Friday, April 16, 2010

LCH.Clearnet warns on loose standards

Original posted on the FT by Jeremy Grant:

LCH.Clearnet has accused some of its global rivals of using loose standards to assess the amount of insurance traders must take out against a catastrophic default, in an apparent attempt by Europe’s largest independent clearing house to win business.

The development is a sign some clearing houses are trying to highlight the dangers of “competing on margin” – that is, lowering the minimum funds that must be posted by market participants to a clearing house to guard against failures.

Regulators fear that clearing houses might start to use margin as a competitive weapon to attract business as they battle for a slice of the vast over-the-counter derivatives markets.

They say this could lead to a “race to the bottom” on the financial strength of a clearing house, increasing the risk that a clearer could collapse, potentially triggering a financial crisis.

Regulators have insisted clearers adopt the highest possible risk management and margin standards in the wake of the crisis to ensure the safety of clearing houses and the wider financial system. A clearing house acts as a buyer to every seller and seller to every buyer in transactions, using margin to ensure transactions are completed in case of default.

Roger Liddell, LCH.Clearnet chief executive, said: “There seems to be a divergence from a risk management standpoint as to how CCPs [central counterparties or clearing houses] are operating.”

He said IntercontinentalExchange and Chicago Mercantile Exchange – two US exchanges with OTC derivatives clearing operations – “margin differently” from each other. Mr Liddell singled out International Derivatives Clearing Group, a clearing house set up last year to clear OTC interest rate swaps, and controlled by Nasdaq OMX, the US exchange operator.

“The most extreme case is between us and IDCG. Their approach to risk is much more lenient than ours,” Mr Liddell said.

Michael Dundon, IDCG chief risk officer, said: “We do not have more lenient standards in that we recalculate our margins on a daily basis. We are very responsive to volatility on a daily basis.”

CME said: “The group regards risk margining as essential to proper counterparty risk controls and does not calculate margins according to commercial considerations.”

ICE said: “We’ve warned that competing on margin could create a race to the bottom.”

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