Nick Nicholls Business Consulting Lead, GFT
On 28 November 2016, The European Commission (EC) announced a proposal for new rulesthat will reduce the risk of Central Clearing Counterparties (CCPs) suffering systemic failure.
CCPs and authorities will now be required to prepare for potential future problems by drawing up recovery plans that include measures to overcome any form of financial distress. There has been much debate and commentary in recent years on the concentration of risk in CCPs and the need for regulation that will ensure recovery and resolution of these systemically important institutions.
The EC’s position is clear. Having mandated approximately 75% of the outstanding $544tln OTC derivatives into clearing through Dodd Frank and EMIR, the EC is taking what it believes are appropriate steps by introducing a recovery and resolution regime that will ensure that no European Tax payer is burdened with risks, should a CCP collapse.
The move towards regulation follows the Financial Stability Board’s (FSB) published discussion note, entitled ‘Essential aspects of CCP Resolution and planning’. The publication highlights general market concerns that there is now a concentration of market risks. Prior to this, the US Securities and Exchange Commission’s (SEC) approved in September 2016 rules requiring clearing houses that guarantee trades in securities and derivatives to maintain a capital buffer of adequate size to meet their obligations in the case of failure.
ElkeKönig, Chair of both the FSB Resolution Steering Group and the European Single Resolution Board said of the proposals:
“CCPs form a central part of the post-crisis reforms of OTC derivatives markets to help reduce risk in the financial system. But we must also ensure that CCPs are themselves robust and this includes appropriate resolution regimes.”
The CCPs position is that regulators should concentrate on operational risks within the framework and avoid dis-incentivising clearing members by imposition of additional margin requirements and a responsibility that any exposure at the point of failure is shared amongst the failing institutions’ members; thereby potentially requiring more capital to account for potential losses – feeding directly into their recovery and resolution calculations.
There are a number of points to be aware of within the proposed regulation:
Confidentiality: Margin calculation may benefit from a harmonised/transparent approach, but at the same time could provide arbitrage opportunity should these be publicly known. Within the documents there is provision for confidentiality – how that is balanced with the need for a transparent plan – even if only amongst the competent, resolution authorities – remains to be seen.
Sale of risk and positions to clearing members: Despite the ECs assuredness that proposed regulation is unlikely to impact clearing member banks, we see a potential for risk and positions apportioned to clearing members. As they take on positions, or enforced ‘tear-up’ of outstanding transactions, they may have to accept a greater capital provision for losses and additional impact their own ‘living wills’.
Determination of losses: Containing losses and controlling what non-defaulting clearing members are willing to pay for those losses will be a difficult within a resolution plan, but may play into the hands of the authorities and add stability as CCP members usual ‘write-down’ of positions to a below ‘normal’ market level could be tempered by those members knowing that they will be expected to take on the CCPs assets.
Harmonisation of approach: Given the track record of authorities and their inability to act in a co-ordinated fashion, the differences in risk management practices at each CCP and their organisational structure, a consistent approach to CCP living wills may be challenging. Brexit and the newly elected US (a significant ‘third nation’) authorities may also create a division in terms of approach.
Operational or extended systemic risk: The document recognises global implications due to interconnectedness of European CCPs and GSIBs. There’s an implied but not specific impact on third country CCPs. The extent to which this is addressed would benefit from some clarity.There is also the exposure that the (I)CSDs have to the CCPs, but no real mention of CCPs exposure to CSDs.
The new proposals have been made to address the unlikely event of a CCP collapsing. Despite this, it remains prudent to ensure that such an event is covered and any systemic failure is prevented. The way in which the resolution authorities and colleges work together and the priorities under which the resolution tools will be used will determine the potential cost to those clearing members. Ultimately, the aim of the new rules should be one of striking a balance between a prudent regulatory approach and maintaining a functioning market.