Central clearing counterparties (CCPs) have played a longstanding role in financial markets. However, their systemic importance has been amplified by the reforms promoted in response to the global financial crisis, such as the “central clearing mandate” agreed upon at the Group of Twenty Pittsburgh summit in September 2009. In that summit, it was decided that all standardized, over-the-counter (OTC) derivatives contracts should be traded on exchanges or electronic trading platforms, when appropriate, and cleared through CCPs. To implement this policy commitment, many jurisdictions have since enacted legislative and regulatory frameworks establishing rules and criteria for the mandatory central clearing of OTC transactions.1
Because of the broader use and increased systemic importance of CCPs, policymakers have turned their attention to measures that could enhance their resiliency, recovery planning, and resolvability. In particular, it has become necessary to connect the dots between two key reforms of the global financial regulatory agenda promoted over the past years: the central clearing mandate and the adoption of effective resolution regimes for financial institutions conforming with the Key Attributes, which aim to preserve financial stability and minimize taxpayers’ exposure to loss (Financial Stability Board [FSB] 2014). Efforts have thus been undertaken by the policy community—under the aegis of the FSB—to develop international guidance on the key elements that should underpin resolution regimes for CCPs.2
The design of special resolution regimes for CCPs is complex. The absence of recent failures by CCPs makes it impossible to draw lessons from practical expe-rience.3 More fundamentally, a number of legal, economic, and regulatory features markedly distinguish CCPs from banks or other financial institutions. A key factor is that CCPs are designed to withstand the risks associated with the failure of large, systemic institutions. They do so through loss allocation rules established in multilateral contractual arrangements between the CCP and its participants—the so-called CCP rulebook—that effectively mutualize counterparty credit risk.4 Putting in place resolution regimes for CCPs requires a thorough understanding of these distinctive features, including how the loss mutualization function performed by CCPs unfolds when a CCP is on the verge of failure.5
This chapter analyzes how certain fundamental legal features of CCPs can inform the design of their resolution regime. The first section describes the “default waterfall,” a key building block of CCPs. The second section examines the interaction between the loss allocation rules agreed in CCP rulebooks and the resolution regime of a CCP, and the relevance of this interaction in several circumstances. The third section discusses the extent to which certain legal aspects, embedded in the structure and function of CCPs, may affect their resolution processes. The fourth section examines cross-border aspects relevant in the resolution of a CCP. The fifth section concludes. Where appropriate, the chapter refers to the guidance adopted by the FSB, which will be critical in assisting jurisdictions to develop and implement resolution regimes specific to CCPs.6
Key Considerations On CCPs’ Waterfall
CCPs interpose themselves between counterparties to contracts traded in financial markets by assuming the rights and obligations of each side to a transaction. In doing so, CCPs run a matched book, whereby payments owed by the CCP to the counterparty on one trade are matched by payments due to the CCP from the other counterparty on the matching trade.7 In case of default of one of its participants, the CCP performs a loss mutualization function by satisfying the claims of nondefaulting participants against the defaulting counterparty, drawing from the waterfall of resources set out in the CCP rulebook.8
Typically, the pecking order established in the waterfall allocates losses: to the defaulting counterparty, first by using the collateral (“margin”) provided by it through the initial margin; and, if this is not sufficient, through its contribution to the mutualized default fund.9 Collateral may be provided in the form of cash, securities, or instruments of credit held by the CCP through different legal arrangements (for example, deposit, pledge, or outright title transfer).
