WASHINGTON -(Dow Jones)- Critics are concerned the financial regulation bill that cleared Congress last week could leave taxpayers on the hook for the failure of another kind of institution: a derivatives clearinghouse.
A provision in the legislation allows clearinghouses that may pose risks to the broader marketplace to access some of the Federal Reserve's loans, including the discount window. The measure would let clearinghouses overseen by federal market regulators, such as the Options Clearing Corp. and CME Group Inc.'s (CME) clearing venture, potentially tap discount window funds without registering as bank holding companies or being primarily regulated by the Fed.
"This is the classic moral hazard dilemma," said former Minneapolis Federal Reserve Bank President Gary Stern. "My preference would be not to cover them explicitly," he added. "I think you'll get better private sector preparation."
Until now clearinghouses haven't had direct access to the Fed's discount window, which is used by banks to meet unexpected cash shortfalls. When OCC and CME ran into trouble and couldn't meet margin calls during the 1987 stock market crash, the Federal Reserve didn't provide them with direct assistance. Instead, Wall Street banks directly tapped the discount window and then in turn helped the clearinghouses meet their financial obligations.
Clearinghouses stand in between two parties to guarantee trades and protect against potential default. The financial bill will be a boon for their business by requiring swap dealers including Wall Street banks and major traders to submit their routine over-the-counter derivatives for clearing.
The discount window provision is a major win for U.S. clearinghouses, several of which fought for it out of concern that they may need an emergency backstop because the bill requires them to take on considerably more risks.
Clearing industry executives say they don't plan to regularly tap the discount window, but that they should have the option. They envision using it in a situation where they might face a short-term cash crunch.
"Some commentators have mistakenly characterized this provision as a potential bailout provision. We disagree," OCC Chief Executive Wayne Luthringshausen wrote in a letter last month to lawmakers. "OCC expects the Fed to limit access to the discount window to situations where systemically important financial market utilities require an emergency source of short-term liquidity."
But critics say extending a lifeline to clearinghouses could lead to less stringent risk management and send a message that the government will intervene in a time of crisis.
"The Fed can provide a lender of last resort-type of function that could be valuable and prevent a market crisis," said Craig Pirrong, a professor of finance at the University of Houston. The problem, he added, is that during the financial crisis it has been "pretty hard to distinguish many times between the Fed acting as a lender of last resort to provide liquidity...and the Fed acting as somebody bailing out insolvent institutions."
Randall Kroszner, a Federal Reserve governor between 2006 through 2009, said he's reserving judgment until regulators implement the legislation. But he acknowledged critics have a valid fear.
"I think the supervisors need to be laser-focused on exactly this issue because the centrally cleared platforms are now going to have an even more important role than they have had in the past," Kroszner said.
Copyright 2009 Dow Jones Newswires
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