital on the line as of Oct 31.

At SwapClear, if a bank fails, its collateral is applied to losses, and next comes the money the bank had put into the clearinghouse's safety fund. After that comes SwapClear's capital, and then finally a safety fund with 3.09 billion pounds ($4.85 billion) paid in by all its members.

Beyond that, banks would face additional assessments. However, once a clearinghouse burns through its own capital, banks can lose confidence in it and clear new contracts elsewhere, leading the clearinghouse to either wither away or collapse.

Many of the biggest clearinghouses now are for-profit companies, which may encourage them to hold as little capital as regulators will let them get away with to maximize profits. A majority of London-based LCH.Clearnet was bought last year by the publicly-traded London Stock Exchange Group (LSE.L). CME Clearing is operated by Chicago-based CME Group Inc (CME.O) and Intercontinental Exchange Inc (ICE.N) runs clearinghouses.

LCH and other clearinghouses have said they have enough capital and business reasons to manage their risk appropriately. If clearinghouses put up more capital themselves, then members would feel emboldened to take more risk, they have said.

Crafting good rules for clearinghouses could take years, said Stanford's Duffie, because of their complexity and the number of regulators involved. In the United States alone, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Federal Reserve all make rules for clearinghouses.

NEED TO ACT "FORCEFULLY"

Regulators have done some work on clearinghouses already - in 2012, they agreed on 24 principles for how clearinghouses should operate. One of those is a sort of capital standard for clearinghouses, namely that the companies must be able to cover possible losses from defaults by its two biggest customers. But regulators are not yet consistently checking clearinghouses' calculations. Rulemakers see the work done so far as only a start, people who have spoken to them told Reuters.

An international panel of rulemakers is now crafting standardized "stress tests" for clearinghouses to ensure the companies can weather tough market conditions. But the regulators have not figured out how those tests will work, or how much of the results will be disclosed to customers and the public. There are no approved plans in place globally to replace clearinghouses and the market services they provide if they should go broke.

Paul Tucker, who worked on reforms for the Hong Kong market after a 1987 clearinghouse failure there and then went on to become deputy governor for financial stability at the Bank of England, said that while it is taking regulators years to get a grip on clearinghouse risk, they deserve some credit.

"We know that by pushing more stuff through clearinghouses they are going to become too important to fail," said Tucker, who retired from the bank last year. "One could accuse previous generations of policymakers of not even seeing that point. Now the question is whether this generation will carry through."

(Reporting by David Henry and Se Young Lee in Seoul, editing by Dan Wilchins and John Pickering.)