With the ink barely dry on the Financial Stability Board’s proposed total loss-absorbing capital (TLAC) requirements for global systemically important banks (G-Sibs), regulatory attention is turning to the loss-absorbing capacity of other financial market infrastructures (FMIs) – primarily CCPs.
Many would say not before time. “This market is incredibly important and incredibly big,” said Hugo Bänziger, chairman of the Eurex Clearing Supervisory Board, at a recent Eurex Clearing/Deutsche Börse meeting in London in late November.
“There is $691 trillion outstanding in the derivatives market with a gross replacement value of $17 trillion. That is equivalent to eight large, systemically important banks.”
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| More prescriptive tools will be necessary if the current system fails to prevent a race to the bottom by CCPs in terms of risk management Benoît Coeuré |
The impact of the simultaneous failure of eight G-Sibs is something that the regulators are clearly worried about. Indeed, CCPs could now be viewed as “super-systemic” institutions.
“You could argue that the continued provision of the services of a CCP is more important than for other financial institutions such as banks,” said Benoît Coeuré, executive board member of the European Central Bank, at the same meeting.
“This is partly because the use of a CCP is mandatory for some products. By concentrating transactions in a CCP, part of the systemic risk in the system has been delegated to them.”
The Committee on Payments and Market Infrastructures (CPMI) of the International Organization of Securities Commissions (IOSCO) recently published a report on the recovery of FMIs, which is designed to provide clear guidance to CCPs on their recovery arrangements.
“We need a recovery framework that gives proper incentives to private participants,” Coeuré said at the meeting. “CCPs need to be well-managed. We need to see the implementation of CPMI IOSCO [principles for] FMIs to be strict and conservative.”
The market also wants clarity on what the regulators will or won’t do in the event that recovery fails and resolution becomes necessary.
“The authorities need to do what is systemically important in a crisis,” Coeuré emphasized. “They cannot have a hands-off approach. For a CCP resolution could be preferable to recovery from a systemic perspective. Designing effective resolution plans is therefore an important issue.”
CCPs have various loss-absorbing tools at their disposal. These include initial margin, a default fund and skin in the game by both the CCP and its clearing members. There is, however, little standardization in how these tools are applied. There is also little agreement between the CCPs themselves and their members as to the equitable allocation of losses if a default should occur.
Stress tests
CCPs should have loss-absorbing resources sufficient to cover the default of their two largest clearing members, but the stress tests applied to achieve this are not standardized either.
“Whilst the PFMIs and EMIR [European Market Infrastructure Regulation] do require an appropriately and prudently sized default fund, there is no requirement for CCPs to disclose the details of the stress tests which they use, which ultimately determine the size of these default funds,” said David Bailey, director of financial market infrastructure at the Bank of England, in a speech delivered at the Eurex event. “Therefore it may be difficult for participants to fully compare the level of stress that CCPs can withstand.”
The concern is such that he feels the market should now consider a TLAC standard for CCPs as well.
“The FSB has recently proposed that there must be a minimum level of TLAC for banks and we will need to consider carefully whether and how this concept could be effectively translated to CCPs,” he said.
The ECB's Coeuré was, however, swift to emphasize that while there was understandable concern over the risk that CCPs embody, clearing is still a positive development for the market.
| It is very important that CCPs take additional responsibility in terms of skin in the game Nick Forgan |
“Since the financial crisis, there might be concerns in the market about the soundness of CCPs,” he said. “The regulators are addressing this and let’s remember the alternative: the non-cleared world was opaque and risky. Risk couldn't be managed because we didn't know what it was. Let's not forget what the counterfactual is here.”
New regulation addressing the recovery and resolution of CCPs in Europe is now expected in 2015. The regulators are keen to emphasize the difference between the needs of bank and non-bank market infrastructures in this process.
“We are finishing the job with bank resolution so it is the right moment to complement the progress made in the banks with progress for non-banks – most urgently CCPs,” Olivier Guersent, deputy DG financial stability, financial services and capital markets union, European Commission, told the gathering.
“We benefit from the learning curve of bank resolution in designing CCP resolution. But we must not be too bank-centric. CCPs are different and we want to have time to consult properly. We will probably borrow some structural features from BRRD [bank recovery and resolution directive], but will be a largely different piece of legislation.”
Hammering out how different CCPs with different business models should address their loss-absorbing capacity will likely prove contentious. There are already widely varying guidelines to address this in place worldwide.
