Restructuring & Insolvency
Recovery and Resolution of Central Clearing Counterparties: AIMA’s Proposals
Following the financial crisis of 2008, new national and international financial policies were needed to ensure that the unprecedented levels of governmental assistance provided to large financial institutions were never repeated. Whilst the initial focus was on the recovery and resolution of banking institutions, attention has now shifted to systemically important non-banking institutions – among them central clearing counterparties or clearing houses (“CCPs”).
CCPs place themselves between counterparties to derivatives and securities transactions, effectively “guaranteeing” the contractual obligations of the two counterparties. This helps mitigate the credit risk of counterparties to the trade, as each is protected from the default of the other by the CCP’s financial resources. In the event a counterparty defaults, the CCP will fulfil the defaulter’s obligations. To minimise risk to its own capital, a CCP collects resources from its members (or participants) in the form of contributions to a default fund and margin called in respect of transactions. Although they strive to be “risk neutral”, CCPs remain exposed to the risk that a counterparty may default on outstanding contracts to such an extent that their resources cannot cover, and subject to market risk - particularly where a very large member with many transactions defaults, as occurred recently in the cases of Lehman Brothers and MF Global. There is, therefore, always the risk that a CCP could fail.
The issue of how to deal with CCP failure is difficult, not least because someone will need to fund the inevitable losses. For this reason alone, the views of the various stakeholders are likely to be at best divergent, at worst polarised.
The AIMA Position Paper
On 1 October 2014, the Alternative Investment Management Association or “AIMA” (the global hedge fund industry association) published a position paper on CCP recovery and resolution. The paper argues that the priority of any regulation should be to prevent CCPs from failing but, perhaps more controversially, that when a certain point of financial distress is reached a CCP be permitted to fail.
The AIMA’s paper suggests various mechanisms by which regulators may prevent CCP failure:
Risk Fund: Requiring CCPs to set aside and maintain a sufficient amount of debt and/or equity to ensure that CCPs have a mutual interest in avoiding CCP failure and that any losses are borne by the CCP.
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2 Recovery and Resolution of Central Clearing Counterparties: AIMA’s Proposals January 2015
Living Will: Requiring existing CCP risk committees to develop and implement a “living will” by which a CCP may be wound down gradually before formal failure, thereby minimising disruption and loss to participants through early return of client margin and the opportunity for clients to transition quickly to an alternative CCP.
Active Risk Committees: Empowering and requiring CCP risk committees to take a more active role in representing all stakeholders.
Transparency: Making financial information available so as to maximise stakeholder confidence and reduce the likelihood of a disorderly “run” on the CCP.
Buy-side participation in auctions: Permitting CCPs to auction defaulting member’s’ out-of-the-money positions to end-users and use the proceeds of to reduce losses.
Much could be said on these proposed recovery strategies, but the following points are of particular note. First, although the prevailing opinion is that CCPs should be required to put capital at risk, just how much “skin in the game” a CCP should have is debatable. Second, any proposal that sees the CCP with a level of capital does not address the fact that there is no clear mechanism through which CCPs are able to raise capital. The utility-like nature of clearing business means there may not be a ready “pool” of potential investors to turn to; especially given major banks are already exposed to CCPs in their capacity as clearing members. Third, in respect of living wills, there is an inherent conflict of interest in CCPs formulating the process by which they should break-up or be wound down, and there are question marks over the legal effectiveness of such arrangements in the absence of legal and regulatory change to facilitate them.
What seems almost inevitable is that, while stakeholders continue to discuss and debate the most appropriate method by which to assist CCP recovery through living wills, the calls for the development of policy to be conducted in an open forum subject to public scrutiny and comment are likely to grow louder. Further, AIMA has not indicated how end-users would participate in any proposed auction of defaulting positions. Would end-users behave as members for this purpose, participating directly or would end-users act through their clearing member, and if so, what rights would clearing members have in respect of this process? Any auction process will require careful thought with consideration given to the practical implications of this approach.
