The threat that central counterparties’ financial stability poses is not being treated with appropriate concern, according to the head of the Systemic Risk Council (SRC), an independent regulatory advisory organization.
“At the moment there is, as far as the SRC can tell, no plan for what would happen if recovery fails other than a government bail-out, or one of these things going into liquidation,” says Sir Paul Tucker, former deputy governor for the Bank of England, and current chair of the organization. “One is absolutely toxic politically, and the other is toxic economically, and therefore politically. That is not a sensible choice for countries to make, and is what the post-crisis reform programme was meant to address.”
“All I know is that if one of these CCPs fails, and the recovery plan fails and there is no resolution plan, it will be an absolute calamity in global markets. The sad truth is that what can happen, eventually will happen, and the single most important lesson of the crisis of 2007/08 is that it is just absolutely vital to prepare,” he says.
However, Rafael Plata, secretary general of the European Association of CCP Clearing Houses, says European regulators’ have made progress.
“The Esma stress test of CCPs is very positive. It is the authorities’ job to look in detail at the ongoing activities of a CCP to make sure there is no systemic concern whatsoever. While Esma acknowledges some limitations of the report, it is more than a good indication of the stability of the European system of CCPs,” says Plata.
On April 3, the European Securities and Markets Authority (Esma) published its framework on the third EU-wide CCP stress test exercises. The exercise is “to assess the resilience and safety of European CPPs to adverse market developments and to identify and potential shortcomings,” according to Esma.
In 2018, the results from Esma’s second CCP stress test were published.
In the report Esma said that “to a significant extent, the results rely on the data provided by CCPs and on a set of validation checks performed by the individual National Competent Authorities (NCAs). Especially when it comes to the liquidity stress scenarios, the exercise tests and assumptions were tested for the first time leading to some residual uncertainties.”
On March 18, the SRC published a response to the Financial Stability Boards (FSB) consultation on financial resources to support CCP resolution and the treatment of CP equity in resolution.
“First of all, I think the Systemic Risk Council’s intervention on the question of CCP resolution planning is important,” says Tucker. “I would say that of course, but I think that there is a risk that resolution isn’t been given nearly enough priority. We haven’t really minced words on that.
“There are, for example, things that the authorities can do when exercising resolution powers that clearing houses themselves can’t do when executing recovery plans, such as suspending contracts for 24 hours, or whatever, to provide a window,” he says.
For Plata, some of the recommendations suggested in the SRC letter are old, and feature misconceptions about CCPs’ risk management.
“It was interesting to read the Systemic Risk Council’s response,” says Plata. “In general, I get the feeling that some of the ideas were discussed and discarded by authorities and industry four or five years ago, and the discussions have evolved quite a lot since.
“There seem to be certain misconceptions about CCPs in that response. For example, one of the ideas that they included was that CCPs could be similar to security dealers. Well one of the basic conceptions of CCPs, is that they are not banks. They do not take risks, banks do. CCPs are risk managers, not risk takers,” he says.
In December 2016, Kay Swinburne MEP and now vice chair of the European Parliament’s committee on economic affairs, was put in charge of leading a team to create the legislative file on the framework for the recovery and resolution of CCPs.
Swinburne expressed her concern at a vote on March 27 by the European Parliament – which passed with 49 in favor – on the issue of resolution and recovery, that “the interinstitutional negotiations envisaged by this House nearly a year ago have not even begun.”
“It is of great concern that the Council have decided not to prioritize this technical file, which is essential for the future financial stability of the EU financial market infrastructure,” she said. “This regulation was designed to address the risk of concentration in EU central counterparties and put in place the safeguards needed to deal with the most extreme scenarios in ensuring the recovery and/or the resolution of central counterparties”.
For Tucker, those who oppose this EU proposal, and the need for greater CCP recovery planning more generally should be held to account when things go wrong.
“Some people say some regulators believe recovery planning can always suffice. We say in the letter that regulators who take that position should in some way be held liable if we end up with only recovery planning, but then it doesn’t work. For example, pay them entirely in locked-in CCP equity or bonds that write down to zero if a clearing house has to go into liquidation. That’s just one possible way of incentivizing people to reveal what they truly believe, but the SRC’s collective position is that it is no light thing for regulators to say that recovery can always suffice,” says Tucker.
“If the people that complain about the EU proposal were prepared to put all of their wealth into these CCPs themselves, so that they would be ruined if one of the clearing houses failed, then I would place more weight on their view. If there are people that take this view but if a CCP failed there would be no personal cost to them, well I don’t know what to make of that. The social costs of these things failing are so much greater than the private costs of them failing,” he says.
At the Eurofi Financial Forum on April 4, the US Commodity Futures Trading Commission (CFTC) chairman Chris Giancarlo spoke about anxiety in the US regarding the European Market Infrastructure Regulation (Emir) 2.2 – the European regulation which will increase supervision of both domestic and third country CCPs.
Giancarlo said concern stemmed from the European Commission being unwilling to acknowledge “any commitment to the 2016 agreement between the CFTC and the EC on CCPs.”
“Does Europe have the right to decide how it wishes to supervise CCPs? Yes. Does Europe have the right to consider how third country CCPs may pose a systemic risk to Europe? Certainly, it does. But should Europe do so without regard to past commitments to the CFTC? Not if it is serious about maintaining trust and recognizing the importance of regulatory and supervisory cooperation with the US,” said Giancarlo.
For Tucker, lessons still need to be learned from the past.
“Three clearing houses have failed since the Second World War. The one in Hong Kong, during the 1987 crash, was an absolute mess. When the clearing house failed, the Futures Exchange had to close, and because the Futures Exchange closed, the Stock Exchange had to close. It may be 30 years ago, but the whole of Hong Kong’s capital markets were closed – not their banking markets, but their capital markets. Imagine that happening in a really big jurisdiction today,” says Tucker.
“Why are CCPs now so big? This isn’t just a market thing, it is because G20 leaders, advised by central bankers and regulators, said that standardized derivatives must go through CCPs, and that is a matter of law in the United States, in the EU, and in parts of Asia. What’s more, core repo markets are centrally cleared, and some equity markets.
“CCPs are too important to fail by design – it’s not like the banks which became too big to fail by accident. What that means is that there need to be both effective recovery plans and credible resolution plans for if and when they do fail. Otherwise, if ever one does fail in a disorderly way and are bailed out by governments on behalf of taxpayers, the question will be why were they allowed to be for-profit private sector entities?” he says.