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The European Parliament’s Recovery and Resolution paper protected buy-side assets to some extent in the event that a CCP failed. A new paper from the International Organisation of Securities Commissions (IOSCO), the collective of securities regulators, is not as clear. It seems to suggest that buy-side firms’ assets could be used to support a central counterparty while it is still functioning as a profit-making organisation.
“This is a very thorny issue and it needs to be addressed", says Barry Hadingham, head of derivatives and counterparty risk at Aviva Investors. “Our clients are being mandated to centrally clear trades because it supposedly makes the market safer than today, but then you get to the question: Who picks up the bill if things go wrong in the cleared environment?”
Kay Swinburne MEP, author of the Parliamentary paper presented in June, says: “The IOSCO paper is very open to interpretation. I understand it was a real issue for IOSCO given that it needed consensus. My regret was that it wasn't more granular but having spoken to David Wright at IOSCO, I understand that it would have been difficult.”
Concern over who will keep trading infrastructure functioning, in the event that it becomes bankrupt, has been raised since central clearing of over-the-counter derivative trades was imposed in line with a mandate from the G20, agreed at its summit in Pittsburgh in September 2009.
Although it is technically possible to trade OTC derivatives without clearing them – and pension funds are exempted from the obligation for three years – the higher capital charges that the Basel III capital adequacy requirements level on any broker that is counterparty to an uncleared trade make it a less appetising option. As a result the de facto position is that both buy- and sell-side firms are required to use central counterparties as clearing houses for their OTC trades.
“This is something that trading firms have not necessarily decided to do, but are being mandated to do", says Hadingham. “As time goes on, people are thinking more and more about the potential side effects including the need for CCP resolution mechanisms. They are being told that it will be better for them as it will be safer.”
CCPs oblige users to provide collateral, posted with them as margin, that the CCP can expend in the event that a counterparty goes bankrupt, as the CCP is then required to continue trading the failed counterparty’s positions. That prevents the firm’s counterparties being exposed to the bankruptcy, thereby minimising its effect on the rest of the market. However it is possible that a CCP could burn through the collateral that has been posted with it. A structure exists – the collateral waterfall – that determines the order in which the CCP draws on other collateral, held by members, to keep it afloat. The clearing brokers may ask clients to agree to provide funds at this point, but there is no obligation for them to agree.
Nevertheless, with the obligation to clear centrally now enshrined in law, there is no way for firms to avoid exposure to a CCP and that makes CCPs, in common parlance, ‘too big to fail’, as they would impact the rest of the market.
Eric Litvack, head of regulatory strategy for Société Générale CIB says: “Once you have exhausted the default waterfall and there is a remaining shortfall, you then have some difficult decisions to make as to whether recovery or resolution is the appropriate path, and here there are many differences of opinion, broadly, between those who believe that nothing is worse than a CCP default and those who believe that a CCP which has proven unable to manage its risks will never recover the confidence of its participants.”
It is acknowledged by both IOSCO and Swinburne that at some point buy-side funds may have to be drawn upon to support a failing CCP. The question is, when?
Liability
The paper that Swinburne issued in June said that only sell-side firms should be responsible for supporting the CCP when it is in the process of going down the waterfall to keep itself going. “Any voluntary participation of clearing members in loss allocation before removal of the CCP’s management should not involve client money, while the resolution authority, once responsible, may employ loss allocation tools such as variation margin cutting or refilling of the default fund by the non-defaulting clearing members", she wrote.
The only point at which client funds could be used would be following the removal of the CCP’s management, who are acting on a for-profit basis, and after the imposition of a resolution authority, working purely to maintain market stability.
Swinburne says: “If an allocation was to be made to clients, who have no direct relationship with the CCP, then we need to work on the basis that a competent authority or a resolution party needs to deal with it. Then it is no longer in the interests of the [CCP’s] management, it is in the interests of the client and the market as a whole.”
The paper also argues for the European Commission ensuring that regulators set principles by which contractual arrangements around how clearing members can pass on losses to their clients, should be governed. As part of that, a clearing member’s default fund contribution would have to be exhausted before any losses from the defaulting clearing member could be passed on to their buy-side clients.
IOSCO is less specific. It suggests that “Uncovered credit losses and, where relevant, liquidity shortfalls could be allocated to direct participants, indirect participants, third-party institutions and/or owners.”
This is not directly in opposition to Swinburne’s point but it does not provide clear guidance. She says, “The IOSCO paper is so vague that I could potentially interpret it in line with my proposal. They have to go with every members opinion but that does mean it gets very watered down and I could interpret many of their points in very broad and possibly contradictory ways.”