For More Information please contact
Vincent Keaveny Partner – Structured
Farid Anvari Of Counsel – Structured
Finance/Derivatives +44 207 919 1564
Counterparty Credit Risk Standards
and CCP Recovery and Resolution
Regulators and industry must hold CCPs to the
Since 2009, when the G20 decided that in order to reduce the
systemic risks to the financial markets the derivatives market
must move to a central clearing model, the industry has been
working alongside regulators to strengthen clearing
infrastructure. The derivatives market has become and will
continue to be, dependent upon central counterparties (CCPs).
Certain CCPs have become too important to fail. Much work has
already been undertaken to minimise the risks of CCPs reaching
the point of non viability (PONV) but regulators and industry
agree that more needs to be done particularly in developing
policies for dealing with CCPs should this point be reached.
Notwithstanding all the work to date it is still challenging for
clearing members, and even more so for their clients, to make
valid comparisons between the risks posed by different CCPs.
Entities entering into derivatives would do well to realise that not
all CCPs are created equal. Good risk management and not just
cost efficiency should be the key factor when clearing members
and their clients chose a CCP yet at present arguably they do not
have the full range of tools to assess this.
On 25th November ISDA published a set of key principles1 on the
adequacy and structure of CCP loss-absorbing resources and on
CCP recovery and resolution. We set out below ISDA's summary
of those principles, look at a regulator's angle on this topic as
indicated by David Bailey, Director at the Bank of England, in his
recent speech2 and give an overview of work taking place on
these issues globally.
Work on CCPs' resilience has been underway at a global level for
many years. The 2012 Committee on Payment and Settlement
1 ISDA Principles for CCP Recovery November 2014 are available on ISDA's website
2 The Bank of England's perspective on CCP risk management, recovery and resolution arrangements speech given by David Bailey, Director, Financial Market
Infrastructure, London 24th November 2014 available at www.bankofengland.co.uk/publications/pages/speeches/default.aspx
Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) Principles for Financial Market Infrastructure3 (PFMIs) represented a significant step forward as regards CCP risk standards. Regulators in a number of jurisdictions have used the PFMIs as a base for their own supervisory frameworks and standards. Indeed in the UK the regime for resolution of CCPs is already in place4. Whilst the PFMIs require CCPs to have default funds in place, each CCP's own stress tests determine the size of its default fund, making comparisons as to the adequacy of a default fund across CCPs difficult to ascertain. Regulatory co-operation across the global marketplace is important to develop a benchmark against which end-users and clearing members alike can measure CCP robustness though even a benchmark may be of limited use due to the wide variety of products CCPs cover. Work continues to be undertaken at the international level by the Financial Stability Board5 as well as the Committee on Payments and Market Infrastructures (CPMI, the renamed CPSS) and IOSCO. CPMI-IOSCO published a report6 in October 2014 on recovery of FMIs which provides guidance to CCPs on recovery arrangements. It identifies a number of possible tools for a CCP such as the right to call for additional resources from members, variation margin haircutting and ultimately contract termination. Regulators and industry agree that it is "important that recovery arrangements do not dis-incentivise effective management by CCPs of their non-default risks. CCPs should bear at least the first tranche of the loss with an amount of their own capital providing a clear incentive to prudently manage these risks" (David Bailey November 2014). ISDA's members agree - see "Significant CCP SITG" below). In its report CPMI-IOSCO state that, consistent with PFMI Principle 23, a CCP should provide sufficient disclosure to enable participants to have an accurate understanding of the risks they incur by participating in the FMI. In October 2013 CPSS-IOSCO consulted on the specific disclosure standards for CCPs. We expect a report from this consultation in the course of this year which it is hoped will bring some specificity to the disclosures expected of CCPs. In Europe the European Commission (EC) has been working on a proposal for an EU framework for the recovery and resolution of non-banks which we understand will focus mainly on CCPs. Whilst this was delayed in 2014 the proposal is expected to be published in Q2/Q3 2015 and will no doubt be informed by the
3 2012 Committee on Payment and Settlement Systems and the International Organization of Securities Commissions Principles for Financial Market Infrastructure are available at http://www.bis.org/cpmi/publ/d101a.pdf and see ISDA's response http://www.bis.org/publ/cpss94/cacomments/isda.pdf
4 UK Special resolution regime extended to UK CCPs - On 15 July 2014, the Financial Services Act 2012 (Commencement No 5) Order 2014 (SI 2014/1847) was published on www.legislation.gov.uk/uksi/2014/1847/contents/made. The Order brought into effect on 1 August 2014 sections 100, 101 and 102 of the Financial Services Act 2012. These sections contain amendments to the Banking Act 2009 relating to the extension of the special resolution regime (SRR) to, amongst others, central counterparties.
