Recent guidance from an international standards board on central-counterparty clearing houses is unclear and inadequate, and without amendments it could lead to "chaos" or taxpayer bailouts, the U.S. Systemic Risk Council said Friday.
The private, nonpartisan council issued the harsh rebuke in a response to new international guidance issued by the Basel, Switzerland-based Financial Stability Board in May. The new guidance updated changes to central clearing involving the over-the-counter derivatives market after the 2008 financial crisis.
In its strongly worded response, the Systemic Risk Council said the guidance is "not fit for purpose as it currently stands" to resolve the problems occurring within clearing houses.
"The world cannot afford to continue with inadequate resolution plans for these vital institutions," said Paul Tucker, chair of the Systemic Risk Council. "The authorities should not risk leaving themselves with a choice between a taxpayer bailout or chaos if recovery plans do not work or threaten to exacerbate a crisis."
The international Financial Stability Board monitors and makes recommendations about the global financial system. The Systemic Risk Council was established in Washington D.C. in 2012 to help implement the Dodd-Frank Act following the 2008 financial crisis.
According to the council, the Financial Stability Board's new guidance does not provide a "clear, internationally agreed solution to the problems of pro-cyclicality and the currently inadequate incentives embedded in plans based on clearing houses’ existing rules."
Tucker said the guidance would leave the world relying on recovery mechanisms that could potentially worsen or trigger another financial crisis. He and the council proposed extinguishing owners’ equity rather than preserving it.
Central-counterparty clearing houses would then issue bonds to owners that could be used to cover losses or recapitalize a failed clearing house. Tucker said the Financial Stability Board's current recovery plan threatens destabilizing, pro-cyclical effects.
He argued that the guidance released in May was too similar in substance to a paper released in November 2018, and that the Financial Stability Board did not approve enough recommendations to address the outstanding issues.
In its response, the council pointed out that the core objective of the guidance is to ensure that "distressed intermediaries and infrastructure-service providers" can be resolved without taxpayer support or exacerbating financial instability. But the council said it was concerned that this objective was not addressed.
It outlined two suggestions moving forward: "In order to incentivize owners to act as systemic risk monitors and managers, owners’ equity should be eliminated upon a [central-counterparty clearing house] entry into resolution, or they should not keep the [clearing house's] profits."
"In order to mitigate pro-cyclicality, resolution regimes and plans should distinguish between 'operational' and 'pure financial' liabilities, with changes made if necessary to clearing houses’ rules."
To make this work, Tucker said the rules of many clearing houses would probably need to change.
"A tragic lesson of 2008 is that what can be foreseen can happen, and what can happen sometimes does happen," Tucker said.
"An unresolvable distressed clearing house, transmitting disorder as it seeks to restore itself, is a foreseeable disaster. Policymakers should address this continuing fault line in the international system."