The Bank for International Settlements is considering new guidance for clearing houses and their members about how the industry should deal with management of default scenarios, after a survey of more than 30 CCPs found mismatched procedures across the industry.
Under the CPMI-IOSCO Principles for Financial Market Infrastructures (PFMI), CCPs must plan for the simultaneous default of up to two clearing members, and have sufficient resources to cover losses and reallocate trades to remaining members. If those efforts are insufficient, emergency resolution plans must be implemented.
“Standard setters have assessed CCPs loss-absorption plans and have considered whether there is a need for further guidance in particular areas,” said Klaus Loeber, head of secretariat at the BIS’s Committee on Payments and Market Infrastructures (CPMI), in a panel discussion at the ISDA’s AGM in Tokyo. “Where there have been differences of application and interpretation of the CPMI framework further guidance may be required.”
Market participants should expect a series of consultations over the coming months, covering topics including governance of stress testing, stakeholder involvement, margin requirements, wrong-way risk, cyclicality, back testing, liquidity costs and treatment of excess capital, Loeber said.
“This is a non-exhaustive list, but it’s clear there are many areas that need to be addressed,” he said. “There will be a string of public consultations coming up in the middle of this year with final guidance expected early next year.”
In addition, there may be a need for additional “encouragement” for national jurisdictions to develop resolution plans, Loeber said.
A July 2015 survey showed that resolution frameworks for CCPs are not well developed and systematic cross-border resolution planning processes are not in place for any of the largest CCPs.
In respect of recovery, the key CCP tool is a waterfall arrangement that starts with initial margin of the defaulting clearing member and is followed by guarantee fund contributions of that member, equity funds provided by the CCP and guarantee fund contributions provided by surviving clearing members.
Depending on the CCP, additional losses may be allocated through recovery tools such as cash calls on clearing members and variation margin haircutting.
Mechanisms for liquidating the positions of the defaulter and re-establishing a matched book include voluntary auctions and juniorisation of contributions of mutualised resources, as well as forced allocation of contracts, and partial or full tear-ups.
However, for market participants the lack of standardisation across the industry is a challenge.
“If a member defaults and the derivative is listed on an exchange then the CCP can easily close it out, but for over-the-counter products default management requires member involvement,” said Rogier van Kempen, an executive director at JP Morgan. “CCPs have many different ways to structure the auction, and to incentivise members to bid appropriately, so if you are a member of 25–30 CCPs that is a challenge.”
Another concern was the potential for risk concentrations at CCPs, particularly in the Asian region, where the relatively small number of operators elevate the possibility of systemic effects.
“We should pay special attention to over the counter markets because of concerns over risk concentration,” said Shunsuke Shirakawa, deputy commissioner for international affairs at Japan’s Financial Services Agency. “Authorities may wish to consider that clearing members should contribute more to CCPs, which could provide further incentives to clear.”
Debate
The balance between clearing member and CCP responsibilities prompted a lively debate, with bank representatives emphasising that the burden should not fall entirely on clearing house members.
“If we get to the point where the clearing house needs to call on members [beyond the margin and default fund] it means that the CCP framework has failed,” said Van Kempen. “For the CCP to rely on [clearing member contributions] where there is stress may not be a good idea because it exaggerates pro-cyclicality.”
In addition, if smaller members cannot pay it will fall on larger banks to make that contribution, Van Kempen said.
“I understand CCPs should have this tool but we think it should be limited as much as possible.”
Martin Pluves, CEO of LCH.Clearnet responded that “assessment” of clearing members should be seen as an extreme tail event, and that margin models were designed to make sure that point is not reached. However, he said, CCPs are not in a position to meet those kind of liabilities.
“I think the losses we are allocating here are not CCP losses,” he said. “The role of the CCP is to administrate mutualised risk management and the losses should find a home back in the markets.”