Eurex warns explicit CCP recovery plans could be “very dangerous”
It could be dangerous to require a central counterparty (CCP) to set out in advance the steps it would take to recover from a severe loss, Eurex has warned – a stance at odds with emerging international policy – because the recovery plans may not work in all conditions.
The issue was raised at the end of last month by the Bank of England (BoE), in a paper on loss allocation at a damaged CCP. It notes that clearing houses have the ability to write into their rulebook the steps they would take when the rest of the waterfall of resources has been wiped out and lays out the advantages of doing so. The paper also offers some suggestions as to what those steps might be – forcing members to replenish a default fund, cutting the amount of initial or variation margin owed to some members, or even terminating open contracts.
But Thomas Laux, head of risk management at Eurex Clearing, argues a prescriptive approach might leave the CCP with the wrong tools for the situation.
“Flexibility is absolutely vital for CCP recovery. It might be very dangerous to have fixed loss-allocation rules defined upfront that may increase systemic risk. An idiosyncratic CCP failure brought about by fraud or a legal challenge is completely different to one brought about by the meltdown of an asset class or the entire market. In the latter scenario, haircutting margin or cancelling contracts may make participating firms even weaker and make the crisis worse,” he says.
The BoE paper stops short of calling for CCPs to make their end-of-waterfall procedure explicit, but it notes that international principles for financial market infrastructures (FMIs) do just that. Published last year by the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions, principle four of the 182-page document deals with credit risk and, within that, consideration seven states that “an FMI should establish explicit rules and procedures that address fully any credit losses it may face as a result of any individual or combined default among its participants with respect to any of their obligations to the FMI”. It goes on to add that these rules should cover “the FMI’s process to replenish any financial resources that the FMI may employ during a stress event, so that the FMI can continue to operate in a safe and sound manner.”
Other CCPs see this as a sound move. “We believe it is good practice to make member banks fully aware of the processes involved in any loss allocation scenario,” says Paul Swann, London-based president of Ice Clear Europe. “We are currently developing a pre-defined set of loss allocation rules that would achieve recovery for Ice Clear Europe and Ice Clear Credit, our credit clearing services in Europe and North America. This is being done in conjunction with member banks and the regulatory authorities, and includes variation margin haircutting alongside other measures.”
Member firms themselves are eager to see some clarity over loss allocation, and there is frustration about the fact that regulatory policy is not yet complete.
“The delay around CCP resolution is unfortunate, given the systemic risk they arguably now pose. The decision to go for mandatory clearing of over-the-counter trades was made in 2009, but four years later the market and regulators are still unsure how to deal with the failure of a CCP,” says John Wilson, global head of OTC clearing at Newedge.
According to Paul Tucker, deputy governor of the Bank of England, CCP resolution is close to the top of the regulatory priority list. “I hope that the Financial Stability Board will before long be able to release an annex to the key attributes for bank resolution regimes articulating how they should be applied to financial market infrastructures – including, most particularly, CCPs. After the European Union’s bank resolution legislation is finalised in the summer, the European Commission is, I believe, planning to table a directive later this year or early next on the resolution of non-bank financial institutions – again, the emphasis is likely to be on CCPs.”
A longer feature on CCP recovery and resolution will appear in the next issue of Risk and will be available online next week.
This article was first published on Risk