5 Financial Stability Board paper Recovery of Financial Market Infrastructures, issued August 2013 http://www.bis/org/cpmi/publ/d109.pdf and October 2014 http://www.financialstabilityboard.org/wp-content/uploads/r_141015.pdf The newly adopted guidance documents have been incorporated as annexes into the 2014 version of the Key Attributes document. No changes were made to the text of the twelve Key Attributes of October 2011.
6 CPMI-IOSCO Recovery of financial market infrastructures - final report October 2014 Report available at http://www.bis.org/cpmi/publ/d121.htm
experience of developing the European Bank Recovery and Resolution Directive (BRRD). On Friday 19th December Member States met with the EC to discuss various elements of the proposed regime. The Commission services (DG FISMA) under Lord Hill asked Member States to comment on a series of questions in order to assist them in drafting the proposal. Outstanding issues include whether early intervention arrangements should be part of a regulatory framework and if so, which powers the authorities should have. The EC is also seeking views on whether clearing members and indirect participants bearing losses in recovery should be compensated for those losses and whether all creditors in resolution (including clearing members) should bear losses in the order of priority of their claims under normal insolvency proceedings. Whether initial margin should be protected from haircutting is also under discussion as is the question of whether CCPs should be obliged to issue a certain amount of bail-in-able debt. Finally, as regards a CCPs loss absorbency, questions have been raised as to whether CCPs should be required to have an ex-ante financed guarantee fund to absorb losses at the end of the default waterfall. A number of key industry associations (of which Baker & McKenzie is a member) have already engaged with the EC on these proposals including ISDA, AIMA and the FIA Europe7 ISDA Proposals ISDA's latest offering to this debate is its Principles for CCP Recovery paper. The paper identifies the key issues that ISDA argues still need to be addressed, and makes several recommendations on how to proceed, which it summarises as follows: Transparent risk management standards, practices and methodologies: The practices, standards and methodologies used by CCPs to size their loss-absorbing resources, which include initial margin, default-fund contributions and CCP ‘skin in the game’ (SITG), need to be transparent to market participants. Without transparency on CCP risk methodologies, the ability of market participants to accurately assess the adequacy of CCP resources is severely hampered. Mandatory, standardised and transparent stress testing: CCP risk management methodologies and frameworks should be regularly tested and assessed using regulatory driven standardised and transparent stress-test criteria to assure market participants they are adequate. Significant CCP SITG: CCPs’ contributions to the loss-absorbing
7 See ISDA advocacy papers on resolution and recovery available at http://www2.isda.org/functional-areas/public-policy/financial-law-reform/
See AIMA advocacy papers available at www.aima.org Earlier this year AIMA published a White Paper on the issue of CCP resolution which sets out its key policy principles on the approach to dealing with a failing or failed CCP. The White Paper argues against the use of client money (such as variation margin) for the purposes of CCP recovery. AIMA indicates that the White Paper has been well received in the European Parliament and Commission. AIMA Guide to Sound Practices on OTC Clearing In July 2014, AIMA published a new Guide to Sound Practices for OTC Derivatives Clearing. This provides guidance on the new regulatory framework in the US and European Union, which affects most OTC derivatives transactions cleared globally. The Guide to Sound Practices is supplemented by a Due Diligence Questionnaire for Clearing Members, which is intended to help asset managers during the process of evaluating different clearing members and clearing houses.