If losses exceed the defaulter’s margin and contribution, the CCP will draw from the resources provided by the other CCP participants into the mutualized default fund and from its resources. Although in all cases losses are first attributed to the defaulting participant, the size and pecking order of the remaining waterfall resources may vary across CCPs, also given that there is no internationally prescribed waterfall structure (Wendt 2015). A common structure provides for a first layer of skin in the game by the CCP before the mutualized default fund is drawn, and for a second contribution after the default fund has been exhausted.10
CCP End-of-the Waterfall Loss Allocation Tools
If the prefunded resources are exhausted, loss allocation arrangements provide for further contributions by the nondefaulting central clearing counterparty (CCP) participants and the CCP to preserve the continuity of critical clearing functions and, where appropriate, return to a matched book. Although such arrangements and the pecking order for their utilization in the waterfall may vary across CCPs (also in the function of products subject to clearing), they can be generally grouped as follows:1
Rights of assessment. CCPs may require nondefaulting CCP participants to contribute additional financial resources through a cash call. In most cases, such calls are capped to a predetermined limit, because unlimited contingent exposures may not be allowed under the legal framework of a CCP or of its participants and may be unfavorable from a capital adequacy point of view.
Variation margin gains haircutting. The CCP may reduce the variation margin payments because of the nondefaulting CCP participants whose positions have increased in value since the default of a CCP participant. Generally, the haircut would be applied pro rata in relation to the relevant CCP participants trading a particular class of products or clearing service. The haircut would not operate symmetrically, in the sense that the CCP participants whose positions have decreased in value would still be required to pay variation margin to the CCP.
Tear-up. Under this tool, open contracts would be settled and terminated by the CCP. Tear-up could be applied to some contracts (partial tear-up) or all contracts (full tear-up) of the CCP or of the affected clearing service. The preconditions for the partial and full tear-up are different, with the former generally being considered in the absence of available options to return to a matched book, and the latter to be possibly used in extreme scenarios and subject to financial stability not being jeopardized.
Initial margin haircutting. This tool entails the haircutting of the initial margin provided by the nondefaulting CCP participants. Initial margin haircutting, however, is considered problematic in many jurisdictions, particularly when the margin is “bankruptcy remote,” that is, protected from the insolvency of the CCP. In some legal frameworks, it is explicitly prohibited (see, for example, EU Regulation, art. 45(4), on over-the-counter derivatives, central counterparties, and trade repositories). Initial margin haircutting may have negative repercussions from a financial stability point of view, in that CCP participants would have to promptly replace it to preserve the financial resilience of the CCP against possible additional defaults.
The defaulting participant’s margin, the mutualized default fund, and the CCP contribution(s) represent the prefunded resources. Because the size of losses may exceed the prefunded resources, the Principles for Financial Market Infrastructures (PFMIs) recommend that CCPs address “how potentially uncovered credit losses would be allocated . . . [and] should also indicate the FMI’s process to replenish any financial resources that the FMI may employ during a stress event, so that the FMI can continue to operate in a safe and sound manner.”11 The CCP rulebook would therefore typically provide for the allocation, among its participants and the CCP, of unfunded losses, as part of CCP’s recovery plans.12 Box 7.1 describes loss allocation tools available for losses exceeding the CCP’s prefunded resources.13
Interaction Between CCP Recovery and Resolution
Loss Allocation Rules and Resolution
The waterfall structure—along with the adequacy of the CCP financial resources—is designed to ensure that the CCP can absorb losses arising from the default of its participants, thus preserving its solvency and viability.14 In other words, the robustness of the CCP loss allocation arrangements should mitigate the risk that the CCP itself would default.
However, it cannot be excluded that the failure of systemic CCP participants (or the multiple, cascading failure of various CCP participants) would put the CCP under stress and destabilize its financial condition. In that case, and when the conditions for entry into resolution are met, the authorities should be empowered to resolve the CCP to ensure the continuity of the clearing services or the orderly wind-down of the CCP that preserves financial stability and mitigates taxpayer costs.
