Regulators must take preventative not reactive approach to mitigate CCP failures
Global regulators and financial institutions should focus on preventative rather than reactive measures to mitigate the knock-on effects of a central counterparty clearing house (CCP) running into difficulty if one of its clearing members defaults.
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. 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.
“CCPs need to focus on preventative measures which stop them getting into this whole mess altogether. One way which this could be done would be for the CCP to close the defaulting member or members’ trades itself by assuming the position, and then winding it down rather than announcing the member is in default since it has failed to make a margin call. Regulators should be focusing on ensuring CCPs can close out positions immediately. This would help prevent market instability. It should also make it a requirement for exchanges to remain open during this market turbulence to enable affected products to continue to trade. The CCP would have to unwind the trade quickly. After two days of normal market conditions, initial margin would run out but most positions would be closed by then. Only the remaining positions would go into default,” said Tim Reucroft, director at Thomas Murray Investor Data Services.
A paper published by CPM/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. “Skin in the game is not a contribution to the default funds. It is an incentive for the CCP to take its risk management seriously. However, this will only be of value if it is management money as opposed to shareholder money otherwise the moral hazard will remain,” said Reucroft.
There have been calls also for CCPs to undertake mandatory standardised stress tests not too dissimilar to the banks. It was a point made in the J.P. Morgan paper. “I want to compare one CCP versus another. I want the CCP to tell me how many clearing members – starting with the largest – that the default fund covers. Does it cover only the largest clearing members, the top three, five or 10 clearing members, or everybody? How deep is the waterfall? All I then need to know is what kind of stress tests do the CCPs use to arrive at the simple metric to calculate on how deep the waterfall is,” said Reucroft.
The failure of a CCP is being taken very seriously by regulators. “The risk of a CCP failure is very high.” said Reucroft. Many CCPs simply do not have sufficient capital while others are increasingly competing on risk. “Portfolio margining sounds good but in a default it could be toxic. You have to unwind everything together or you get a close out mismatch when one side of the portfolio becomes gross and not net, but there is only net margin to cover. It is like pulling the plug on the waterfall,” said Reucroft.
CCPs are not immune to failure. The Paris-based Caisse de Liquidation des Affaires en Marchandises (CLAM) collapsed in 1974 when traders were unable to meet margin calls while the Kuala Lumpur Commodity Clearing House in Malaysia failed following defaults by six brokers trading palm oil contracts on the Kuala Lumpur Stock Exchange. The Hong Kong Futures Exchange also had to be rescued by the government in 1987. One risk that needs to be urgently addressed is that large clearing members are likely to be members of several CCPs so a high-profile default would not just be contained to one CCP. In addition, there would need to be cross-border cooperation between regulators if a large CCP clearing swaps across multiple jurisdictions ran into trouble.