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The international authorities are working together to simplify the network of transactions by mandating that standardised over‑the‑counter (OTC) derivatives are centrally cleared. That entails a concentration of risk around central counterparties (CCPs) and so relies upon them being safe and sound. CCPs’ risk management is a first line of defence: managing clearing‑member positions to reduce the likelihood of default; ensuring financial mitigants to cover potential losses are adequate. Should mitigants be exhausted, CCPs need a comprehensive recovery plan, including ex ante arrangements to mutualise remaining losses amongst surviving members. In case the plan fails, the authorities must be able to resolve a CCP safely without recourse to public funds.
The authorities have reframed the regulatory, supervisory and resolution regimes for clearing houses. Globally, the key measures are the “Principles for financial market infrastructures” (PFMIs), issued by the Basel Committee on Payment and Settlement Systems (CPSS) and the International Organisation of Securities Commissions (IOSCO); and on resolution, the Financial Stability Board’s (FSB) Key Attributes of Effective Resolution Regimes for Financial Institutions. In the European Union, the core regulatory measure is the European Market Infrastructure Regulation (EMIR), which is due to be followed over the next few years by a resolution directive for non‑banks and infrastructure providers, including CCPs. In the United Kingdom, where prudential supervision of post‑trade financial infrastructure is being transferred to the Bank of England, we have set out our planned approach to supervising CCPs. Taken together, these measures amount to the authorities putting in place a framework for determining how resilient a clearing house should be, and what happens if one fails. That is a legitimate and proper role for the authorities, acting in the wider public interest, given the spillovers and social costs of CCP distress. Moreover, the package reflects international agreements, in the interests of fostering a level playing field supportive of capital markets remaining global and integrated.
The driving principle is that CCPs need to do more than just look after their own risks in a narrow way. Their technical policies – for margining, collateral – set the terms of trade in the markets they serve. This is reflected in the CPSS/IOSCO Principles, which require CCPs to act in support of the stability of the broader financial system.
In the past, supervisors – whether of banks, dealers or financial infrastructure – did not instinctively like to contemplate insolvency: its occurrence means that their prophylactic efforts and recovery plans have proved insufficient. But the authorities have a duty to ensure that they do not run out of road; they need some control over events rather than just watching as chaos breaks out due to a CCP’s insolvency and consequent entry into a standard liquidation procedure. To be clear, resolution is an alternative to liquidation and, as such, is a last resort. Unlike liquidation, its objective should be to maintain continuity of clearing services or, if that is not possible, to withdraw services in a way that is as orderly as possible, with contained spillovers to capital markets and the rest of the financial system.
CCPs themselves have a big role to play in ensuring that they are resolvable. But, ultimately, resolution planning has to be the responsibility of the resolution authorities. That is because resolution of a CCP involves, in its essence, a reconstruction by the resolution authority of a failed infrastructure‑provider – its capital structure, liabilities, operations and management. To be able to do that, the resolution authority needs a rich set of powers bestowed upon them by a clear statutory framework. The benchmark is set out in the Financial Stability Board’s Key Attributes, an international standard endorsed by G20 leaders that jurisdictions must meet. With more systemically relevant activity going through clearing houses, jurisdictions must take early steps to ensure that their resolution regimes also cover CCPs effectively, and soon. At a minimum, resolution authorities need the power to take control of a CCP that is no longer viable (or doomed to become unviable) and where there is no reasonable prospect of its recovery. At that point, if for whatever reason the CCP’s own loss allocation rules have not been exercised in full, it may be enough for the resolution authority to complete that process. The right to effect the CCP’s rules should also extend to any outstanding contractual obligations to tear up contracts or to replenish default funds.