CCPs Need ‘Skin in the Game’: BlackRock

Terry Flanagan

Derivatives clearinghouse represent linchpins in the financial system, yet themselves are not taking adequate measures to protect themselves from failure, according to BlackRock.

In an April 27 comment letter summarizing the positions it took at a March 19 roundtable held by the U.S. Commodity Futures Trading Commission, BlackRock said that “the best way to ensure that a failed or failing CCP does not have a systemic impact on the financial system is to strengthen its defenses so that events, such as the default of one or more CMs, can be buffered by sufficient resources.”

Originally CCPs were member-owned utilities designed to mutualize the risk of clearing by relying on the resources of their clearing participants, in particular those firms that are clearing members.

Today, however, CCPs are often commercially owned, for-profit independent institutions – yet they largely maintain their historical risk allocation, noted BlackRock. A CCP’s mutualized guaranty fund is typically the primary line of defense against losses incurred in a clearing member default in excess of the defaulting member’s margin and guaranty fund contribution. While some CCPs do contribute capital to their guaranty fund, CCP exposure is generally minimal.

Given the evolution in the structure of a CCP, BlackRock believes the CCP should be required to contribute more than a minimal amount, and that the amount should be risk-based and measured by the lower of either a fixed percentage of the fund or the largest single clearing member contribution. “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,” said the letter. “As for-profit institutions, the CCP can issue equity, debt or a combination thereof to fund its cash/cash equivalent contribution to the guaranty fund.”

In addition to their guaranty fund contributions, clearing members may also be called upon to contribute additional monies in the event funds are needed by a financially distressed CCP. However, the right to claim funds from a CM is not the same as holding the funds, particularly in times of severe market distress. “We think market participants should be concerned that in times of substantial market turmoil – ‘wartime’ – the CCP may have significant difficulty in collecting these unfunded liabilities,” said BlackRock.

At the March 19 meeting, Kristen Waters, global chief operating officer of risk and quantitative analysis at BlackRock, said that although the clearing process was very well tested during the financial crisis, products were simpler and there was less concentration in clearinghouses.

Liquidity is the most difficult type of risk to manage during times of stress, and planning up front with higher cash margin and high quality collateral requirements is vital, according to Waters. At the CCPs exhaustion point, when a CCP is as close to risk neutral as possible, a complete tear-up should occur and collateral should be returned – CCPs must act very quickly and decisively to ensure certainty to the marketplace.

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