The trigger to initiate resolution proceedings over financial institutions—including CCPs—is based on an assessment by the authorities of their nonviability (or likelihood thereof). Therefore, resolution regimes should provide for a timely and early entry into resolution. When the supervisory and resolution functions are performed by two different agencies, the supervisory authority would be naturally in charge of making the assessment on the nonviability of the CCP, while the resolution authority would exercise the relevant resolution tools and powers and implement the resolution strategy. Even in this scenario adequate coordination arrangements should be in place to ensure that action is not unduly delayed. For instance, the resolution authority should be able to request that an assessment on the viability (or lack thereof) of the CCP is made by the supervisor. Under the international standards of the Key Attributes, CCPs may be placed into resolution when the available recovery measures (including the resources examined in the preceding paragraph) are not yet exhausted and fully applied.15 In that case, the resolution authority would be able to enforce the rights and obligations of the resolved CCP, including under its loss allocation arrangements. Several questions on the interaction between recovery and resolution would then arise.16
If CCPs’ loss allocation arrangements ensure their resilience and recovery, a key issue is to what extent these arrangements would continue to apply when the authorities intervene to resolve a CCP. If they continue to apply, the question is how resolution differs from recovery. If they do not apply, it would need to be examined what is the scope and degree of departure, and what are the consequences of this departure for transparency and predictability, as well as for legal certainty.
Very different approaches may be followed in principle under the legal frameworks for resolving CCPs. On one hand, the resolution authority could be empowered to apply the loss allocation arrangements provided (or fixed) in the CCP rulebook, without being allowed to depart from them. This option would provide a high level of certainty to CCP participants, who would be able to measure their exposures to the CCP. Arguably, it would also bring clarity on the incentives driving CCP participants in the CCP default management and recovery process applied before resolution is commenced. This is because there would be predictability on the order of allocation of losses both in recovery and in resolution.
On the other end of the spectrum, resolution authorities could be authorized to apply the loss allocation arrangements in the order and manner that best fit the circumstances, as considered necessary to safeguard financial stability and regardless of the provisions of the CCP rulebook.17 Enabling a wide degree of flexibility may be crucial in extreme scenarios—such as those likely to be in place when a CCP is resolved—when the authorities need to take urgent actions to stabilize the financial system and avoid contagion.18
Each approach bears significant legal implications, including from the perspective of the legal risks involved. Moreover, vesting resolution authorities with a wide discretion in the selection and application of loss allocation arrangements have far-reaching economic consequences, because each arrangement can affect CCP participants very differently. For example, although cash calls are generally applied in proportion to the contribution to the mutualized default fund, variation margin haircutting of payments owed by the resolved CCPs can more closely reflect the scenario of a CCP insolvency and the resulting losses. Also, these tools have different repercussions for end users, in view of the possibility to shift losses from clearing members to their clients.19
Clearly, this is a complex issue, the intricacies of which are exacerbated by the circumstance that the resolution of CCPs is uncharted territory.20 The merits of the different approaches, including their possible variations, have been extensively debated by the industry and policymakers alike. The FSB (2017) seeks a balanced stance, recognizing the merits of flexibility within certain bounds. The guidance establishes a presumption that the resolution authority will continue to ‘“follow the steps and processes under the CCP’s rules and arrangements where it intervenes before these have been exhausted” The presumption is, however, qualified by the possibility of departing from CCP rules and arrangements, if necessary, to achieve the resolution objectives and to avoid significant adverse effects on the financial system, and subject to the limits and safeguards consistent with the Key Attributes and the FMI (FSB 2014, Annex).21 To some extent, this approach resembles the power that, in a bank resolution, the resolution authority has to depart from the pari passu treatment of creditors when this is necessary to protect financial stability (FSB 2014, EC 5.1).
Although it is difficult to draw conclusions on such an untested matter, some general considerations can be made. First, a key difference between recovery and resolution is that the commencement of a resolution proceeding entails a change of control over the resolved entity; it is no longer in the private hands of the CCP and its shareholders and management, but under the administrative powers of the resolution authority. Even when the order of allocation of losses, as fixed in the CCP rulebook, is followed in resolution, the CCP’s contractual rights and obligations, including loss allocation arrangements, would be exercised by the resolution authority rather than by the CCP, with the former stepping into the shoes of the latter. In principle, the authorities’ intervention should instill public confidence in the resolution process and in the preservation of financial stability.