For example, the Commodity Futures Trading Commission has not stipulated a minimum requirement for skin in the game, while the European Banking Authority/European Securities and Markets Authority require skin in the game in the default fund equal to 25% of the CCPs' regulatory capital requirements. The Monetary Authority of Singapore requires skin in the game equal to 25% of the default fund itself.
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| Kay Swinburne, European Parliament |
Where the regulators come down on this issue divided market participants and CCPs at the Eurex meeting.
“CCPs do add risk to the system in terms of product margin and setting collateral,” said Nick Forgan, co-head of global clearing JPMorgan. "It is very important that CCPs take additional responsibility in terms of skin in the game. You have to look at the sizing of the default fund contribution by the CCP.
“This is currently around 2% globally – we have very low CCP capitalization today. It serves to have the CCP have skin in the game. You can add to that protection by having a more material level of capital below the guarantee fund.”
Thomas Book, CEO at Eurex Clearing, was, however, understandably less keen on greater CCP skin in the game. “It gets dangerous if you need to increase skin in the game of the CCP,” he claimed, warning “you decrease the skin in the game of the clearing members. You need to keep members highly incentivized”.
A notable difference between banks and CCPs is that banks have bail-in able capital while many CCPs do not.
“We need a TLAC concept for CCPs,” declared Kay Swinburne, member of the European Parliament, at the November meeting. “There are CCPs that don't have debt instruments that can convert so they need a pre-fund.”
The new regulations need to provide robust protection against member clients facing losses as a result of the failure of a CCP.
“Where does recovery end and resolution start?” Swinburne asked. “As soon as you start allocating losses to anyone who is not a clearing member at that point you need an external party to allocate losses. Saving taxpayers from bank bail-in is important, but saving investor clients from taking CCP losses is just as important.”
'Innocent bystanders'
This is something that preys on member firms’ minds as well.
“Our concerns have been to ensure that innocent bystanders aren’t impacted until the resolution stage,” said Stuart Anderson, vice-president, derivatives at BlackRock. He believes that some loss-absorbing strategies impact clients long before resolution is necessary. CCPs in trouble can call for additional resources from members, variation margin haircutting and ultimately contract termination.
“Variation margin haircutting reduces profit rather than taking an external capital source, but most pension funds are using [derivatives] to hedge risks in their portfolio,” he argues. "It is inversely correlated – if they are in the money on the derivative, they are in a loss on the asset. So if you haircut the initial margin, they are taking a further loss."
Both JPMorgan's Forgan and Anderson agreed that from their perspective CCPs need to pre-fund their defence against potential losses.
“CCPs should have a recapitalization fund that is fully funded upfront,” said Forgan. “This makes the system more expensive, but we see a preference for recapitalization over liquidation.” Anderson agreed: “The idea of a recapitalization fund to allow a failed CCP to very quickly reopen is a good one.”
| There is a real moral hazard here. Draft legislation should ensure a critical set of tools to resolve CCPs Olivier Guersent |
The regulators have their work cut out in designing the legislation, conscious of the systemic risks that CCPs pose to the system.
“It would be tragically ironic if in addressing the causes of the last financial crisis we create the new too big to fail,” Anderson mused.
The regulators are all too aware of this and want to be seen to take a tough line. “There is a real moral hazard here,” said the European Commission's Guersent. “Draft legislation should ensure a critical set of tools to resolve CCPs. One of the sources will have to come from margin haircuts. You will have to force losses on innocent players.
“In an insolvency scenario, they should be prepared to lose. In a resolution scenario, hopefully they would lose less.”
Guersent seemed ambivalent about the need for a TLAC requirement for CCPs. "Over and above the default waterfall, the incentives should be enough and we will have to rely on a variety of sources [for loss absorption],” he said. "I don't think that a TLAC for CCPs would be in isolation a solution to the problem.”
It is therefore very much in the end clients’ interests that the CCPs get their loss-absorption houses in order quickly. However, when the audience at the Eurex/Deutsche Börse event were asked whether they expected to have activated recovery and resolution plans in place in the next five to 10 years, the rather alarming answer from 37% of them was that this would be “hard to imagine”.
Regulatory focus is now such that they need to start imagining such a situation as new legislation could be in place in 2015.
“The regulatory approach has so far been non-prescriptive with FMIs being able to choose their own loss-absorbing tools,” Coeuré pointed out.
He had a warning for the market though: “More prescriptive tools will be necessary if the current system fails to prevent a race to the bottom by CCPs in terms of risk management. If this happens, the authorities will step in and the approach will become more prescriptive.”
