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EU's derivatives proposal carries risks of its own

Proposals that emerged this week to improve regulation of European derivatives markets aim to push more and more financial transactions through central counterparties, or CCPs—clearing houses that act as a buyer in every sale of a financial instrument and a seller for every purchase.

It's a world-wide trend. By standing in the middle of every deal, CCPs are supposed to prevent the "cascade of uncertainty" that followed Lehman Brothers' demise two years ago this week.

That arose because financial institutions couldn't figure out their exposure to the failed firm—they simply didn't know how many of the myriad of pass-the-parcel transactions they were involved in ultimately depended on it.

But pushing CCPs to the center of the derivatives markets has brought to the fore another concern: that they themselves could become a source of risk to the financial system. "CCPs can go bust too," says Richard Portes, economics professor at the London Business School.

One way to address this risk is to ensure that CCPs, like major banks, have direct access to ready cash—liquidity from central banks.

Yet in making its proposals this week, the European Commission, which originally favored making access to central-bank liquidity a prerequisite for CCPs, backed away from the requirement.

An early draft of the proposed EU regulation, viewed by The Wall Street Journal, said CCPs "must have access to central bank liquidity."

The final proposal published this week said CCPs must have access to adequate liquidity, "which could result from access to central bank or to creditworthy and reliable commercial bank liquidity, or a combination of both."

Few people think commercial-bank credit lines are worth much to a problem institution at the center of a financial crisis. Such promises tend to melt away in the panic. For an institution in the center of a storm, the only sure guarantee of liquidity during a crisis is a central bank. So why did the commission change its mind?

According to people who have followed the process, the U.K. pushed strongly for the change over objections from Paris and Berlin, which argued forcefully for the central-bank requirement to remain. (The argument could well resurface as the 27 EU governments and the European Parliament seek to amend the proposals.)

The problem for the U.K. was that the requirement would have threatened the position of London as Europe's CCP hub because the U.K. uses the wrong currency. The Bank of England can provide pounds but not the currencies in which most financial transactions will be denominated: the euro and the dollar.

For liquidity support in those currencies, London-based CCPs would need access to the European Central Bank and the Federal Reserve.

Theoretically, such support could be provided through swap lines via the Bank of England, but why should the ECB stick its neck out to underpin a CCP based outside the euro zone? "London didn't want the central-bank liquidity" requirement, says Mr. Portes.

Central-bank backstops sound like a good idea, but some experts see a downside: They dull incentives for CCPs to engage in state-of-the-art risk management.

CCPs have an excellent record in managing risk going back more than a century, through depression and world wars. Their financial stability has been protected, by bank credit lines, by their own capital and that of their owners, and by the collateral they require from clients, which can be adjusted to reflect the risks the clients are running.

"There are costs and benefits of having access to central bank lending. It can help prevent the CCP from being questioned during a crisis but it can also reduce some of the incentives for CCPs to be at the cutting edge of risk management," said Randall Kroszner, professor of economics at Chicago University's Booth School and a former Fed governor.

Yet pushing CCPs to clear more, riskier and less-liquid financial instruments, as the commission is now demanding, means the chance of accidents increases. Clearing cash transactions that are settled within three days is one thing; dealing with derivatives that may be unwound in months or years is quite another, the experts say.

Risk could be further heightened by another requirement—also contained in the commission's proposals—that aims to improve competition by allowing investors to choose which CCP they use. At present, that choice is largely determined by the trading venue. The change would require CCPs to be interlinked, creating, as the industry calls it, interoperability.

However, connecting every CCP to every other risks recreating among the CCPs the cascade of uncertainty that occurred among banks and securities firms in 2008. As a result, while stating it as a long-term aim, the commission is moving cautiously on interoperability, suggesting the process will be closely monitored by financial supervisors before it is allowed to go ahead.

Interoperability, says Mr. Kroszner, is in principle the right way to go "but it's the practicalities of how this will operate which will determine whether you have reduced risk or increased the potential for systemic problems. If it's not done the right way, you're playing with fire."

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