European regulators advise CCPs to review their TLAC processes
The European Commission and other global regulators are assessing the options by which to deal with the failure of a central counterparty clearing house (CCP).
The shift to mandatory clearing of over-the-counter (OTC) derivatives as mandated under the Dodd-Frank Act and European Market Infrastructure Regulation (EMIR) has turned CCPs into systemically important financial institutions. Some have gone further and referred to CCPs as “Super” systemically important financial institutions. As a result, a number of global bodies including the Bank for International Settlements (BIS) and the International Organisation of Securities Commissions (IOSCO) are urging CCPs to have recovery plans in place.
“The impact of a CCP failure – were it burn through its default waterfall and CCPs’ 25 per-cent capital contribution, and clearing member and default funds – would be catastrophic. CCPs may need to look at having in place some extra layer of total loss absorbing capacity (TLAC) according to some market participants and central banks. We are looking at this challenge, and what we need are simple rules in place to prevent such a scenario from occurring,” said Patrick Pearson, head of market infrastructure at the European Commission, speaking at the Global Custody Forum in London.
TLAC is already imposed on banks and stipulates the minimum amount of capital and liabilities that can be written off so as to prevent the use of taxpayers’ money to provide a bail-out. Another regulator highlighted everything must be done to prevent a disorderly CCP default. The Bank of England recently all but confirmed it would act as the lender of last resort to a CCP in trouble. Nonetheless, it is believed this is not going to be unconditional lending and liquidity would not be extended to a CCP that was unlikely to remain solvent. It is speculated that central bank lending will only be extended to CCPs should a CCP face a liquidity shock as opposed to a massive hole in its default fund, for example.
However, global regulators have been urged to focus more on preventative measures as opposed to reactive measures to mitigate the risk of a CCP failure. A paper published by CPMI/IOSCO advocated CCPs be allowed to replenish any funds it uses after a stress event, including demanding additional cash calls from clearing members or raising further equity capital. A white paper by J.P. Morgan in September 2014 demanded CCPs put more skin in the game into the guarantee fund. The J.P. Morgan paper recommended CCPs contribute more than 10 per-cent of member contributions or the largest single clearing member contribution in order to better align interests and ensure proper risk management and governance. It urged CCPs and clearing members to top-up a re-capitalisation fund, which could be accessed if the CCP uses all of the capital available in its risk waterfall. This would enable the CCP to keep operating during bouts of extreme market stress.
These thoughts have been echoed by asset managers including Blackrock and Pimco. A report by Pimco urged the minimum contribution from CCPs to be the highest of 5 per-cent, $20 million or the third largest clearing member contribution. “We believe that requiring a minimum contribution from the CCP to the guarantee fund will help to incentivise the CCP to manage its risk appropriately and provide a systemic safeguard should there be simultaneous failures of its clearing members,” read the Pimco paper. CCPs have rejected this as unnecessary, arguing EMIR requires CCPs to contribute a minimum of 25 per-cent of their own capital resources, which must be used to deal with a default before contributions from non-defaulting members are used up.
CCPs have defaulted or nearly defaulted in Hong Kong, Malaysia and France. There are concerns some CCPs are too willing to accept semi-standardised OTC contracts, which may be too high risk for them to clear. Others are concerned CCPs are increasingly competing on margin, a problem that has strained relations between EU and US regulators with the latter permitting easier margin terms. “There needs to be international consistency on margin requirements,” said Pearson.