02 April 2013

ISDA publishes 'Risk sensitive capital treatment for clearing member exposure to CCP default funds'

In its latest paper, ISDA concludes that capitalisation of clearing members' exposure to CCPs should be done on a consolidated basis across all CCPs, not at the CCP level which is the current regulatory requirement.

Executive Summary

• ISDA has been working on a proposal that it considers can be calibrated to measure properly the risk of loss of a Clearing Member’s (“CM”) default fund contribution and meet regulatory requirements. The proposal builds on existing frameworks and in ISDA's view has a firm theoretical underpinning which should deliver appropriate sensitivity to the key risks to the default fund. Part of the proposal, specifically the Historic Drawdown Measure (“HDM”) has been reviewed by the Joint Working Group (“JWG”). ISDA now proposes to incorporate the HDM into an Incremental Default Risk Charge (“IDRC”), which is the type of model that is currently used for trading book default risk. ISDA's proposal is that Central Counterparties (“CCPs”) would be required to provide the HDM data to CMs. CMs would then run an IDRC model to estimate the 99.9th percentile loss on the basis that they might become liable for calls on the default fund over a one-year time horizon. The capital requirement covers funded and unfunded losses.
• Incorporation of HDM into an IDRC framework captures the risk of multiple CM defaults, not only on a single CCP but across all CCPs on which the CM clears. In contrast to ISDA's proposal, BCBS 227 treatments, and HDM by itself, overlook the risk of multiple CM defaults. Only the IDRC analysis provides insight into the potential contagion risk across CCPs.
• The recent risk-weighted assets (“RWA”) variability exercise has highlighted the variation in capital requirements generated by IDRC models and ISDA fully understands the need to ensure a prescriptive and conservative calibration of an IDRC model used for the purpose it proposes.
• The HDM data is an input into the IDRC model. This recognises that when a CM defaults it will likely default on multiple CCPs simultaneously. Thus, it must be taken into account that a CM has exposure to all of the CCPs on which it clears simultaneously and it is insufficient to capitalise exposures to each on a stand-alone basis.
• Using limited HDM data provided so far by some CCPs, ISDA is able to estimate a conservative probability that a non-defaulting CM’s default fund contribution will suffer a loss when another CM defaults, and the likely size of the loss. The approach is consistent with the IRB approach used for credit risk on the banking book and the Incremental Risk Charge (IRC) applied to cover credit risk in the trading book.
• ISDA's proposal can be calibrated to obtain a Loss Given Default (“LGD”) for each CCP default fund based on its HDM data and other stress-testing work, taking into account the default probability of each CM on a CCP. The model inputs can be tightly prescribed by regulators to control the risk of model variability. Alternatively, regulators may wish to provide CCPs and CMs with some scope for model judgement. However because of the potential for regulators to tightly prescribe model inputs ISDA sees this approach as non-IMM.
• An IDRC model could be made publicly available for all CMs to use.

Conclusions

Capitalisation of CMs’ exposure to CCPs should be done on a consolidated basis across all CCPs, not at the CCP level which is the current regulatory requirement. Capitalising by CCP on a stand-alone basis is the same as summing VaR across risk factors rather than taking into account diversification benefits.

On a consolidated basis – and by CCP – the IRC approach delivers a capital requirement for total default fund liabilities, funded and unfunded. Our binomial analysis suggests that capital should be proportional to the square root of the number of CMs.

Please click on the link below to read the full paper.

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