Second, regardless of whether a fixed order of allocation of losses is followed, resolution regimes should leave to the resolution authority a certain degree of discretionary judgment. Flexibility is needed, for example, in relation to the timing and price applied in the use of the tools to return to a matched book, or to the selection of the relevant resolution tool (for example, transfers to a private purchaser or to a bridge bank).22
Third, as resolution regimes for CCPs are being developed, it will be important to ensure, ex ante, the clarity and transparency of any discretion conferred to the resolution authority to depart from the CCP’s loss allocation arrangements. This would also help mitigate legal risks arising from resolution processes.
Nondefault Losses
CCPs may face financial difficulties for reasons other than the default of their participants. Fraud, operational risks (for example, cyberattacks), or litigation may jeopardize their financial condition. CCPs could also incur investment losses, or their custody or settlement bank may fail. Although CPMI/IOSCO (2014) requires CCPs to have sufficient capital to absorb losses from general business, custody, and investment risks, it cannot be excluded that such losses may threaten the viability of the CCP and lead to its resolution.23
As loss allocation arrangements set out in the CCP rulebook typically apply to default losses, the contribution of CCP participants through initial margin or default fund could not be called upon in case of a nondefault loss.24 The rationale underlying this legal construct is that while for default losses the deployment of the waterfall resources is in line with a “mutuality” principle among CCP participants, for nondefault losses CCP participants are not in a position to exercise risk management over the CCPs.25 Losses would therefore fall on the CCP’s unsecured creditors (including, in some cases, CCP participants, such as for variation margin payments owed by the CCP to them) once its equity has been written down.
Therefore, legal frameworks for resolution of CCPs should set out clear rules for the allocation of losses for nondefault events, particularly among the CCP’s unsecured creditors.26 Several policy and financial stability considerations are relevant in the design of such rules. For example, the imposition of losses to certain classes of creditors could be justified based on their influence over the governance of the CCP or for the risks they bring to the CCP. In contrast, financial stability and resolution objectives may be undermined if losses are imposed on certain classes of creditors (for example, providers of critical services or of liquidity to the CCP).
Mechanisms to achieve these goals may include statutory bail-in tools, providing for the subordination of the unsecured liabilities that would first absorb losses through write-down or conversion into equity, as well as statutory cash calls to the clearing members.27 Both tools could ensure the replenishment of equity so the CCP can meet its regulatory capital requirements and restore its viability.
A different issue arises when the resolution of a CCP originates from a combination of default and nondefault losses; there, the triggers for initiating the resolution proceedings have a mixed nature. To cater for such possibility, adequate flexibility should be provided in the design of resolution regimes for CCPs so the authorities could apply loss allocation arrangements—attuned to the specific circumstances at hand—in a single resolution measure.
Equity Write-Down
In line with creditor hierarchy rules under insolvency laws, resolution regimes typically provide that shareholders sit at the bottom of the hierarchy and that equity is written down first before losses are allocated to other creditors. Imposing losses on owners can create appropriate incentives to ensure that shareholders put in place adequate governance and risk management controls.
The specific features of CCPs give rise to certain challenges in the application of this key principle. As examined in the preceding sections, CCP rulebooks provide for an order of allocation of waterfall resources, whereby CCPs’ contribution (or skin in the game) may not be the first loss-absorbing layer and may be drawn at different stages, and in different amounts, under the waterfall.28 CCP shareholders may also be shielded from losses by means of contractual limited recourse provisions, particularly with nondefault losses.
The contractual arrangements in the legal structure of CCPs could complicate the imposition of losses on shareholders and may expose the resolution authorities to compensation claims under the “no creditor worse off than in liquidation” (NCWOL) safeguard. Moreover, unless existing shareholders are written down, it may be difficult to award newly issued equity to the CCP participants and creditors who have contributed resources beyond their obligations under the CCP rules and arrangements, or who have otherwise contributed resources to restore the financial soundness of the CCP.
