Insurer Consortium Offering Coverage for Derivatives Clearinghouses
A group of insurers is for the first time offering to shoulder risk for clearinghouses backing hundreds of millions of derivatives trades, proposing more protection in markets where a collapse could cripple the global financial system.
About 20 insurers were brought together by GCSA LLC, a New York-based underwriter, who declined to identify them. They are capable of offering $6 billion to $10 billion of protection to clearinghouses such as CME Group Inc. and LCH.Clearnet Group Ltd., GCSA President Chris Cononico said during an interview.
Goldman Sachs Group Inc.’s Lloyd C. Blankfein and regulators such as the Federal Reserve have identified clearinghouses, which collect up-front funding so they can pay off a member’s obligations should one default, as a source of risk in the global financial system. Their importance is increasing following the 2008 crisis, with U.S. rules requiring them to help prevent future disasters by serving as a firewall in the $693 trillion over-the-counter derivatives market.
The insurers’ proposal could ensure clearinghouses don’t become insolvent during another crisis, David Hardy, the chairman of GCSA, said during a phone interview.
“We think there is a place for an insurance product,” Hardy said. Clearinghouses “are a bigger focal point for risk. You’ve got people like Lloyd Blankfein describing them as the new too-big-to-fail,” said Hardy, the former chief executive officer of LCH.Clearnet, the world’s largest clearinghouse for interest-rate swaps. “It’ll be useful for everyone to be looking at all the alternatives.”
Cononico and Hardy will pitch their idea, as they have for the past year, to executives this week at the Futures Industry Association’s annual conference in Boca Raton, Florida.
Clearinghouses rely on their bank members to provide cash and assets to hold on reserve in case of a default. The collateral is aimed at reducing systemic risk. When losing positions arise, clearinghouses demand cash so that risk doesn’t accumulate. They also have what’s called a default fund, where bank members deposit cash and securities to be held in reserve as an additional level of loss protection.
Cononico said that default funds at derivatives clearinghouses around the world now total about $30 billion.
When a bank fails, such as Lehman Brothers Holdings Inc. in September 2008, derivative clearinghouses begin a loss-recovery procedure known as a waterfall.
First, margin from the failed bank is used. The second line of defense comes from default funds contributed by that bank. After that, the clearinghouse uses money that it set aside itself. If losses continue to mount, contributions to the default fund from members that remain solvent are used.
The GSCA insurance would kick in if all those steps weren’t enough to keep losses from snowballing, Cononico said. Clearinghouses would pay for the insurance with their own money, not member funds, Hardy said.
“The issue of what to do at the end of the clearinghouse has been very difficult and divisive, and no one has come up with a solution,” said Craig Pirrong, a finance professor at the University of Houston. “This would be a constructive approach to that problem.”
The insurers are making their proposal at a time when clearinghouses are seeing their role in financial markets expand. In the U.S., the Dodd-Frank Act required most swaps to be cleared starting last year, a decision that affected contracts ranging from interest-rate to credit-default swaps.
Besides CME Group and LCH.Clearnet, the major derivatives clearinghouses around the world are owned by Deutsche Boerse AG, IntercontinentalExchange Group Inc., Options Clearing Corp. and Hong Kong Exchanges & Clearing Ltd. Representatives of the clearinghouses declined to comment.
The GCSA consortium, which is working with broker Lockton Cos., is made up of insurers that aren’t connected to the derivatives market or the banks that serve as members of clearinghouses, Hardy said. That’s meant to lessen the concentration of risk in the event of a bank failing, he said.
“If everything came from the banks, then those issues are all being baked into the infrastructure,” Hardy said.
Neil Nimmo, executive chairman at Lockton, declined to identify the individual insurers in the consortium, citing non- disclosure agreements. He said there are three kinds of companies involved: those active in the Lloyd’s of London market, insurers incorporated in Bermuda, and European reinsurers.
Because the insurance kicks in after all the money deposited by banks in the clearinghouse’s default fund is gone, it won’t reduce what’s known as wrong-way risk, Pirrong said. That’s the potential that losses and stress increase on the bank members as a financial crisis worsens, leaving them less able to make good on their commitments to the clearinghouse.
“The default fund is full of wrong-way risk,” he said. “The losses would hit the default fund at precisely the time the banks are in trouble.”
The insurance group has yet to sign a major clearinghouse up for the protection. It does have an agreement with NOS Clearing ASA, a freight and commodities markets clearinghouse that was acquired by Nasdaq OMX Group Inc. in 2012, Cononico said.
“This insurance product is new,” he said. “A lot of people don’t really understand what we’re offering.”
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