It is neither “logical” or “appropriate” for central counterparty clearing house (CCP) participants to call for greater capital requirements for CCPs, says Roger Storm, head of regulation, risk, and committees at Swiss clearing house SIX.
“Many people think of CCPs as a form of bank and would like to apply Basel III banking requirements for such areas as capital requirements. However, this is not logical and not appropriate since the CCP doesn’t actively seek to take on risk but to independently assess and manage the risks that the banks bring to the system,” says Storm.
Discussions at the Financial Stability Board (FSB) between CCP owners, participants, and authorities are currently ongoing regarding the use of variation margin gains haircutting, resources and responsibility for non-default losses, and the boundary between CCP recovery and resolution.
In November last year the FSB published its discussion paper on CCP resilience, recovery, and resolution. The paper outlined hypothetical default and non-default loss resolution scenarios which are likely to be beyond extreme market conditions for which a CCP should hold sufficient financial resources. For example, if two or more of a CCP’s largest participants were to default.
The International Swaps and Derivatives Association (Isda), the Institute of International Finance (IIF), and the Futures Industry Association (FIA) collectively published a response to the discussion paper. The collective response was clear to state from the beginning that it did “not reflect the view of many CCPs, and many of the CCPs are in disagreement with the views.”
For Ulrich Karel, head of clearing services at Isda, unless you are sitting within a CCP you don’t really have the visibility to see how likely these extreme scenarios are, and while they may seem unlikely, they could potentially produce a large loss.
“If you look at cyber-attacks for instance or internal fraud, which is pretty similar and might actually be linked, you could imagine that someone somehow manages to hack into a CCP and they wire away all the cash that a CCP has,” says Karel.
“If someone managed to wire that off to some jurisdiction where you can’t get it back, then it would be an immensely high loss. CCPs obviously argue that it wouldn’t be that likely, that there are reconciliations involved that would pick this up very quickly.”
At an industry event in Chicago last week, Dietrich Domanski, secretary general at the FSB said that significant work had been devoted to CCP resilience, recovery and resolvability but that work still remained to be done on policy development, implementation, and evaluation.
“Crisis management groups (CMGs) are a key component in ensuring appropriate resolution arrangements are in place, given the cross-border activities of many CCPs. Authorities have begun to establish CMGs for CCPs that have been identified as systemically important in more than one jurisdiction,” said Domanski.
“CMGs and institution-specific cooperation agreements that underpin their operation are not yet in place for all such CCPs and resolution planning for CCPs is still at an early stage.
“These are topics where – fortunately – we do not have much recent experience to drawn on. On the one hand this is a measure of success of CCPs. But on the other, the events at Nasdaq Clearing last September remind us that stress events can have unexpected outcomes and there is no room from complacency,” he said.
Domanski was referring to an event last September when one trader in the power market defaulted resulting in a €114m loss in Nasdaq’s contingency funds, and impacting the capital contribution of the CCP’s other 166 members.
An International Monetary Fund (IMF) working paper published in March last year concluded that current resolution policies were insufficient “to avoid the costs of resolution being borne by taxpayers, and propose alternative policy suggestions for addressing the problem of a failed CCP.”
The paper went on to state that “the combination of mandatory clearing and concentration of counterparty risk into a central infrastructure increases the risk of failure of the infrastructure itself. This issue arises for the largest CCPs, which clear OTC derivative products in accordance with the new mandates.”
For George Gilbert, assistant general counsel for capital markets at ICI Global, a regulated funds association, questions around the distinction between CCP recovery and resolution remain the key issue.
“I think that is actually a really critical issue that has not received nearly enough attention, and the reason for that is once you have a CCP get into some sort of financial distress there will be efforts made to recover that CCP. That recovery process will be done by the CCPs managers and the other stakeholders,” says Gilbert.
“This is something that hasn’t received a lot of attention, and I don’t know why because the standard isn’t very clear,” he says.
“Complex debates” continue between CCP owners and market participants regarding where responsibility for non-default related losses (NDLs) lies, said Dietrich Domanski at the industry event.
For ICI Global’s Gilbert, it is the “immediate stakeholders” of a CCP that should take on the monetary responsibility for NDLs.
“We and other market participants have said at a minimum to the regulatory community, whatever you do, you need to make sure that a CCP and its immediate stakeholders - we are talking about the managers, the shareholders - that those are the groups that are responsible for non-default losses,” says Gilbert.
“It’s a market confidence issue. If the market knows there is a plan to wind-down a failed CCP, and believes that the resolution authorities would respect that plan, that is likely to promote confidence during what would otherwise be a very uncertain time,” says Gilbert.
In a response to the FSB discussion paper, the European Association of CCP Clearing Houses (Each) said that in the case of NDLs loss allocation “should be proportional to the level of responsibility and /or benefits extracted from a service of each stakeholder, including CCP owner or CCP user.”
Concluding that the association strongly welcomed the principle “which refers to losses potentially being borne by the CCP’s clearing members.”