Clearinghouses’ default “waterfall” offers no panacea against their potential failure
By Bora Yagiz, Compliance Complete
NEW YORK, Apr. 10, 2014 (Thomson Reuters Accelus) – The push of derivative contracts into central counterparties (CCP) – also known as clearinghouses — has been underway for more than five years, yet it remains unclear how these entities would fare under stressed market conditions in the U.S.
In the U.S., the CCPs mostly come in two forms – either as derivatives clearing organizations (DCO) that clear financial instruments such as options, futures, and swaps or securities clearing agencies (SCA) that clear securities for its members. The former group is regulated by the CFTC, the latter by the Securities and Exchange Commission, while other types of clearing entities (such as CHIPS or DTCC) that carry a state member trust charter fall under the jurisdiction of the Fed.
Rationale for central clearing
The rationale behind regulators’ intention in pushing for central clearing, following the decision of the G-20 leaders in the Pittsburgh summit in 2009, was to improve transparency in financial markets, mitigate systemic risk, and protect against market abuse.
These goals would be achieved through a clearinghouse placing itself at the center of trading financial institutions, aggregating and netting down their individual exposures to one another through novation –effectively becoming a buyer to the original seller, and the seller to the original buyer by matching either sides of a trade. This way, the CCPs would minimize the overall counterparty credit risk ingrained in the financial system and ensure that potential ripple effects emanating from a defaulting member would remain contained.
Through a well-defined default waterfall hierarchy — similar to the multi-tiered capital structure of banks, or tranches in a collateralized debt obligation — the CCPs would thus assume the default risk of its trading members and ensure the continuity of the trading system. Typically, as first line of defense, the defaulting member’s sources are used to absorb the losses, i.e. its initial margin, and its contribution to the pool of default fund. The capital of the CCP will then be tapped into if losses are still not covered. Sources of non-defaulting members in the default fund pool would be pulled only as a last resort to mutually share the losses.
In theory, the CCPs can also ask clearing members to increase their contribution through “assessments,” but it has well-defined established limits.
Defects of the default waterfall
The default waterfall structure has a number of defects, however, in addressing risks emanating from the clearing members as well as from the CCP itself.
It may give non-defaulting members a false sense of security, as it ignores the wrong way risk that may arise during a system-wide shock when the credit exposure to a counterparty increases in tandem with the default risk of that counterparty. In other words, the default fund that the CCPs rely on as a last resort may fail altogether since the non-defaulting members would be in the least likely position to bear them.
A consortium of about 20 insurers have recently stepped in to address the possibility of such failure by offering to provide a safety net of about $6 billion to $10 billion to clearinghouses such as the CME Group or the LCH.Clearnet Group.
On the face of it, this insurance plan could ensure clearinghouses against insolvency, as advocated by David Hardy, the chairman of the underwriter for the consortium, even if it means an increase in the cost of doing business for the CCP users.
Such a plan, however, could also amount to a mere transfer of risk from clearinghouses to the insurers that may fall short of honoring their obligations, and as such fail to provide the required liquidity to keep the CCPs afloat when the crisis hits. A case in point is AIG. The company misjudged the risk it assumed when it issued credit default swaps to protect its clients against bond defaults in the wake of the financial crisis. Its assumption that the quality of the insured debt ensured minimal risk even under worst-case scenarios proved fatal.
This could even be triggered by a CCP itself if it were to raise the initial margins in response to swift changes in market conditions. Given that the market may already be illiquid when the CCP does that, CCP members rushing in to liquidate their positions may put the CCP at risk.
“Other options have certainly been floated around by industry regulators and market participants,” said Douglas Harris, a managing partner with Promontory Financial Group. “One concept that has gained some support is variation margin gains haircutting, where the net in-the-money positions of the clients of clearing members are used to cover losses at the end of the waterfall.”
While this idea found supporters from clearinghouse lobby groups, such as ISDA, the buy-side has been opposed to it. The firms that use clearing members’ services understandably find it unfair to use their own money in bailing them out.
The CFTC regulations adopted at the end of 2013 — see below for details — require CCPs to maintain “committed” liquidity to support all non-cash collateral, including US Treasuries. This means that, absent an explicit commitment allowing a quick conversion into cash, even the US Treasuries cannot count as part of their capital.
