The Financial Stability Board's recent proposals on resolution of central counterparty clearing houses ("CCPs") demonstrate that they will not be too-big-to-fail, and that if they do fail, viable routes are available to ensure systemic risk is properly managed.
The FSB said it is vital that CCPs do not become a new source of too-big-to-fail risk, given their central mandate for clearing certain standardised over-the-counter ("OTC") derivatives, their ability to mitigate and manage counterparty credit, and as such their increasing importance in the financial system.
On 16 August, the FSB began seeking comments on the essential aspects of CCP resolution planning which are considered vital to the development of effective resolution strategies.
These include resolution strategies, timing of entry into resolution, adequacy of financial resources, tools for returning to a matched book and allocating default and non-default losses, application of the 'no creditor worse off' safeguard and treatment of the CCP's equity in resolution, as well as cross-border cooperation and effectiveness of resolution actions.
The FSB also published, on the same day, a separate joint report with the Basel Committee on Banking Supervision, CPMI and IOSCO on a work plan that seeks to enhance the resilience of CCPs, with recommendations for recovery and resolution plan.
Sam Ahmed, managing director of DerivAsia in Singapore, said the fact that FSB, CPMI and IOSCO are looking at CCP resolution in such granular detail shows that global clearing houses have become systemically important as a result of the clearing mandates, but a lot of work remains to be done on the policy and regulation on recovery and resolution.
The CCP Resolution Debate
Tom Jenkins, partner, financial services at KPMG China, said CCP resolution has been an issue of some industry debate with different market participants having different views on what action should be taken under resolution and the amount of losses that clearing members and CCPs would have to bear. Market participants are also concerned about how prescriptive the regulations on resolution will be. He said questions have also been raised about whether regulators should give prescriptive guidelines or whether they should allow more flexibility.
"These two factors have been a topic of some debate because it can impact the allocation of losses between the shareholders of a CCP and the clearing members. Clearing members want to know what the position would be in terms of the losses they have to bear. One view is that the earlier resolution is triggered, the earlier action may be taken which could lead to losses for clearing members," he said.
Jenkins said market participants, first and foremost, want to have clarity on the resolution process. There are also concerns about the types of tools which authorities would use to resolve CCP losses.
Maximise Certainty and Predictability
The International Swaps and Derivatives Association ("ISDA") recently echoed the same view. ISDA said there may be situations where a resolution authority has to intervene before CCP-led recovery efforts are completed, such as when it is felt that the recovery measures set out in the CCP rule book would further increase systemic risk or lead to contagion.
"But if resolution authorities elect to enter a CCP into resolution, we believe it is important to abide by certain conditions to maximise certainty and predictability and maintain market confidence," ISDA said.
ISDA also expressed its concerns about when authorities should intervene. It said that recovery should be led by CCPs as far as possible, but if that is not possible, the indicators for a resolution authority intervention should be defined upfront.
"Clarity over the entry point would, again, help provide certainty about the process," ISDA said.
Tools available for Authorities during Resolution
The FSB has proposed a number of tools available to authorities to resolve a failing CCP. They include re-capitalising the CCP, applying haircuts on initial margin, and reallocating open contracts to other clearing members, particularly if a CCP's failure is caused by the default of a clearing member, amongst others.
One of the concerns of market participants is how the resolution authorities will deal with the existing contracts held by clearing members in the event of a CCP resolution. Ahmed said a CCP at this stage has no position of its own, i.e., there should be a "matched book". This will involve tearing up of contracts, a process whereby all the trades should either be taken up by other clearing members or terminated between the clearing members.
Clearing Members should be Compensated for Losses
Ahmed said it is also unclear whether the government or regulators will take over in the event of the bankruptcy of a CCP.
"The main thing is that clearing members should not have exposure to a CCP that has failed," he said.
ISDA took the position that clearing members should be compensated for any losses incurred through loss-allocation or position-allocation tools, over and above the CCP's funded and unfunded default resources, whether through recovery or resolution.
"This emulates the outcome that would be achieved if clearing participants were to go through an insolvency process," ISDA said.
ISDA recommends Rules and Tools defined in CCP Rule Book
ISDA also recommended that resolution authorities follow the rules and the tools defined in the CCP rule book, in the event that they need to intervene. It has also proposed a recovery framework.
"By following this transparent rule book, a resolution authority would provide comfort to market participants and minimise market disruption, as well as ensure the concept of 'no creditor worse off' – a central element of the ISDA recovery framework – is applied," ISDA said.
Further Guidance maybe Required
The FSB said that although the 2011 key attributes of effective resolution regimes for financial institutions and existing guidance describe a number of tools that are available to authorities, they do not discuss how the tools could be used or combined to develop strategies to resolve CCPs effectively.
"In some areas, further guidance may be required to assist jurisdictions with implementing effective resolution regimes and to assist resolution authorities with developing credible resolution strategies and plans," FSB said.
All Starts with Resilience
Ahmed said it is important that CCPs have strong resilience to begin with so that they are able to absorb all the trades that are cleared through them. Being resilient means that CCPs must have strong margining methodologies and collateral management capability, amongst others, and are backed by sufficient capital buffers that can withstand any shock caused by market events, he said.
CCPs must also be equipped with the relevant tools for the recovery process. Ahmed said a smooth recovery process would require a CCP to have the capability to auction the trades of the defaulting member to other clearing members along with full or partial tear up of trades.
ISDA also emphasised the importance of CCP resilience, saying that ensuring CCPs are strong to begin with will minimise the prospect of a recovery or resolution action.
"That’s why the measures outlined in our paper on CCP resilience – transparency, stress testing, appropriate skin in the game, monitoring of concentration risk and scrutiny of suitability of products for clearing – are vital," ISDA said.