In 2009 G20 leaders considered the failings which led to the 2008 financial crisis and proposed new methods of mitigating risk to ensure global market prosperity. In the EU, this was achieved in the derivatives market through the introduction of the European Market Infrastructure Regulation (“EMIR”)1, which included the obligation to clear certain classes of “over-the-counter” derivatives (“OTC Derivatives”) through central counterparties (“CCPs”) (Article 4, EMIR “Clearing Obligation”).
A CCP interposes itself between counterparties to a trade, reducing counterparty risk. Given that they clear trades for clearing members (“CMs”) who are the largest global financial institutions, CCPs are key systemic cogs and any failure could have ramifications for the global financial markets. Following the publication of the EMIR clearing standards on 1 December 2015, the date for official clearing of certain classes of interest rate swaps by category 1 counterparties (CMs) is now set at 21 June 2016, with a frontloading window operating from 21 February 2016. The imminence of increased clearing in the market has meant that the undisrupted operation of CCPs is now more important than ever; imposed clearing should not create more risk than it is intended to avoid.
WHAT ARE THE RISKS?
One of the biggest risks both of and to clearing is failure of a CCP. A suspension of clearing or collapse of a CCP could leave CMs unable to execute trades, affecting liquidity and leading to further defaults. This could spread market contagion (a sort of “domino effect” – see IMF Working Paper WP/15/21: “Central Counterparties: Addressing their too important to fail nature”). It is therefore essential to make sure that CCPs are resilient against market pressures.
Many of these bodies, who were previously owned by CMs, are now profit-making entities whose interests arguably lie in making a return for shareholders and they may be willing to take greater risks in order to provide such returns. The market resembles an oligopoly; only those mandated by the relevant authority (in the EU this is the European Securities and Markets Authority) can clear trades and only then for the specific products for which they have been authorised. In the EU, as of 30 October 2015, only 16 CCPs had been mandated to clear and there were a number of products for which only one or two CCPs were authorised. This concentrates risk in the hands of a few CCPs. Should a CCP, which is the sole provider of a product, find itself in difficulty, it may lead to a suspension in the market for such a product, as there is no means to clear.
This article will focus firstly on the potential failure of CCPs in the event of a CM default, but will further consider other reasons for failure below.
MITIGATION OF THE RISKS: DEFAULT WATERFALLS
In 2012, the Committee on Payments and Markets Infrastructures, together with the International Organization of Securities Commission and the Financial Stability Board produced Principles for Market Infrastructures (“PFMIs”) to better manage risk in key infrastructures. The regulators oversee these infrastructures using the PFMIs as indicators, however, a framework for recovery and resolution is not prescribed by the PFMIs and each CCP has their own.
Clearing through CCPs is intended to reduce counterparty risk by ensuring that trades are always matched as each party trades with the CCP rather than each other. Counterparty risk is then held at CCP level. When a CM defaults, CCPs usually try to recover losses in the order set out below:
1. Defaulting CM’s collateral
The initial margin posted by a CM is used to cover CCP losses in the first instance.
2. CMs’ guarantee fund
Losses are usually then recovered through contributions made by the defaulting CM to a separate guarantee fund, established to assist with resolution upon default. The contributions of non-defaulting CMs to this fund are then called upon.
3. CCP contributions
CCPs usually make a contribution before or after the guarantee fund is utilised.
4. Further contributions from non-defaulting CMs Should further resources be required, CCPs allocate the loss (either to a predefined or uncapped amount) to the remaining CMs (through the request for additional contributions or variation margin haircutting).
Only where the methods invoked by the CCP fail to ensure its survival will a resolution authority step in.
PROPOSALS OF MARKET PARTICIPANTS
In their July 2015 letter to the European Commissioner for Financial Stability (“Investment Letter”), various investment managers asked CCPs to take greater responsibility on default. They believe members who had deposited money in good faith should not be subject to providing additional contributions or be subject to haircuts, as this would lead to “perverse systematic consequences which will undermine financial stability”. If a CCP is entitled to keep the margin posted in order to transact, this would “fundamentally alter the market’s view of cleared products”; collateral should only be used where a CM itself has defaulted and not where another CM defaults as this is contrary to the purpose of client clearing and segregation of assets in EMIR. They asked for the buffer provided by CCPs (see point 3 above) to be increased, through risk-based contributions. This additional “skin-in-the-game” would help ensure that CCPs limit the risks they take.
CCPs play an important role in avoiding the volatility seen following the 2008 crisis. One only has to look at the CM failure of HanMag on the Korea Exchange (“KRX”) following a trading error to see that CM default waterfalls do work to preserve the efficacy of the markets. However, it seems unfair KRX’s resources were the last to be tapped here and the default was ultimately satisfied by non-defaulting CMs (see “Bridging the Week” by Gary DeWaal: December 1 to 5 and 8, 2014); greater CCP “skin in the game” should be maintained to promote fairness as well as continued operability.
