The alignment of interests between central counterparty clearing houses and market participants, the suitability of recovery tools and determining when a resolution authority should step in are the three main concerns in CCPs' recovery and resolution plans.
At the Asia Securities Industry & Financial Markets Association ("ASIFMA") annual conference held in Singapore last week, Agnes Koh, chief risk officer at the Singapore Exchange ("SGX"), who sat on the panel on CCPs' recovery and resolution plans, said CCPs, tasked with the remit to carry out mandatory clearing, must ensure they are resilient enough to ensure the overall safety and soundness of the financial system.
CCPs, she said, are now in a better place, having implemented the Principles for Financial Market Infrastructures ("PFMI"), worked with regulators over the years to raise risk management standards and introduced improved governance structure and greater transparency.
Alignment of Interests Between CCPs and Market Participants
Given that CCPs function on the basis of mutual benefits and shared risk with their clearing members and users, Koh said this should hold true even when there is a catastrophic event.
"Designing our risk management capability of recovery tools [we] really have to work very closely with the industry as to … how the option process works and how to allocate resources. There were a lot of discussions around skin in the game [as well]," she said.
While regulators have come up with a list of what are considered suitable recovery tools, including variation margin haircutting and initial margin haircutting, not all these tools are suitable for every jurisdiction, Koh said.
Speaking in the context of Singapore, Koh said SGX has no intention of including variation margin haircutting as a recovery tool in its resolution and recovery plan as it was deemed to be in conflict with the motivation behind a CCP's existence.
"If it [variation margin haircutting] has to be [part of the recovery and resolution plan], perhaps it is something which the resolution authority could use as a last resort," she said.
The Financial Stability Board has suggested there should be a point in time when resolution begins, during which the resolution authority would step in. The industry, however, has reflected back to the FSB that a certain degree of flexibility would be required.
"You really don't know, whatever the scenarios may be; there could be different triggers. When does recovery end is hard to tell, and you have to look at what resources are available and what recovery tools have not been deployed," Koh told the audience.
Asian Clearing Houses not Averse to the Presence of a Resolution Authority
According to Koh, Asian clearing houses, in general, are not averse to the presence of a resolution authority during the recovery phase as it provides some measure of oversight to the resolution process. It also has an added advantage for the surviving clearing members.
"In the recovery phase, you also talk about replenishment of funds and that perhaps might give some confidence to the surviving members to be more willing to put in additional margin," she said.
Larry E. Thompson, general counsel at the Depository Trust & Clearing Corporation ("DTCC"), who sat on the same panel, agreed there has to be an understanding among all parties about the need to align the interests of CCPs and the users. They would also need to come to a consensus on their risk management goals.
"If you look at the history of CCPS and in terms of what has happened, there had been developments that have misaligned some of those issues. We need to really think of CCPs in different categories, not one-size-fits-all," he said.
Thompson said at DTCC, which is a user-owned cooperative, the users, who are also the owners and yet at the same time sit on the firm's risk management committee, are the ones who will be involved in its recovery process. The users would also point out if the risk management tools were inappropriate.
"We think there is a right alignment all the way through, in particular to those issues. We think that kind of flexibility on the part of the regulators would be great. We agree that they [regulators] should be involved; they should be sitting down to deal with resolution planning, but on a day-to-day basis, it is really the management that should be running the close-out procedures," he said.
If clearing members were already aware of their risk in CCPs, and that they would have "skin in the game", putting additional skin in the game capital by CCPs may in fact encourage clearing members to leave, Thompson said.
"The more you [CCPs] put into the skin in the game, the more they [clearing members] have to put into the institution," he said.
For-profit clearing houses such as SGX and Hong Kong Exchanges & Clearing Ltd faced a different set of challenges. Koh said SGX, like many clearing houses, has substantial skin in the game in the business, and it has committed more than 25 percent of its own funds to the clearing funds in the cash market and 30 percent in the derivatives market.
"It is almost a demonstration that as an exchange and a clearing house we are in this together," she said.
CCPs, however, have to strike a balance because they wanted to ensure they did not sink all their money into the clearing funds, nor did they want to depend on their clearing members to replenish the funds for their viability, Koh said.
The continued viability concept, she said, is important and determines how SGX structured its 25 percent contribution. SGX has structured it in such a way that it put the first 15 percent in the first layer of the clearing funds with contributions from all the non-defaulting members. It then put another 10 percent into the clearing funds.
"It's not about [putting in] the entire 25 percent in the first layer. That potentially could not incentivise the members in the way they conduct the auction and take in the bids because you could possibly run out of all that 25 percent in the first layer and the clearing system [may] possibly [be] a lot … worse off than if you had put it in a more appropriate manner. … If it [the clearing fund] is insufficient, we are still there to hold the ball. I am giving a demonstration of how we align the interests of all participants," she said.
Close-out procedures also need attention, Thompson said. DTCC, which runs a cash equity CCP, does not have an auction process. There is a liquid market whereby all the securities on exchanges are assets in the retail or bond market.
"It's a very different close-out procedure when you don't have an auction process versus the close-out procedures. We don't have an exposure at T+3 at the moment. Hopefully by 5 September 2017 it will be T+2. In the fixed-income market, it is T+1 exposure at this particular point in time. [There are] very different exposures and very different way[s] of looking at what exposures you are going to run," he said.
Another panelist, Jenny Cosco, co-head of government affairs, Asia-Pacific at Goldman Sachs, said a distinction needs to be made between flexibility of the resolution authority to deviate from CCP rulebook and the flexibility of the CCP to leave its recovery and resolution process. The privacy of the rulebook is paramount from the clearing members' perspective, she said.
Understanding and having certainty and transparency about the recovery and resolution processes is extremely important for clearing members to risk-manage their positions, Cosco said. The challenge, however, lies in being unable to prescribe what is considered appropriate tools for different scenarios. She said clearing members were concerned a resolution authority may deviate from the rulebook when it steps in.
"There should always be room when you talk about loss allocation or within the default waterfall … It is really important to have a CCP-led recovery in consultation with [the] risk committee of the clearing members," she said.
Incentives, Skin in the Game
Incentives, according to Cosco, should be at the heart of the design of the recovery and resolution plan when dealing with default losses. Clearing members, which have skin in the game through their contributions to the default funds of CCPs, have an incentive to ensure that CCPs redevelop their match book and that they are sustainable.
Cosco said the PFMI principles should be at the heart of the design of a recovery and resolution plan; it needs to be comprehensive and it should incentivise clearing members to participate in the auction process and to return the CCP to viability. Variation margin gains haircutting was not the most optimal solution however, she said.
"In fact, no one can suggest that as an optimal solution when you go into loss allocation. I would also say when it gets to resolution, and you look at other provisions around compensation and so on, again, if clearing members do not understand the risk they are exposed to, they may be incentivised to protect their own positions instead of going to help the CCP, so regulators are designing those resolution [principles] to take that into account," she said.