Global regulators have increased their focus on central counterparty clearinghouses (CCPs), examining how well placed they are to cope with concentrated risk. But stark choices need to be raised about who bears the ultimate risks, according to market participants.
The Committee on Payments and Market Infrastructures and the International Organisation of Securities Commissions (CPMI-Iosco) released a consultative report on August 16, Resilience and recovery of central counterparties (CCPs). The report requests comments on the Principles for financial market infrastructures (PFMI) and offers guidance on aspects of CCPs’ financial risk management framework.
The same day, global regulators also released a progress report on their collective work on enhancing the resilience, recovery planning and resolution of central counterparties. And, again on August 16, the Financial Stability Board (FSB) published a discussion note Essential Aspects of CCP Resolution Planning. That note seeks industry feedback on how clearinghouses might be resolved without bailouts, or without losses that cause systemic risk in the financial system, and builds on the FSB’s 2014 work on resolution regimes.
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"Banks feel initial margin haircutting can’t seriously be on the table" |
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In 2009, the Group of Twenty (G20) committed to ensuring all standardised over-the-counter (OTC) derivatives contracts were cleared through CCPs. That agenda has since been pushed forward with legislative measures globally, including Dodd-Frank in the US and European Market Infrastructure Regulation (Emir) in Europe.
According to John Court, managing director and deputy general counsel at The Clearing House, around 75% of interest rate stops have moved to clearinghouses and standardised credit swaps are also moving to clearinghouses. But the downside is a concentration of risk in CCP market infrastructure and it is this concentration with which regulators are increasingly concerned.
Counsel see the concerns as valid, but also much work ahead. “It’s a legitimate point to make that the use of CCPs is about transferring risk,” said Michael Thomas, partner at Hogan Lovells. “The general issue of CCP resolution isn’t resolved,” he added.
KEY TAKEAWAYS
Global regulators are focusing on the resilience of central counterparty clearinghouses (CCPs);
Around 75% of interest rate stops have moved to clearinghouses and standardised credit swaps are also moving to CCPs;
Regulators are concerned, and want to limit systemic risks following default by a central counterparty member;
Regulators are examining risk management, and CCP recovery plans, as well as considering where future burdens may fall;
Haircutting initial margin, suggested by regulators, is however an industry non-starter.
Tricky questions
Much of what which is coming out of the FSB and CPMI–Iosco is therefore trying to ensure that there are firewalls globally in place to prevent or reduce the likelihood of members being liable for uncovered losses, including requirements to ensure the proper governance of CCPs and their risk management, and robust recovery plans for CCPs.
As a result, this summer’s regulatory activity on CCPs has a clear goal, to limit potential systemic risks arising from any default by a central counterparty member as much as possible.
Were a major CCP to go down, the implication for financial markets, through a ripple effect, would be huge. In fact, according to Thomas, it could be an order of magnitude greater than what would happen if an individual financial institution failed.
“Regulators don’t want to have to get to a position of having to answer the really difficult question –what if they all fail?,” said Thomas.
The concentration of systemic risk in CCPs also creates a dilemma: who should shoulder the burden if a CCP does run into serious trouble?
“There’s a stark choice that needs to be raised about who bears the ultimate risks for CCP survival – the shareholders, the national bank or government or the members?,” Thomas said.
There are already expectations that shareholders have skin-in-the-game, but no regulatory proposals suggest that the owners should be on the hook for everything. In turn, the idea that a national bank be ultimately responsible for CCPs is understandably resisted by governments.
Bailing out a CCP would likely be political suicide, although the state is unlikely to leave the chain entirely. “Is it really conceivable that a major CCP would be allowed to fail, when the impact of a major CCP failure would be so devastating?,” said Thomas.
That leaves the third prong; members’ liability. Significantly, the structure of existing regulation, according to Thomas, implies that members face significant liability. Defining the boundaries of that liability, however, remains contentious.
Haircutting initial margin
One such point of contention is how regulators are considering the haircutting of initial margin, meaning using the margin funds posted by CCP members for the resolution of a CCP in the event of a CCP failing.
Haircutting is not a concept that’s alien to CCPs – many already have recovery or loss allocation arrangements involving the haircutting of variation margin, and in addition, or alternatively, other forms of loss allocation such as cash calls from members.
But applying that approach to initial margin is meeting industry resistance. “Haircutting initial margin is something that I understand would not be very popular,” said Thomas.
According to Court, the notion of bailing in initial margin can’t work. It would cause market participants to rethink how and if they engage in the market.
“Haircutting of initial margin is something we feel strongly about. Everyone in the private sector agrees that this is a total non-starter,” said Court. In other words, it’s an issue that goes to the fundamental economics of swaps and clearing.
“You post initial margin to protect yourself in order that you can go out and replace your trade. If initial margin is used to recapitalise a CCP or is used as a loss allocation tool, it kicks one of the legs out of the stool of engaging in the market,” said Court.
“In short, banks feel initial margin haircutting can’t seriously be on the table,” Court said.
In May, The Clearing House and the International Swaps and Derivatives Association (Isda) issued a white paper designed to inform the FSB’s public consultation on guidance for CCP resolution. Responses to the FSB’s discussion note should be sent to the FSB by October 17.
Comments on the CPMI-IOSCO report Resilience and recovery of central counterparties (CCPs) should be submitted by October 18.
See also
CFTC CCP decision signals harmonization
Webinar: EUUS CCP agreement needs more clarity
Regulators edge closer to CCP resolution plan
