CCP Battle Drags On
The prolonged transatlantic battle over the mutual recognition of central counterparty clearing houses (CCPs) reflects deep differences over the costs of resolving a failing CCP. And asset managers may find that their share of those costs is on the rise.
On May 7 Jonathan Hill, European Commissioner for Financial Stability, Financial Services and Capital Markets Union, and Timothy Massad, Chairman of the US Commodity Futures Trading Commission (CFTC), released a brief statement announcing that discussions over the recognition by European regulators of US-based CCPs had so far failed to reached a conclusion.
European regulators have now twice pushed back a deadline to impose significantly higher capital charges on banks clearing derivatives trades via “non-recognised” CCPs. So far, Europe’s securities market regulator (ESMA) has only granted recognised status to 10 non-EU CCPs, all in the Asia-Pacific region.
At issue is the uneven global implementation of rules intended to ensure the safety of CCPs and other financial market infrastructures.
Under Europe’s Market Infrastructure Regulation (EMIR), a CCP must put at risk at least 25% of its total minimum capital ahead of non-defaulting clearing members in the so-called default waterfall (the layers of financial safeguards available to a CCP to protect against the default of a clearing member). This 25% “skin-in-the-game” requirement is applied to a minimum capital requirement set by the Europe Banking Authority (EBA) but generally of the order of one years operating costs.
In the US, however, the CFTC requires merely that a DCO (Derivatives Clearing Organisation—the local term for a CCP) have capital to cover a year’s operating costs, with no skin in the game.
US regulators have so far taken the view that if a CCP has access to “funds” sufficient to cover the default of its largest two clearing members it complies with the principles for financial market infrastructures set out in 2012 by the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions (CPSS-IOSCO).
In Asia, the CCPs have gone even further than in Europe in seeking to shore up CCP stability: SGX in Singapore requires skin in the game of a minimum 25% of the default fund as a whole.
BlackRock, the world’s largest asset manager and the most vocal participant in post-crisis regulatory debate, has so far come down squarely on the side of those backing higher contributions by CCPs to default funds.
“We believe the CCP should be required to contribute more than a minimal amount…We estimate that the contribution by the CCP would likely be in the range of 8% to 12% of the [default] fund,” BlackRock wrote in an April 27 letter to the CFTC.
“Having more skin in the game will incentivize the CCPs to at all times have robust risk management and would align incentives between the CCP, clearing members and market participants,” BlackRock argued.
BlackRock’s suggestion mirrors a September 2014 call by US bank JP Morgan for CCPs to raise the size of their default contributions from current levels of around 2% globally to 10%.
CCP LCH Clearnet argued in a recent white paper that calls for significant extra contributions by clearing houses to default funds could end up destabilising the market infrastructure.
“The majority of a CCP's total loss-absorbing capacity comes from its clearing members either as initial margin or as default fund contributors. The purpose of skin in the game is to align the incentives of the CCP operator with those of the clearing members. Any requirement for the CCP operator to contribute significant additional resources to the default waterfall would fundamentally change the operator's risk profile, creating increased risk exposure to member default at the very time that the market needs the operator to be resilient.”
According to Tim Reucroft, director of research at Thomas Murray IDS, these arguments should be seen in the context of a larger battle over the funding of CCPs. Thomas Murray IDS produces risk assessment reports on 29 CCPs from around the globe.
“Who should pay for using derivatives?” asks Reucroft. “It’s a three-way battle between CCPs’ own capital, clearing brokers’ contributions to default funds and the initial margin contributed by the clearing brokers’ clients.”
Ultimately, suggests Reucroft, derivatives end users may well end up having to foot a larger share of the bill to ensure CCPs’ stability.
“Asset managers are aware that if they force their clearing brokers to put more money into CCPs’ default funds the clearing brokers will simply charge more for their services. Hence the calls for CCPs to put up more cash,” says Reucroft.
“But the CCPs are being asked to contribute capital to a default fund which they can’t control,” says Reucroft. “They set the rules and regulations, but they can’t do much to prevent a default. I don’t see CCPs as being the primary port of call for capital.”
“The people who introduce risk to the CCP are the ones who should pay for it,” argues Reucroft.
“As many clearing brokers are acting purely as agents, those introducing risks to the CCP are largely the clearing brokers’ clients. Risk mutualisation has a cost and it’s the clients who will probably end up having to pay if they wish to continue to do this kind of business.”