Regulators Warn Against Race to Bottom in Clearing

Terry Flanagan

Benoît Cœuré, member of the executive board of the European Central Bank, warned that regulators may become more prescriptive if there is a race to the bottom between central couterparties or across jurisdictions.

Cœuré spoke at the Exchange of Ideas conference, “Central clearing – guarantee of stability or new moral hazard?”, organised by Eurex Clearing in London today.

He said the mandatory use of central clearing for some over the counter derivatives is a relatively new regulatory tool for managing systemic risk and has brought central counterparties to the forefront of regulatory priorities. As risks are becoming concentrated in clearing houses, it is critical that they have effective recovery and resolution plans to ensure that the failure of one or more CCPs does not lead to instability in the financial system or to bailouts from taxpayers.

Last month the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) published a report on “Recovery of Financial Market Infrastructures” while the Financial Stability Board issued a paper on the “Key Attributes of Effective Resolution Regimes for Financial Institutions”.

“When we talk about recovery in relation to CCPs, we refer to the ability of a CCP to recover from a threat to its viability and financial strength so that it can continue to provide its critical services without requiring the use of resolution powers by authorities,”Cœuré said. “Resolution, on the other hand refers to the orderly winding-down of a financial market infrastructure, and would take place only if recovery fails or is not desirable.”

He added that the regulations covering clearing houses in the CPMI-IOSCO Principles for Financial Market Infrastructures and national laws are conservative so that recovery procedures should not need to activated. “However, even if the safety rules under the PFMI are properly implemented, the unthinkable may still happen,” Cœuré warned.

CPMI and IOSCO will monitor whether these principles have been adopted across 28 jurisdictions.

They have published two reports and will soon start to assess whether jurisdictions have adopted the necessary legislation or policies for implementation of the principles.

The first assessments of the principles’ implementation for CCPs and trade repositories in the EU, Japan and US will be released early next year which will then be followed by other jurisdictions. Assessment of individual CCPs will start in autumn 2015.

The principles require that CCPs have a recovery plan to deal with the default of a major clearing member and ensure that clearing services can continue by allocating any losses and liquidity shortfalls that are not covered by prefunded resources. “One could even argue that continued provision of services is more important for CCPs than for other financial institutions,” said Cœuré.

Unlike banks, CCPs have the ability to base recovery plans on contractual agreements with clearing members so that, if and when needed, they can draw on additional resources from members, rather than end clients or taxpayers.

Cœuré said CCPs also need to think about the optimal design and number of recovery tools as any one tool likely to be insufficient.

“Uncapped cash calls are comprehensive, but may create disincentives for central clearing,” he added. “Variation margin haircutting can be effective, as it reduces pay-outs rather than requiring additional pay ins, but its systemic effects can be uncertain due to the way losses are allocated. Initial margin haircutting may also be considered as comprehensive, but on the other hand, it could increase the potential for contagion risk.”

The CPMI-IOSCO report analyses a range of recovery and the potential conflicts of interest between stakeholders.

“Mechanisms should be foreseen for involving all relevant stakeholders in the CCP’s decision-making process: this could mean establishing procedures whereby the CCP board formally consults direct participants, indirect participants and/or linked CCPs, as relevant, or having such relevant entities directly represented on the board, on the risk committee, or on other relevant committees,” Cœuré said.

He added that regulators have taken a cautious approach to developing standards and regulation as the recovery of CCPs is a new area.

“A more prescriptive approach will, in my view, become inevitable if the current approach fails to prevent a race to the bottom between CCPs or across jurisdictions,” warned Cœuré.

Regulators also need to work together to make sure CCP recovery tools do not threaten the stability of the financial system and are consistent with the approach of banking regulators.

“Authorities could be faced with a situation where the application of resolution procedures is preferable to the activation of a recovery plan,” he added.

Resolution may be preferable if loss allocation tools over-expose certain participants, such as buyside institutions or individual banks or if clearing members decide they do not not want to continue using a CCP.

Cœuré said regulators need to do further work to consider situations such as the simultaneous failure of multiple CCPs and to understand their interconnectedness, and deeper analysis of reverse stress testing to cover hypothetical portfolios and extreme market conditions.

“This is why CPMI-IOSCO have identified stress testing as a policy priority, and will soon launch a work stream to develop potential guidance regarding best practices and methodologies,” he said.

Featured image via bahrialtay/Dollar Photo Club

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