Nick Nicholls Business Consulting Lead, GFT

 In November 2016, The European Commission (EC) announced a proposal for new rules that will ensure that all Central Clearing Counter-parties (CCPs) will be dealt with more effectively should they experience severe distress or failure.

There has been much debate in recent years that has focussed on the level of risk found within CCPs, and the overall need for regulation that will support the recovery and resolution of these systemically important institutions. The proposed rules require CCPs to draw up recovery plans which will include measures to overcome any form of financial distress that exceeds their default management resources and other requirements under EMIR (European Market Infrastructure Regulation).

The EC is taking what it believes are appropriate steps by introducing a recovery and resolution regime that will ensure that no European tax payer is burdened with risks should a CCP go under.

The position of CCPs is that regulators should concentrate on operational risks within the framework and avoid dis-incentivising clearing members by imposition of additional margin requirements, and a responsibility that any exposure at the point of failure is shared amongst the failing institution’s members – potentially requiring more capital to account for potential losses (feeding directly into their recovery and resolution calculations).

Risk cannot be eliminated but its impact can be minimised. The question facing market participants is what should reasonably be expected in terms of the costs and resources required to mitigate against systemic and credit risk.Given the nature of risk, there is always the danger that institutions will seek to move away from banks to less well-regulated alternatives, or contain those risks on their own books.

The Impact Assessment

The impact assessment of the regulation found that given the cross-border nature of business undertaken at CCPs, and the multiple financial counterparties and clients, the current rules and unilateral (divergent) approaches by EU member nations were inadequate to contain a systemic failure induced at a CCP. Their proposed solution is a harmonised, non-prescriptive approach across all jurisdictions within the EU.

There are a number of points to be aware of within the proposed regulation:

Confidentiality: Margin calculation may benefit from a harmonised/transparent approach, but at the same time could provide arbitrage opportunity should these be publicly known. Within the documents there is provision for confidentiality – how that is balanced with the need for a transparent plan – even if only amongst the competent, resolution authorities – remains to be seen.

Sale of risk and positions to clearing members: Despite the ECs assuredness that proposed regulation is unlikely to impact clearing member banks, we see a potential for risk and positions apportioned to clearing members. As they take on positions, or enforced ‘tear-up’ of outstanding transactions they may have to accept a greater capital provision for losses and additional impact their own ‘living wills’.

Determination of losses: Containing losses and controlling what non-defaulting clearing members are willing to pay for those losses will be a difficult within a resolution plan, but may play into the hands of the authorities and add stability as CCP members’ usual ‘write-down’ of positions to a below ‘normal’ market level could be tempered by those members knowing that they will be expected to take on the CCPs assets.

Harmonisation of approach: Given the track record of authorities and their inability to act in a co-ordinated fashion, and the differences in risk management practices at each CCP and their organisational structure, a consistent approach to CCP living wills may be challenging.  Brexit and the newly elected US (a significant ‘third nation’) authorities may also create a division in terms of approach.

Operational or extended systemic risk: The document recognises global implications due to interconnectedness of European CCPs and GSIBs. There’s an implied but not specific impact on ‘third country CCPs. The extent to which this is addressed would benefit from some clarity.There is also the exposure that the (I)CSDs have to the CCPs, but no real mention of CCPs exposure to CSDs.

The European Commission has stressed that the rules for recovery and resolution of CCPs cover the unlikely scenario of CCPs facing severe distress and difficulties. However, taking such a prudent approach would ensure that this is covered and that there is less risk of EU tax payers footing the bill for huge systemic failure. For market participants, the consequence of this regulation is a further variable to consider when pricing cleared verse non-cleared derivatives.