The banking sector isn't the scariest part of the financial system anymore

A danger signAP ImagesThe most dangerous data breaches in history were caused by hackers and human error.

The regulator is sounding the alarm on the $600 trillion derivatives industry, warning that it has the highest concentration of risk and the least ability to manage it.

Global regulators published a report into the stability of 10 central derivatives counterparties and clearinghouses on Wednesday. The results are slightly terrifying.

Some central counterparties — we don’t know who, they’re not named in the report — have no guidebook to follow if they get into financial trouble. And regulators are worried. If these were banks, they would risk losing their banking licence.

Some context: a derivative is an agreement between two parties to pay each other money depending on the performance of some other underlying asset, such as gold or shares in Apple.

The total value of these contracts in the world is more than $600 trillion, according to the Bank for International Settlements.

Central counterparties and clearinghouses act as a third party in trillions of dollars worth of derivatives transactions, assuming the risks and sharing the losses if one of its members defaults. An example of a central counterparty in the UK would be LCH Clearnet, which is run by the London Stock Exchange.

Without a central counterparty, you could get a chain reaction of defaults. If bank A can’t pay the money it owes on a losing derivative trade with bank B, that might stop bank B from paying the money it owes to bank C, and so on.

A central counterparty’s job is to guarantee the trade, stepping in if one party can’t pay the other and funding the trade itself from contributions from its members. This turns a chain of deals into a web, which can support itself even if the weakest link goes down.

It should make the system safer.

But here’s the most damning sentence in Wednesday’s report, which was carried out by CPMI and IOSCO, the two regulatory bodies that make global rules for markets (emphasis ours):

“Some CCPs have not yet put in place sufficient policies and procedures to ensure that they maintain the required level of financial resources on an ongoing basis, including adequate arrangements to ensure a prompt return to the target level of coverage in the event of a breach; and some do not include sufficient liquidity-specific scenarios in their liquidity stress tests

“Again, for such CCPs, these are serious issues of concern that should be addressed with the highest priority.”

Even the International Swaps and Derivatives Association, the derivatives industry group thinks this is a problem. “They are absolutely right to focus on this issue,” ISDA said in an email.

“Several clearing houses have become systemically important as a result of global clearing mandates, and it’s vital this infrastructure is as secure as possible — which means establishing a credible and robust recovery and resolution framework,” ISDA said.

Central counterparties are a good idea and it makes sense to use them.

The fall of Lehman Brothers in 2008 left a mess of bilateral derivatives deals. The data was so sparse that it often wasn’t clear who had traded what derivative with who or who owed money to whom. Global regulators reacted with rules designed to force more trades through central counterparties. It worked, and they swelled in size.

The problem is that the policy to move trades onto central counterparties was implemented before the rules could be written to make sure institutions themselves were safe. That’s like forcing more traffic down a road before you paint the road markings and put up the speed signs. The debate is still raging, eight years after the 2008 financial crisis, how to properly address this issue.

Central counterparties keep records of trades and help suck risk out of the banking system, but this only works if they themselves are well capitalised and have plans in place to deal with a sudden collapse of one of its members or get close to failure.

Otherwise, they’re just unexploded nuclear bombs nestling deep in the financial system.

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