To address these challenges, authorities should have the legal authority to allocate losses on shareholders and make equity fully absorbing in resolution. The simpler way to achieve this goal is by providing for a full write-down of equity upon entry into resolution. At the same time, such a full write-down may have implications on the effectiveness of the loss allocation arrangements examined previously, on the incentives driving the recovery and resolution process, and on the NCWOL safeguard.29 Clarity is needed, therefore, as to when the full write-down of equity would occur in the resolution process.30
Structural Elements of CCPs
Certain elements inherent in CCP legal structures and function may impact the design of their resolution regime. Attention is given here to three issues: (1) the existence of silos and limited recourse provisions in CCP rules and arrangements, (2) the impact of resolution actions on netting sets, and (3) the interaction between the resolution of a CCP and that of its participants.
Silo Structures and Limited Recourse Provisions
Many CCPs operate through silo structures, whereby losses are allocated only within a clearing service offered by the CCP, and CCP participants not active in such a service are insulated from losses.31 The case may arise in which, whereas losses are contained in only one siloed service, they would be so severe to threaten the overall viability of the CCP, thereby justifying the intervention of the authorities to resolve the CCP.
In this case and notwithstanding such limited recourse provisions, it seems reasonable to assume that the resolution authority would take control of the CCP, rather than just intervene on one specific clearing service. Resolution processes are indeed “legal-entity-driven.” Presumably, the NCWOL safeguard would also be determined by comparing the treatment of the CCP creditors (including CCP participants active in the affected clearing service) with the counterfactual of the liquidation of the CCP as a legal entity.32
The choice of resolution tools may be based on whether losses have occurred only in a siloed clearing service to ensure continuity of the CCPs’ clearing services not affected by the losses. For example, tear-up may be applied selectively only to the affected clearing services.
Netting Sets
The CCP would generally enter with its participants into transactions that compose a “netting set” of transactions subject to a legally enforceable close-out netting agreement if one of the counterparties—including the CCP—defaults. Netting may apply on a cross-product basis, that is, contracts may relate to different asset classes and CCPs’ clearing services. This may offer benefits from several points of view, including for capital adequacy purposes.
The question arises as to the possible consequences of resolution actions on netting sets. For example, the resolution authority may transfer to a private purchaser or bridge bank only assets in a specific, siloed service, leaving behind other assets. Possibly, the exercise of selective tear-up, through the termination of some but not all contracts, may lead to similar consequences. These actions may hinder cross-product netting across the different silos, and thus break up netting sets.33 The implications of resolution actions for netting sets should therefore be examined by resolution authorities, particularly at the stage of resolution planning. Possible actions may include structural measures that would minimize cross-product netting across different siloed clearing services, so that a single netting set would apply within a specific clearing silo.34
Interaction between Resolution Regimes of the CCP and of Its Participants
The financial difficulties of one or more of the CCP participants that give rise to default losses and to the resolution of the CCP may also be the triggering event of a resolution proceeding over the CCP participants, as governed by the relevant resolution regime. In this case, the resolution of a CCP could be concomitant with the resolution of one or more of its participants. Depending on where the CCP participants are established, their resolution process may be initiated in the home jurisdiction of the CCP—which also governs the resolution of the CCP—or in foreign jurisdictions. In either case, the question arises about how the resolution regimes and processes would interact, and how the CCP rules and arrangements—also applicable when the CCP is in resolution—are aligned to the key objective of preserving the continuity of critical clearing functions.
Where CCP participants are subject to resolution, it is important to ensure the operational continuity of their access to the CCP services.35 Continuity is conditioned on the ongoing fulfillment by the firm under resolution of its obligations toward the CCP. If the obligations are not fulfilled, the CCP would be entitled to initiate a default management process. The same conclusion applies if the CCP is under resolution. In this case, it would be the responsibility of the resolution authority, stepping into the shoes of the CCP and exercising its contractual rights, to ensure the continuity of access to FMI services, or to terminate the positions of the participant that, while being subject to resolution, is not fulfilling its obligations to the CCP. The same need for continuity would also arise when a firm in resolution is a provider of critical services (such as custody or settlement) to a CCP in resolution. Resolution authorities will need to identify and monitor in resolution planning any possible conflicting objectives that may emerge between the resolution regimes and processes applicable to the CCP and to its participants or providers of critical services, with a view to putting in place appropriate coordination and cooperation arrangements.
