Central counterparties (CCPs) are a fundamental part of global financial markets, facilitating most over-the-counter (OTC) derivatives transaction flow and risk positions. If a CCP shuts down, it may not be able to continue its important services without the help of resolution authorities or public money. To address this threat, the International Swaps and Derivatives Association, Inc. (ISDA) published a position paper CCP Default Management, Recovery and Continuity: A Proposed Recovery Framework (Proposed Framework) on January 26, 2015. The Proposed Framework, a copy of which can be found [here], provides a comprehensive recovery plan in the event that a CCP faces a threat to its viability.
ISDA stresses that the recovery of a CCP is preferable to its closure (i.e. clearing service termination). This is particularly important in times of market distress and instability. The continuity of critical CCP clearing services would be less disruptive and costly to a turbulent financial market and to market participants that use cleared OTC derivatives to manage and hedge risk exposure. In that vein, CCPs must adopt effective default management processes and have measures in place to prepare for the default of one or more clearing members.
An effective default management process involves the ability of a CCP to re-establish a matched book. According to the Proposed Framework, CCPs can re-establish a matched book by:
- holding a voluntary portfolio auction and transferring defaulted clearing members’ positions to solvent clearing members;
- making limited cash calls to solvent clearing members to increase default resources;
- implementing loss-allocation mechanisms in the form of a pro-rata reduction in unpaid payment obligations of the CCP; and
- considering partial contract tear-up, subject to applicable legal, regulatory capital and accounting treatment.
CCPs should fully compensate affected clearing participants if recovery measures involve loss allocation or partial contract tear-up. Affected clearing participants should receive a pro-rata share in the CCP’s claims against the estate(s) of the defaulting clearing member(s) and future CCP revenues or profits as a form of compensation.
ENTRY INTO RESOLUTION
If a default management process fails to re- establish a matched book, the CCP may have to consider closing down the affected clearing service (i.e. full tear-up). It is at this time that the relevant resolution authority may have to step in and evaluate whether resolution (as opposed to clearing service termination) could restore the affected clearing service.
SEGREGATED CLEARING SERVICES
The Proposed Framework encourages the segregation of clearing services if a CCP offers multiple clearing services. A segregated clearing service structure would mitigate the risk of contagion across other clearing services and allow a CCP to continue despite the termination of a single clearing service.
IMPORTANCE OF TRANSPARENCY AND PREDICTABILITY
The Proposed Framework reiterates the importance of clearly defined recovery measures in CCPs’ clearing service rule book. ISDA suggests, at the very least, a clear definition of the maximum time frame for the default management process before recovery measures are considered to have failed, and the applicable legal construct, source and utilization of resources. A maximum time frame should contain certain milestones, such as having a voluntary portfolio auction take place over a five-day period.
A well-defined clearing service rule book is also helpful in determining the viability of a clearing service. CCPs can compare the actions planned in its clearing service rule book with expected outcomes during the default management process by using actual events as a reference. If expected outcomes are achieved, the default management process can be deemed effective.
SCOPE OF THE PROPOSED FRAMEWORK.
The Proposed Framework is consistent with Recovery of financial market infrastructures, the report published by the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions in October 2014. However, ISDA focuses on addressing the default of clearing members and providing tools to re-establish a matched book. The Proposed Framework does not address other types of losses, such as those related to liquidity shortfalls or those not caused by a clearing member default.