UK's FSA Warns US Against Lowering Barriers To Swap Clearing

Only the most sophisticated financial institutions should be members of derivatives clearinghouses, and the barriers to entry should be high enough to weed out firms lacking the necessary expertise, a senior U.K. regulator has said.

In a letter to the U.S. Commodity Futures Trading Commission, Alexander Justham, director in the market division at the Financial Services Authority, said weak standards for swaps clearing--especially in the case of complex instruments--"could lead to increased risk to the system."

The letter, sent Monday, came in response to the CFTC's request for comments on a set of proposed rules. In December, the CFTC voted in a proposal that would set a $50 million cap on clearinghouse membership fees. The Securities and Exchange Commission has a similar proposal.

Two large U.S. clearinghouses currently have higher capital requirements: $1 billion in adjusted net capital for a firm to be a member of CME Clearing, owned by the Chicago Mercantile Exchange, or CME Group Inc. (CME); and $5 billion in Tier One capital to be a member of ICE Trust, owned by IntercontinentalExchange Inc. (ICE).

Both ICE and CME are working with regulators on the proposed rules and say they will comply with the final versions.

Justham said the FSA supports fair and open access to the business of swaps clearing, but entry requirements "need to be tailored." An FSA spokeswoman declined to comment further and a CFTC spokesman did not immediately return a request for comment.

Justham's letter highlights the potential for divergence in derivatives regulation globally--which could benefit more-lax jurisdictions--and underscores how Europeans may take a different approach than the U.S.

"The views within the regulatory community in terms of what constitutes appropriate capital levels and default/risk management expertise are not yet aligned," Athanassios Diplas, global head of systemic risk management at Deutsche Bank, said in an email Friday.

The Dodd-Frank financial regulation overhaul law enacted in the U.S. last summer will force much of the over-the-counter derivatives market through central clearing, and force users to trade swaps on exchanges and other transparent execution platforms. The CFTC and SEC are preparing the necessary rules and are expected to implement them later this year.

Under the new regime, the business of clearing is estimated to be worth several billion dollars, according Booz & Co. consultants, since as much as 80% of the market may have to be cleared.

Clearing involves a trade being given up to a clearing member such as a large bank, which earns a fee for facing off against a clearinghouse on its customer's behalf. The clearinghouse is exposed only if a clearing member fails; in the meantime it aims to build a guarantee fund so it can backstop derivatives positions if member capital runs dry.

Some industry participants--chiefly big banks already engaged in swaps clearing--contend that accepting less-creditworthy firms as clearing members may increase risk, not reduce it. They also assert that a clearinghouse failure could put taxpayers at risk for more bailouts because the entities could be deemed too big and interconnected to fail.

"There is a lot to the theory that the more people at the party, the more you dilute the risk, but we need to enforce strong conformity, strong data enhancement," said Mike Zimits, global head of derivatives clearing at Citigroup, at a swaps conference in New York Thursday.

On the other side of the debate are small- and medium-sized financial institutions, some of which already clear other derivatives and want to clear swaps. They say they're being shut out of the market because incumbent swaps dealers control execution and clearing, thanks to their influence over clearinghouse risk management committees.

"Opening up the system for proportionate participation...will get more people competing on price, competing on ideas, to make the system better for end users," said Jon Corzine, chairman and CEO of MF Global Holdings, in a keynote speech at Thursday's swaps conference. "The $50 million adjusted net capital limit seems to make some sense, but $5 billion to participate is exclusionary."

At issue is the need for positions to be reassigned among clearing members if a member defaults. If a smaller member does not have a trading desk, the larger dealers worry that they could be left holding the bag. They add that the lower the bar is set, the less incentive there is for a clearing member to be better capitalized than the weakest member.

A $50 million clearing membership fee is "the price to come to the dance," Zimits said at the conference, adding, "There is a lot more that is needed to play this game."

-By Katy Burne, Dow Jones Newswires; 212-416-3084; katy.burne@dowjones.com

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