Cross-Border Aspects
CCPs are internationally active firms because their participants and service providers typically operate in different jurisdictions. Therefore, effective cross-border frameworks for a CCP’s resolution must be in place so that actions taken by the resolution authority in the home jurisdiction of the CCP are given effect in other jurisdictions (for example, where CCP participants are established).36
Also in this context the features of CCPs, including those of a legal nature, assume relevance because they may have an impact on the cross-border effectiveness of the resolution actions. In particular, certain challenges generally arising in the cross-border resolution of financial institutions may not emerge in a resolution of a CCP. CCPs do not operate through foreign branches, and their rules and arrangements are included in the CCP rulebook: a single, multilateral contract uniformly agreed upon by the CCP, with its participants and subject to regulatory approval by the CCP regulator and supervisor. As examined in the preceding sections, such a contract includes rules on the default management process and on loss allocation among CCP participants. Typically, the CCP rulebook is governed by the laws of the jurisdiction in which the CCP is established—which is the same as the CCP resolution authority—and defers to the jurisdiction of the local courts in case of disputes between the CCP and its participants. Furthermore, in line with the Principles for Financial Market Infrastructures’ (CPMI/ IOSCO 2012) margin posted by CCP participants with the CCP (for example, into the default fund contribution) should be held under legal arrangements that ensure the enforceability of its use, including when the collateral forming part of the margin is held in foreign jurisdictions or through global custodians.37
All of these elements may simplify the cross-border resolution of a CCP by containing the effects of the CCP resolution in the home country of the resolution proceeding. There would be no need to enforce the resolution actions in foreign jurisdictions, because the CCP participant has contractually agreed to be bound by the laws of the CCP home resolution authority, in which the resolution measure deploys its legal effects.
However, challenges from a cross-border perspective may still arise. First, resolution losses are allocated not by the CCP according to contractual arrangements but by an administrative authority. CCP participants, including foreign ones, agree in the rulebook to the decision-making process initiated by the CCP, but not necessarily by the administrative authority. Moreover, there might be a disconnect between the CCP rules and arrangements and the statutory resolution tools. For example, the resolution authority may exercise resolution tools and actions that are not reflected in the CCP rulebook or may otherwise depart from the loss allocation arrangements provided under the rulebook. CCP contractual arrangements may also be governed by a law different from that of the CCP home jurisdiction. The question arises whether any of these grounds may lead to a challenge of the cross-border effectiveness of the resolution action in jurisdictions in which the CCP foreign participants are established or in other jurisdictions (such as where the collateral is held).
These concerns could be mitigated by incorporating into the CCP rulebook an explicit clause whereby the CCP and its participants would agree to be bound by the resolution regime of the CCP home country. This would help align the contractual loss allocation arrangements provided under the rulebook with the statutory regime for resolution. Further, through such a clause the CCP participants would adhere to the decision-making process provided under the statutory regime, led by the authority rather than by the CCP.
CCP home jurisdictions might require that CCP contracts governed by foreign law include a clause recognizing contractually the resolution powers vested in the CCP home resolution authority. This contractual approach—leveraging on the simpler group and legal structure of CCPs and on the existence of a single rulebook—would help enhance the cross-border effectiveness of resolution actions over a CCP.38
Conclusion
CCPs have become more systemic as a result of the reforms promoted in the global financial regulatory agenda. Effective arrangements should therefore be put in place for their possible resolution so CCPs do not become sources of financial stability. The policy community, under the aegis of the FSB, has taken steps to develop international guidance on the key features that should underpin CCP resolution regimes, and a key milestone has been achieved through the adoption of the Guidance on Central Counterparty Resolution and Resolution Planning (FSB 2017).