Having more predictable access to funds through a central bank’s discount window could therefore be the ultimate guarantee, but it is a double-edge sword. Regulators in the U.S. have been reluctant to make a formal public commitment to the use of the discount window, and insist as a precondition that the CCPs stack up liquid securities that are “backed by highly reliable funding arrangements” in their liquidity arsenal. The Fed fears that the initial margins collected from members may be invested in securities that may not be readily available for a fast enough conversion into cash when needed by the CCPs.
This could put the CCPs based in the U.S. at a disadvantage vis-à-vis their global counterparts — such as the European CCPs that can benefit from their central banks’ lines of credit. Eurex Clearing based in Germany blatantly boasted of its guaranteed liquidity access to Bundesbank on its website.
Possible conflicts of interest
Ambitious CCPs may find their own interests to be in conflict with those of the market participants. In an effort to capture more market share from their competitors and to attract more end users, clearinghouses may resort to relaxing margin requirements or to lowering default funds contributions. This could, in effect, nullify the benefits of the default waterfall and put in jeopardy the public benefit of clearing that they are entrusted with.
Similarly, clearinghouses may take risky bets with their money in order to maximize their rate of return on investments. It is true that the CFTC issued a rule in 2012 restricting CCPs’ use of the initial margin for investment purposes to a certain type and quality of investment assets, and imposing concentration limits based on asset, issuer, and counterparty. However, no such regulation exists regarding the use of CCPs own capital or the default fund.
Moral hazard among members
The default waterfall also creates a moral hazard where the better quality end-users may be discouraged from becoming clearing members since their funds would essentially be used to clean up the losses of a weak member. And, if the CCPs were to try to raise the membership admission bar too high, it may result in a smaller network with a reduced liquidity pool for trading.
Carefully balancing the default fund and the initial margin requirements to optimally manage the risk may provide the solution. According to a research paper the Bank of England found that loss-mutualizing properties of a default fund could be more beneficial than relying on initial margins where most of the members are of good credit quality with low probability (but high impact) of experiencing losses. Conversely, the paper showed that the benefits accruing from the use of the default fund are higher when the members are thought to be more likely to default yet with losses that are more manageable.
International and domestic efforts
The minimum risk management standards, or the “Principles” set by the International Organization of Securities Commissions (IOSCO) and Committee on Payment and Settlement Systems (CPSS) go some way in tackling these issues and setting international standards.
The Principles, taking into account the idiosyncratic characteristics of each CCP and its respective jurisdiction, generally avoid being prescriptive. They, instead, provide a road map for liquidity risk and credit exposure management and the drafting of a resolution plan. They require among other things, that the CCPs should allocate liquid resources to cover shortfalls arising from the failure of all the affiliates of a member.
The principles also require that “a CCP should cover its credit exposures to its participants with a high degree of confidence for all products through an effective margin system that is risk-based and regularly reviewed,” and that it should maintain sufficient financial resources to absorb simultaneous defaults by its two largest clearing members in extreme, but plausible, market conditions.
In the United States, following FSOC’s designation of certain CCPs as systemically important financial institutions (SIFI) in 2012, regulators have issued new rules seeking to improve risk management standards at clearinghouses.
The CFTC published new regulations for SIDCOs, including substantive requirements relating to governance, financial resources, system safeguards, special default rules and procedures for uncovered losses or shortfalls, risk management, additional disclosure requirements, efficiency, and recovery and wind-down procedures.
Separately, the SEC has proposed an enhanced regulatory framework in March 2014 for the CCPs that it regulates. It requires, among other things, the CCPs to hold “qualifying liquid resources” sufficient to withstand the default of the participant with the largest aggregate exposure, hold liquid net assets funded by equity equal to at least six months of current operating expenses – in addition to CCP’s funds to cover member defaults — and conduct daily back-testing, monthly sensitivity analyses and annual model validation. In a move beyond the IOSCO-CPSS principles, it requires CCPs to develop plans for recovery and orderly wind-down, rather than just for one of them.
The Fed also proposed regulations, with comment period ending by end-March. Each regulator’s regulations closely follow the IOSCO-CPSS framework.
“Adequate governance and liquidity risk management by CCPs are, therefore, the key ingredients for the proper functioning of the derivatives clearing market,” said Ernest Patrikis, a partner with White &Case LLP.
Regulators are approaching the end of the beginning in issuing regulations for the CCPs. The next steps will be the implementation of these regulations, and strike a balance between establishing incentives for CCPs to conduct their own due diligence and ensuring their viability in times of crisis.
(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)