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The larger CCPs have become critical components of the financial markets infrastructure and are emerging as major hubs concentrating the vast majority of global OTC derivatives transaction flows and risk positions. Great care needs to be taken to ensure that CCPs are not the new ‘too big to fail’ institutions requiring public money to prevent their failure. There are a number of important points in the paper Principles on CCP Recovery.
Chief among them: there needs to be more transparency with regards to the risk management standards and methodologies used to size CCP loss-absorbing resources. In particular, industry participants would like to see more disclosure on initial margin methodologies and the process for computing default-fund contributions (for instance, margin periods, stress scenarios used and assumptions made), and more detail on the risks faced by the CCP (for instance, the largest concentrations and exposures to clearing members). Without greater disclosure, it’s very difficult for market participants to accurately assess risks.
ISDA also makes an important recommendation on so-called CCP ‘skin-in-the-game’ (SITG). CCP SITG plays a significant role in aligning the CCP’s behaviour with that of its clearing members by encouraging the CCP to maintain robust risk management practices. As such, ISDA recommends that SITG should be split into two tranches – one junior (to encourage good initial margin practices) and one senior to mutualised default resources (to encourage robust default fund sizing methodologies). Furthermore, for SITG to be effective, it should be material. Further quantitative analysis should be conducted to determine its optimal amount and structure within CCP loss-absorbing resources.
There also needs to be a plan in place to address what would happen if CCP loss-absorbing resources prove to be insufficient. Regulators have suggested a variety of recovery tools, and in this respect, ISDA strongly recommends that recovery plans for each CCP are transparent and clearly defined. ISDA also strongly supports viable CCP recovery plans – a view that is consistent with regulatory objectives. Central to these plans is the notion that CCP recovery and continuity is likely to be less disruptive and less costly to the financial system than closure.
Another important ISDA recommendation is that recovery initiatives should only proceed so long as the default management process is effective. If it’s deemed to be no longer viable for any reason – for instance, the failure of an auction – then the CCP may have to consider closing the clearing service. Of course, it’s likely that resolution authorities would be evaluating which would be the most effective course of action in this situation.