Banks must bear the risk of derivatives losses: CME paper

[NEW YORK] CME Group Inc, the world's largest derivatives market, wants its bank members to bear responsibility for ensuring there is enough cash on hand in the case of a default.

The debate over how clearinghouses are managed and the level of resources available has gone back and forth between the Chicago-based exchange owner and its largest bank members such as JPMorgan Chase & Co.

CME said in a white paper published today it has set aside the equivalent of 5.25 per cent of the money its bank members have put into a collective default fund. In September, JPMorgan said CME's contribution, referred to as skin in the game, should equal 10 per cent.

Clearinghouses such as CME's serve as an antidote to panic in derivatives markets, holding money that can fulfill a failed trading firm's obligations.

Although most of the funds they hold are in the form of margin that backs trades, they also pledge some of their own money.

The importance of ensuring they are adequately funded was emphasized in the 2008 financial crisis, the intensity of which was blamed in part on a lack of clearinghouses in the over-the-counter derivatives market.

A clearinghouse's "most important contribution to managing systemic risk is the management of concentration risk among their largest participants," CME said in the paper.

"CME Clearing believes that skin in the game requirements must be developed on principles that incentivize market participants to manage the risks they create."

In November, Federal Reserve Governor Jerome Powell called for more coordinated global regulation of derivatives clearinghouses to increase their liquidity, transparency and ability to withstand shocks without government bailouts.

"Given the increasingly prominent role that central clearing will play in the financial system going forward, it is critical that we collectively get central clearing right," Mr Powell said in Nov 6 speech in Chicago.

CME has US$375 million of its own money ready to use if a clearing member defaults, an amount it says is equal to 5.25 per cent of the total default fund contributions made by its bank members.

Clearinghouses are backed by their members such as JPMorgan, Deutsche Bank AG and other global banks. The firms deposit initial margin and cash and securities to the default fund to provide a cushion against losses if they go bankrupt. Clearinghouses value positions on a daily basis and demand money from losing bets so that risk doesn't intensify.

The financial health and risk-management practices of clearinghouses are more important than ever as U.S. law requires most swaps to be backed by the services. Europe is following suit with rules to clear most swaps.

The unregulated swaps market contributed to the 2008 financial crisis and worsened its aftermath in large part because the trades were done between private parties where unfunded risk was allowed to build. For example, in 2008 American International Group Inc had to be rescued by the US government with more than US$180 billion after its swaps business blew up.

BLOOMBERG