By contrast, LCH.Clearnet in its white paper on CCP recovery argued against such additional contributions stating that “(t)he resources of the CCP operator are designed to protect against operational and business risks and, if necessary, to manage an orderly wind-down.” The risk of CM default should lie with the CMs as the CCP is merely a “mutualised risk structure”. This is difficult to align with EMIR; the clearing of OTC derivatives was supposed to remove counterparty risk. By increasing CMs’ exposure to each other through these additional contributions, counterparty risk is increased once again. Furthermore, CCPs are profit- making businesses and arguably should take responsibility for ensuring continuation of the clearing services they are paid to provide.
CCPs carry out stress-testing based on their own criteria. Standardised stress-testing across CCPs would provide an effective method to reduce market risk. CCPs and CMs would better understand their ability to withstand market pressures and market confidence should also increase as participants appreciate the risks and interdependencies of CCPs. CCPs could accurately quantify the total loss absorbing capacity they require and align capital to meet this. One possibility is the use of scenario analysis software to establish interdependencies, chances of default and risk of failure. Due to the global nature of the financial markets, implementation should be on an international basis.
In January 2015, the International Swaps and Derivatives Association (“ISDA”) proposed a CCP recovery framework, focussing on auctioning the defaulting CM’s portfolio to non-defaulting CMs and funding potential losses through pre-defined default resources. Auctioning positions avoids resorting to default funds, although whether this is possible is questionable, particularly given a default of a CM is likely to be due to issues or market conditions which affect other CMs and thus limit their capacity to take on a trade. Additionally, for certain products, there are only a few market players, further restricting the ability to auction positions.
RECAPITALISATION VS LIQUIDATION
JP Morgan Chase & Co in its September 2014 perspective on CCP resolution suggests that recapitalisation should be preferred over liquidation. They believe this is necessary given the risk of price volatility and lack of replacement CCPs should a CCP fail. They advocate a separate recapitalisation fund, funded by CCPs and CMs. The applicable government agency would then “bail-in” the CCP using this fund in exchange for equity. The investors, however, in their Investment Letter, suggested that “recovery of a CCP at all costs should not be the only option on the table”. They argue that CCPs should have plans in place for a swift liquidation of a CCP, allowing CMs to recover margin and re-establish positions elsewhere.
It may not always be possible or prudent to recapitalise a CCP. Given the oligopolistic structure of the clearing market, the failure of a CCP could lead to widespread market disruption. Whilst CCP liquidation should not be avoided at all costs, it is easy to see why efforts must be made to recapitalise a CCP without resorting to the tax-payer. Methods need to be developed to ensure that where liquidation is required, continuity of trading is maintained.
OTHER REASONS FOR CCP FAILURE
Although CCPs are subject to regulation and market standards, they are profit-making institutions with the usual risks this brings. CCPs also take on other roles (custodian, liquidity provider or otherwise), creating additional risk. In the event that a CCP is wound up for a reason other than CM default, it is difficult to see how the CCP can call on CMs’ contributions (particularly where such assets have been segregated). The only recovery tool is likely to be an independent guarantee fund, which has been funded by CCPs and CMs. The use of insurance options could also help to reduce this risk, although the viability of such options would need to be considered in depth, particularly given that insurers may also be affected by existing market conditions as well as the likely high value of the claim.
As noted, the failure of a CCP could lead to suspension of clearing. There is an argument in such a case for emergency bilateral trading, effectively suspending the clearing requirement to avoid market-inoperability. A requirement for two CCPs to be mandated to clear a product before it is subject to the clearing requirement may also be prudent. Should a CCP be unable to clear a product for any reason, CMs would transfer their positions to another mandated CCP, possibly linked with an auction process to clear trades through other venues, as well as a fast-tracked authorisation process, to ensure speed and effectiveness.
CM default is usually due to market-wide issues, meaning that many CMs are at risk of default. This could mean that guarantee funds are insufficient. Standardised stress-testing may also help as the markets would better understand repercussions and mitigation techniques to ensure they have sufficient capital to survive. In the banking sector there has been a move towards stress-testing and capital assessment. Given the significance of CCPs, it may be wise to look at introducing similar requirements for CCPs.
CCPs reduce counterparty risk by ensuring trades do not remain unexecuted. CCPs, however, could potentially magnify risk as trading is concentrated through a few institutions with a few participants. Measures therefore should be put in place to mitigate systemic and market risk particularly where there are adverse market conditions. Greater focus is required on the recoverability and resolution of CCPs to avoid increased risk and market contagion. The current methods and waterfalls to mitigate risk do not appear to go far enough, focussing on single CM default and not considering wider issues affecting the marketplace. CCPs need to not only operate in the event of a CM default or other adverse market conditions but also ensure that they are not culpable in causing such conditions through the concentration of risk. As well as the issues regarding default waterfalls and data collection for capital purposes discussed above, insurance options or provision for the fall-back execution of trades bilaterally should be considered to ensure trading continuity. Given the interdependency of CCPs and CMs, a unified, international approach should be taken to better understand the risks of mandatory clearing through CCPs and promote market confidence. Until this approach has been clarified, CMs should take the opportunity to review CCP rulebooks and understand how they may be called upon to contribute in the event of a default. CMs and CCPs should also consider their resilience to default of another CM or collapse of a CCP to ensure they are able to continue to trade and access liquidity in the marketplace.