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CCPs will be required to establish robust recovery, continuity and resolution mechanisms. These must be addressed in relation to two situations: (1) at the “end of the default waterfall”; and (2) where there are non-default losses (NDL) that exceed a clearinghouse’s financial resources above the minimum regulatory capital requirements.
The introduction of mandatory central clearing for standard over-the-counter (“OTC”) derivatives will mean that central counterparties (“CCPs”) become the most systemically important market participants. As such, CCPs will be required to establish robust recovery and continuity mechanisms. Although the primary goal in a default situation should be recovery and continuity of the CCP, the need for resolution cannot be excluded and resolution mechanisms must also be in place.
Recovery, continuity and resolution must be addressed in relation to two situations, namely:
Default Losses
For Default Losses, this paper advocates Variation Margin Gains Haircutting (“VMGH”) as a robust recovery and continuity mechanism which will operate as part of the default waterfall following the exhaustion of all other layers of the default waterfall. VMGH allows the CCP to distribute remaining losses by recourse to pro rata unpaid gains at the beneficial owner level. The CCP would impose a haircut on cumulative variation margin (“VM”) gains on the portfolio of trades of each beneficial owner which have accumulated over the days since the commencement of the default management process, i.e. day of the CM default giving rise to the Default Losses.
NDL
Whilst not the primary focus of this paper, the paper notes that NDL should be viewed as a very different scenario from Default Losses – since the CCP is potentially insolvent but its clearing participants may all remain solvent – and further work must be undertaken to assess appropriate recovery / resolution measures. VMGH (or similar end-of-the-waterfall considerations) are not an appropriate or adequate resource for allocation of NDL. Even though VMGH mimics the economics of insolvency it would not guarantee the solvency of the CCP. There is no easy way to anticipate the size and nature of any such NDL and upon which entities they might fall, nor is there any obvious reason why such liability should be reallocated amongst CMs and other clearing participants in accordance with a VMGH mechanism, so other measures need to be considered to allocate losses appropriately.