Clearing houses may need stronger buffers to avoid being too big to fail

* G20 watchdog guards flexibility on closing clearers

* Watchdog raises prospect of dipping into initial margins

* FSB wants new guidance package in place in 2017

By Huw Jones

LONDON, Aug 16 (Reuters) - Clearing houses may need bigger cash buffers to shield taxpayers from bailing them out, global regulators said on Tuesday in proposals aimed at stopping the sector from becoming a new breed of "too big to fail" firms.

Clearing houses like LCH.Clearnet and Eurex Clearing stand between two sides of a derivatives trade to ensure its completion even if one side goes bust. They handle transactions like interest rate and credit default swaps worth trillions of dollars.

After opaque derivatives trades contributed to the 2007-09 financial crisis, the Group of 20 economies (G20) decided that most swaps must be cleared to increase safety and transparency, meaning clearing houses will swell in size.

On Tuesday the Financial Stability Board (FSB), which coordinates regulation for the G20, published draft guidance it wants in place by the end of next year.

It reinforces the board's rules on how destabilised clearing houses, also known as central counterparties or CCPs, can recover, or be "resolved" or shut down without sending the financial system into meltdown or requiring taxpayer cash.

Regulators believe separate reforms since the crisis are stopping big banks from being "too big to fail", but worry that clearers could end up holding taxpayers to ransom in a crisis.

"With CCPs being an increasingly important part of the financial system... it is vital that CCPs do not themselves become a new source of too-big-to-fail risk," the FSB said.

Clearers must already show they have enough funds set aside so they could cope if their two biggest customers collapsed and weren't able to complete their trades, but the FSB is questioning whether this is enough.

The buffers that clearers have in place are a "minimum", and more may be needed to ensure adequate risk management on a day-to-day basis, let alone for coping with a collapse, the regulators said in the documents put out to public consultation.

Building up the buffers would mean the clearing house raising capital itself or forcing its members to have bigger default funds of their own.

The FSB rebuffed calls from the derivatives industry to be specific on when regulators would intervene to close down a clearer if recovery efforts were not working.

"Authorities could set out boundaries before which resolution would not be triggered, and after which resolution would most likely be triggered," the FSB said.

Regulators still need flexibility on when to pull the trigger on resolution, it added.

Scott O'Malia, chief executive of the International Swaps and Derivatives Association, an industry lobby, had called on Monday for regulators to "abide by certain conditions to maximize certainty and predictability and maintain market confidence".

Separately, LCH.Clearnet said regulators should focus on ensuring continuity of service.

The FSB also asks whether "initial margin haircutting" should be part of any whip-round for plugging losses at a collapsed CCP - a sensitive issue.

Initial margins are cash and securities that users have posted at the clearer to back trades.

The United States has banned dipping into this pot for plugging losses at a collapsed clearing house, but some industry and European Union officials want to include it among the "tools" for dealing with failed clearers.

Asset managers and insurers had lobbied to stop the inclusion of variation margins - a separate margin posted to cover day-to-day shifts in contract values - as it would hit them hardest given they have long positions that are hard to get out of quickly.

The FSB draft guidance does not mention haircutting of variation margin as a source of cash for plugging losses. (Reporting by Huw Jones; Editing by Susan Fenton)