As evidenced by the FSB guidance, the design of resolution regimes for CCPs should be heavily informed by their legal, economic, and regulatory features, which make CCPs very different from banks and other financial institutions. A key distinctive factor is that CCPs are systemic risk managers and perform this function by mutualizing counterparty credit risk through the CCP rulebook, a single, uniform multilateral contractual arrangement concluded between the CCP and its participants.
This chapter has discussed how this loss-mutualization function performed through the single rulebook interacts with CCPs’ resolution processes, by reviewing the powers of resolution authorities to enforce, or to depart from, the rulebook, by looking at the scenario whereby the resolution of a CCP originates from “nondefault losses,” and by examining how CCPs’ specific features pose certain challenges in allocating losses to equity. The chapter has also examined a number of elements inherent in CCPs’ legal structures and function that may have an impact on the design of their resolution regime, and has then turned to cross-border aspects, where the existence of a single rulebook may arguably contribute to enhance the effectiveness of resolution actions over CCPs.
As resolution regimes for CCPs are developed in coming years, it will be important to take into account all of these legal features—and the role each can play in enhancing the resolvability of CCPs.
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United Kingdom, HM Treasury. 2014. “Secondary Legislation for Non-Bank Resolution Regimes.” Consultation outcome, June 9, London, United Kingdom. https://www.gov.uk/government/consultations/secondary-legislation-for-non-bank-resolution-regimes.
Wendt, Froukelien, 2015. “Central Counterparties: Addressing their Too Important to Fail Nature.” IMF Working Paper 15/21, International Monetary Fund, Washington, DC.
Alessandro Gullo is Senior Counsel of the IMF Legal Department. The author thanks Ross Leckow and David Blache for their valuable suggestions. While the views expressed in this chapter are to some extent based on the author’s experience as an IMF staff representative with the Financial Stability Board Cross-Border Crisis Management Group for Financial Markets Infrastructures, and on the fruitful discussions held at this forum, the views expressed herein are his own and should not be attributed to the IMF.
The underlying rationale of the central clearing mandate is that CCPs can not only facilitate multilateral netting and improve collateral policies but also serve a key role for systemic risk management (see Tucker 2011).
See the implementation guidance on financial market infrastructure (FMI) resolution (FSB 2014, Appendix II, Annex I) and the more recent “Guidance on Central Counterparty Resolution and Resolution Planning” (the “CCP Resolution Guidance”), adopted on July 5, 2017 (FSB 2017). The latter document complements the Key Attributes (FSB 2014) and the FMI Annex by providing more specific guidance on implementing them in resolution arrangements for CCPs. Its preparation was preceded by two consultations with stakeholders: first in August 2016 on a high-level discussion note on “Essential Aspects of CCP Resolution Planning” (FSB 2016) and then in a consultative document on “Guidance on Central Counterparty Resolution and Resolution Planning” (FSB 2017).
For an analysis of previous CCP failures and near-misses, see Gregory 2014.
Elliot (2013) states: “One of the key ways in which CCPs are distinguished from most other financial firms is that their obligations to their members, and vice versa, are governed by a central rulebook.”
Papathanassiou (2016) points to the asymmetries surrounding FMI rules on default procedures in their interaction with crisis management regimes.
A legislative proposal on resolution regimes specific to CCPs was put forward by the European Commission in November 2016, “Proposal for a Regulation of the European Parliament and of the Council on a Framework for the Recovery and Resolution of Central Counterparties and Amending Regulations (EU) No. 1095/2010, (EU) No. 648/2012, and (EU) 2015/2365” (EC 2016).
This feature plays a crucial role in CCPs’ recovery and resolution arrangements. As in the case of default of a CCP participant, the CCP will need to close out its unmatched positions and return to a matched book by offsetting or hedging transactions or by auctioning the positions to nondefaulting participants. If these options are not available or fail, the CCP would apply several tools under its rulebook (as examined later in this section), lest its own financial soundness be endangered.