AIMA’s proposals provide that once a CCP has reached the “point of non-viability”, regulation should ensure the rapid and efficient wind-down of CCP positions and return of client money, rather than attempt to preserve critical CCP functions.
Resolution authority powers: To ensure rapid wind-down, AIMA has suggested that resolution authorities have certain powers, including the ability to write down equity, bail-in outstanding creditors who are not clients, and tear-up contracts.
Suspension of Clearing Obligation: Where a contract is subject to mandatory clearing and no alternative CCP is available for the clearing of products cleared by the non-viable CCP, clearing obligations would be suspended.
3 Recovery and Resolution of Central Clearing Counterparties: AIMA’s Proposals January 2015
There will be concern that AIMA’s suggestion to “suspend” clearing obligations runs contrary to the general shift of financial regulatory reform towards increased mandatory clearing. It would be surprising for regulatory authorities to abandon their current position, in which clearing is perceived as a risk minimisation and management tool in favour of a suspension of mandatory clearing.
Loss Allocation and Bail-In
One problem related to clearing is that losses may exceed CCP assets. AIMA has looked at a variety of options to deal with this issue. AIMA’s solution is to develop a method of loss allocation which distributes the losses in a predictable manner among available assets. In particular it is AIMA’s view that losses should be borne primarily by those who benefit from CCP success and who therefore, can be expected to have had increased visibility and control in relation to its functioning and are best placed to absorb losses to allow larger systemic consequences to be avoided. Potential options for loss absorption and management include:
Margin Haircut: AIMA does not consider a reduction in client margin to be an appropriate option to minimise losses particularly where mandatory clearing prevents parties selecting counterparties according to credit risk.
Rights of Assessment: AIMA considers that this tool best ensures that losses are borne by participants that benefit from CCP success in proportion to their participation and that those members are well placed in terms of capital, size and regulatory safeguards to absorb CCP losses without systemic consequences. However, it will be important to ensure that any such contributions are subject to clear and transparent rules and are capped at a pre-agreed level.
Insurance: AIMA supports the development of an insurance product which would avoid the need for write-down of non-defaulting member default-fund contributions, provided that this does not materially affect the cost of clearing.
Regulators have broadly become comfortable with loss allocation by way of margin haircuts. However, the issue with this mechanism is that the ultimate cost of CCP failure is often passed on to end-users, whilst some in the end-user community would argue that it should be borne by clearing member banks as part of their market intermediation role. Rights of assessment have been used as an alternative to margin haircutting in relation to deliverables clearing services where margin haircutting is conceptually problematic, and arguably rights of assessment have the benefit of being more transparent than margin haircutting. Unfortunately, rights of assessment (which are currently used) do not address end-user concerns as to who should bear losses, and again allow for CCPs to pass losses on to members, who may in turn pass them on to end-users. Insurance could serve as a mechanism to redress this imbalance. However, as yet there is no product available to CCPs and any such product would almost inevitably lead CCPs to look to clearing member banks, who would in turn look to end-users to allow them to indirectly cover the costs of any premium.
4 Recovery and Resolution of Central Clearing Counterparties: AIMA’s Proposals January 2015
The position paper will not be without its critics. Regulation mandating clearing of certain derivatives contracts has arguably made CCPs “too big to fail”. Given their importance as a vital piece of financial infrastructure, it seems unlikely that governments will refuse to dedicate central bank resources to failing CCPs – the consequences of failure being too far-reaching whether for monoline national CCPs or large multi-product CCPs. For that reason, AIMA’s proposals to allow CCPs to fail are likely to be revisited. Furthermore, the suspension of mandatory clearing obligations goes against the current view of regulators as to how best to manage financial markets in complex products such as derivatives, and it can be expected that regulators will continue to pursue increased clearing and elect to support CPPs rather than suspend clearing obligations.
It does, however, appear inevitable that CCPs will, like banks, be obliged to assume greater risk by maintaining greater capital. It is also likely that regulators will support the notion that CCP stakeholders (including end-users) be afforded adequate representation in any risk management committee and provided with sufficient information on CCP activities to enable their representatives to contribute meaningfully to the committee’s work.
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