resources pool should incentivise robust risk management, align CCP management incentives with those of the clearing members (CMs), and be fully funded, material and substantial. Clearly defined CCP recovery plans: Ensuring the continuing operation and restoring the viability of a failed CCP is less disruptive and costly, and therefore preferable, to its liquidation or full contract tear-up. Toward this end, CCP recovery mechanisms should be clearly defined and transparent; they should be pursued as long as the CCP default management process (DMP) is effective. Where CCP rules provide for cash calls to CMs, they should be limited, capped and fully transparent. Loss-allocation tools should only be considered if they are rules-based, clearly agreed upon and in place, and are economically viable for all categories of clearing participants. Clearing service termination or resolution: Recovery efforts should only be undertaken as long as the DMP is effective and the clearing service is viable. If the DMP has failed and/or further recovery efforts to re-establish a matched book are either ineffective, unfeasible or create systemic instability, then the CCP is faced with the prospect of considering the closure of the clearing service. It is likely that, at this point, the resolution authorities will be evaluating which course of action is most effective. The Bank of England's perspective on CCP risk management, recovery and resolution arrangements8 In his recent speech David Bailey (Director, Financial Market Infrastructure, Bank of England) clearly envisages CCPs being allowed to go into recovery or resolution procedures rather than being bailed out by government. A key point for Bailey is loss allocation. In his view the losses that may be incurred by CCPs, whether they be default or non-default losses (due to things such as poor treasury decisions), should be borne by a combination of the CCP itself, CCP capital providers, CCP members and clients rather than the tax payer. Whilst Bailey believes national resolution authorities must have flexibility to assess different CCPs' failure and react differently he does acknowledge that safeguards are needed including a No Creditor Worse Off safeguard, which would limit the individual losses to the losses they would experience in insolvency. It seems that the direction of travel as far as the Bank of England is concerned is that CCP recovery and resolution should be aligned with insolvency rather than bail out. Arguably this view undermines attempts made in recent global derivatives regulations, including EMIR9, to bolster segregation of CCP users'
8 The Bank of England's perspective on CCP risk management, recovery and resolution arrangements speech given by David Bailey, Director, Financial Market Infrastructure, London 24th November 2014 available at www.bankofengland.co.uk/publications/pages/speeches/default.aspx
9 Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (known as EMIR) available at http://ec.europa.eu/finance/financial-markets/derivatives/
assets and positions which protects creditors from exposure to losses arising from other CCP users. It should be no surprise however that regulators appear to have systemic risk issues higher up their list of priorities than protection of individual CCP users' collateral. Actions to consider Analyse CCP risk management processes and default management procedure - Greater scrutiny of CCPs' risk management is required due to the key role they play in the derivatives market place. Some say CCPs are "too big to fail" and so will always benefit from government bailout: regulators have thus far been clear that they expect CCPs to rely on their own resources and, where such resources are not sufficient, CCP closure is an acceptable outcome. It is conceivable that a CCP's loss absorbing resources could be exhausted so market participants need to be confident that they know their own exposures, the CCP's default management procedure and, in the worst case, CCP service closure processes. Clearing arrangements - Market participants would be well advised to ensure that they have clearing relationships with more than one clearing member and, where possible, potentially more than one CCP clearing service to have continuity in the event of either CCP default or clearing member default. Market developments - Guidance is expected from CPMI-IOSCO on the public quantitative disclosure standards for CCPs which should help to get market participants in a better position to use only those CCPs that are well risk managed. Currently, clients have had limited information provided to them in respect of CCPs' risk management compared to clearing members. Conclusion Clearing members and their clients need to understand the risks involved when transacting through different CCPs. Whilst it may be tempting for end-users to assume that the regulators are monitoring and maintaining the robustness of the CCPs it is beholden on every market participant using a CCP to understand and provide for residual CCP risks. This would be facilitated not only by having standardised stress testing requirements, the results of which would be available to market participants, but also by having clear and transparent resolution tools. However, there is a balancing act to be done: regulators tend to want to have flexibility to resolve CCPs whereas markets need certainty. Whilst standardisation of requirements is desirable (apples can be compared with apples) if all CCPs were to use the same standards then some argue that this could exacerbate the problem of centralisation of risk; in particular, it is not clear if reducing variation in CCP policies is desirable considering the wide range of different products different CCPs clear. Any standardisation of stress test scenarios must take into
account the specific nature of the CCP and its products moreover whilst authorities need the ability to act quickly and decisively they must do so in a predictable and transparent fashion to avoid loss of market confidence. The more global regulators require clearing of products the more important these issues become for all market participants. Baker & McKenzie Derivatives Practice - London Baker & McKenzie is one of the world's leading international derivatives practices and we have developed a vast wealth of experience and talent around the world which we harness to provide an unparalleled global service to our clients. Our approach is to provide practical, professional and cost-effective advice. We act for a diverse client base including corporate end-users both multinational and domestic, investment and commercial banks, governmental and supranational entities, insurance companies, financial market intermediaries, funds and investors. Our wide client base gives us a unique view of all aspects of the global derivatives market. We advise on derivatives regulation, clearing and the full range of derivative products from OTC derivatives and exchange traded products to debt capital markets instruments and securitisation structures.
Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an "office" means an office of any such law firm. This may qualify as "Attorney Advertising" requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome. Before you send e-mail to Baker & McKenzie, please be aware that your communications with us through this message will not create a lawyer-client relationship with us. Do not send us any information that you or anyone else considers to be confidential or secret unless we have first agreed to be your lawyers in that matter. Any information you send us before we agree to be your lawyers cannot be protected from disclosure. This Client Alert is for information purposes only. Its contents do not constitute legal advice and should not be regarded as detailed advice in individual cases. For further information, to contact the Team, or to subscribe/unsubscribe to the Client Alert, please email structuredcapitalmarkets @bakermckenzie.com.