By Huw Jones
LONDON (Reuters) - Clearing houses may need bigger capital cushions as more and more trading in financial derivatives comes their way, the Bank of England said in a paper on Friday.
BoE Governor Mark Carney has said that regulators must make sure that clearing houses don't end up becoming the new breed of "too big to fail" financial firms.
Clearers have a default fund and stand between two sides of a trade, ensuring completion even if one side goes bust.
The BoE paper is likely to be studied closely by the industry for regulatory pointers as many of Europe's clearers, such as LCH.Clearnet (L:LSE), ICE Clear Europe (N:ICE) and CME Clearing Europe (O:CME) operate from London under BoE supervision.
Clearers are set to grow massively as new rules require far more off-exchange financial derivatives transactions to be cleared to improve safety and transparency.
Opaque, uncleared derivatives such as credit default swaps were at the heart of the 2007-09 financial crisis and under tougher new global rules a large clearing house must hold enough capital to deal with its two biggest members going bust, known as the Cover 2 standard.
The BoE paper said this amount of capital is prudent for much of the time but may not be enough for clearers with many members, given the way losses could ripple through several clearing house members in certain circumstances.
"If these are found in practice, higher levels of financial resources may be needed to ensure clearing house robustness," the BoE paper said.
This "weakness" in Cover 2 could be considered if the rule is revised and the BoE paper suggests a "simple backstop" for Cover 2 could be considered, such as demanding that the clearer's default fund should also be bigger than some fixed percentage of the "cover all" capital requirement.
"One basic requirement for calibrating this percentage would be knowledge of the ratio of Cover 2 to cover all, so a reasonable first step would be the disclosure of both measures by all systemically important CCPs," the BoE paper said.
(Editing by Greg Mahlich)