Author Name: Thomas Book, CEO Eurex Clearing
The lessons from the past and the conclusions for the future
Eurex Clearing recently published its White Paper on the functioning of CCPs and their contribution to reduce systemic risk, given the ongoing discussions on the role of Financial Market Infrastructure as the new regulatory regime takes hold. The main purpose of the paper was to analyse how CCPs serve their markets and the positive impact they have on user's risk management. Of particular interest was the question surrounding CCP market structure resilience for extreme market scenarios, and how CCPs, their members, and regulatory stakeholders will ensure that even in circumstances which overwhelm the existing levels of collateralization, a CCP enables either the recovery or resolution in an orderly manner.
Experiences of 2008
A well documented feature of the recent financial crisis was its systemic nature. From its roots in subprime mortgages in the United States, the crisis took on its most dramatic peak in September 2008, in particular with the demise of Lehman Brothers and bail-outs of various financial market participants, most notably AIG, by governments with taxpayer money. The insufficient collateralization of market and credit risk for bilateral transactions, coupled with interconnected institutions appeared to threaten not only the entire financial systems but also the real economy. A particular problem was the uncertainty of exposure of firms to each other through opaque derivatives trades.
Ultimately, the situation was assuaged by massive public intervention, directly and indirectly. Shortly after the governmental and regulatory interventions and rescues, plans began to be drawn up for a global commitment to improve the financial market structure and risk management. The swath of regulations covered various aspects of the industry, ranging from compensation, capital requirements and consumer protection.
A reform of the OTC derivatives risk management was high on the regulatory agenda as this market was identified as not working properly with the effect of huge losses at certain market participants. The famous G20 commitment of Pittsburgh states that a substantial portion of these trades have to be cleared through CCPs in the future, while the uncleared would be subject to new rules for risk management and collateralization. In parallel, regulators also reviewed the existing CCPs, with new rules to enshrine best practice and set high standards. The general process was to define what a CCP should be first, and then to proceed to mandated clearing at the authorized entities. The progressive implementation of the clearing obligation, as it is called, is currently underway.
CCPs contributing to financial market stability
A CCP is in essence a simple mechanism: it becomes the seller to every buyer and buyer to every seller for a particular market which it "clears". This means that the original trading partners are not legally exposed to each other, and the CCP guarantees that the trade is ultimately settled as agreed. In order to do so, the CCP requires collateral from the two trading participants, called "margin". In the event of a default of one of the original trading parties, the CCP uses their margin to cover the liquidation costs, the so-called "defaulter pays" model. If losses exceed this, the CCP uses common resources in the form of a clearing fund provided by its non-defaulting members. The clearing fund not only provides an efficient way to collateralise against extreme tail-risk, but provides ex ante incentives on the clearing members to accept sufficient margin figures. To ensure that the CCP's incentives are also aligned with strong risk standards, the CCP provides its own money for use before the mutualisation across the non-defaulters is applied.
This construct directly addresses those features which contributed to the dramatic counterparty credit risk concerns during the turbulent days of 2008. The trading participants essentially outsource the collateralisation levels to a neutral counterparty, which is configured with an incentive scheme that ensures prudent margin levels. The strict mark-to-market procedures and margin calls means that the participants cannot take on risk without collateral. In the event of a default, rather than a disorganized n-to-m relations termination of trades, the CCP applies its rules and pre-defined loss allocation in an orderly fashion.
Added to this basic configuration, CCPs are able to provide other risk mitigation tools, such as multi-lateral netting of positions, concentration add-ons, and risk information tools.
These features are what contributed to the success of the cleared markets during the crisis. In times of uncertainty, including when members of CCPs defaulted, the markets continued to operate, and none of the major CCPs experienced losses beyond a fraction of the defaulter's contributions. The theoretical benefits were given practical confirmation, and gave new impetus to broadening CCP market coverage.
Ensuring CCP market safety
It goes without saying, that CCPs only deliver these benefits to their members and the wider financial markets if their risks standards are appropriately configured, and are not themselves a threat due to say, operational risk or fraud. Examples are few and far between, but CCPs or clearing houses have experienced a variety of disruptions, with a sample included below.
Of particular interest is the experience in Hong Kong during the 1987 Black Monday aftermath, wherein a clearing house, its guaranty company, and the futures exchange underwent an ad hoc recovery plan in the face of a dramatic and fast market crash.
The broadening of CCP use to large portions of the OTC markets, and the general attention given to systemic risk management has generated substantial interest in such cases –formerly relegated to the rear pages of financial publications. In light of the former, global regulatory standards and jurisdictional rules have been adopted to strengthen and harmonize CCPs. In the main markets, CCPs must re-apply for authorisation under the new regulations, only after which they are permitted to offer their services. As an example, the exhibit below summarises important parts of the European rules for ensuring safe CCPs.
Despite such standards, nothing can ever be perfectly bullet-proof, and given their important role, CCPs will require specific recovery and resolution plans to ensure that if their safety measures are overwhelmed, continuity can be ensured or orderly wind-downs can be conducted. Recovery and resolution plans, or living wills, were initially drafted by the largest banks to mitigate the likelihood of future public support. At present, authorities and policy makers are preparing to adapt such planning to non-banks, in particular to CCPs.
CCP recovery and resolution plans are important, and in some sense this has always been part of CCPs in the sense of organized default management and loss allocation planning. A key distinction in the upcoming recovery and resolution frameworks will be the choice, but not obligation, of a "Resolution Authority" to intervene. The resolution authorities will have special powers enabling equitable distribution of losses without exposing the tax-payer. The resolution authorities should be selected so that they are familiar with the CCP(s) in question, and able to quickly and decisively act. The range of possible actions should be flexible and broad, given that the scenarios in which CCPs' existing lines of defence are threated are extremely unlikely and thus uncharted territory.
The recovery and resolution plans should first distinguish what makes CCPs special; namely that they are not a risk taker within their markets, but rather a risk manager between their participants. Thus, losses arising form the CCP's own business –operational risk, fraud, investment losses, etc. should be handled separately from those arising from the default management of its members. This is in contrast to losses from member defaults, for which the lines of defence of the CCP form a loss absorption buffer.
For the contingent market risk that the lines of defence are designed for and calibrated towards, the central position of a CCP is a great benefit, as it allows the risk management to be based on information on concentrations, trading patterns and thus likely liquidation costs. This trend towards centralisation is also added to by the netting benefits in a handful of CCPs. A limited number of CCPs is also useful in terms of systemic risk management during a recovery and resolution: resolution authorities will be able to act in such a way that the effects are coordinated and equitable across the involved parties.
The resolution tool kit should provide for continuity through further funds, or resolution of the entire CCP (or a failing sub-part) if the former is impossible or undesired. The possibility of resolution must exist, and typically means a wind-down or tear-up of open positions, and the complete termination of the CCP's activities. For recovery, various alternatives exist for further funds to be collected from the CCP or its participants, some better suited to certain asset classes. The structure and use of any such tools by the CCP would be in consultation or ex ante agreement with those affected by them. For all elements of the plans, risk beneficial incentive structures should be preserved, so that the recovery and resolution framework fosters market discipline.
In the coming months, the global standards on CCP recovery and resolution are expected from the FSB and CPSS/IOSCO, after which jurisdictional drafting will take place. There is broad support and keen interest in these developments across CCPs, their members and participants, and the plans are expected to provide a macro-prudential complement to the existing micro-prudential standards. As such, the new regime will benefit from not only strengthen markets and CCPs, but also the tool kit to cope appropriately with potential events that surpass expectations.