Although in this specific instance the term CCP participant refers to a clearing member of the CCP, the expression is used throughout the chapter to include more generally the users of a CCP’s clearing service, either directly as a clearing member of the CCP, or indirectly as a client of clearing member. For a similar definition, see the glossary attached to the CCP Resolution Guidance (FSB 2017).
Initial margin is defined by the Principles for Financial Market Infrastructures (Committee on Payments and Market Infrastructures [CPMI]/International Organization of Securities Commission [IOSCO] 2012) as the “collateral that is collected to cover potential changes in the value of each participant’s position (that is, potential future exposure) over the appropriate close-out period in the event the participant defaults.” To reflect the exposure from changes in market prices over the life of a cleared contract (which may be sizable in the case of derivatives contracts), “variation margin” payments are made, whereby a CCP participant whose net position has fallen in value pays to the CCP the value of this decrease (and, conversely, a variation margin is paid by the CCP to participants whose net positions have increased in value). Upon a participant’s default and failure to pay variation margin, the CCP will be exposed to changes in the market value of its unmatched positions. The initial margin serves to protect it against this contingent market risk for losses that may be incurred between the point that a CCP participant defaults and fails to provide variation margin and the point at which the CCP returns to a matched book by offsetting/hedging transactions or by auctioning the defaulting participant’s position.” Initial margin is a good faith deposit on future performance, typically considered to be client money; this is a key reason why its “haircutting” is viewed as problematic, as explained in Box 7.1.
See also Regulation 648/2012, art. 45 (4), of the European Parliament and of the Council on OTC derivatives, central counterparties, and trade repositories: “a CCP shall use dedicated own resources before using the default fund contributions of the non-defaulting clearing members.”
The PFMIs were published in April 2012 by the Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions (CPMI/IOSCO 2012).
See the report on “Recovery of financial market infrastructures” (the “Recovery Report”), published in October 2014 by the CPMI and the Board of the IOSCO. “Recovery is defined as the actions of an FMI, consistent with its rules, procedures, and ex ante contractual arrangements, to address any uncovered loss, liquidity shortfall or capital inadequacy, whether arising from participant default or other causes . . . to restore and maintain the FMI’s viability as a going concern.”
Elliott (2013) defines loss allocation rules (or end-of-the-waterfall rules) as the rules setting out—in the CCP rulebook—how losses exceeding the CCP’s prefunded default resources are to be allocated between participants. For the purposes of this chapter, loss allocation rules include prefunded default resources and the arrangements relating to uncovered losses.
Principle 4 of the PFMIs requires that CCPs involved in activities with more complex risk profiles or that are systemically important in multiple jurisdictions should maintain financial resources sufficient to cover at least the default of their two largest participants in extreme but plausible market conditions. Furthermore, the Recovery Report (CPMI/IOSCO 2014) requires FMIs to have a set of recovery tools that is comprehensive and effective in allowing the FMI, where relevant, to allocate any uncovered losses and cover liquidity shortfalls.
This may also ensure that there are sufficient loss-absorbing resources available in resolution. See the FMI Annex (FSB 2014, Annex, para. 4.3) and the CCP Resolution Guidance (FSB 2017, para. 3), according to which entry into resolution should be possible if recovery measures are not likely to return the FMI to viability or they are otherwise likely to compromise financial stability. The FSB August 2016 Discussion Note on “Essential Aspects of CCP Resolution Planning” (FSB 2016) recognizes that recovery may fail at any point in the waterfall, or there may be confidence or financial stability issues at any point in the waterfall, so that resolution becomes the necessary option.
The FSB, CPMI, and IOSCO have paid attention to the interaction between the CPMI-IOSCO standards on CCP recovery and recovery planning, on the one hand, and those of the FSB on resolution and resolution planning, on the other hand, to ensure consistency between these two sets of guidance. See their common statement, dated July 5, 2017 (“Chairs’ Report on the Implementation of the Joint Workplan for Strengthening the Resilience, Recovery and Resolvability of Central Counterparties”).
Under a variant of this approach, the CCP and its participants would consent in the CCP rulebook to an unbounded flexibility governing the CCP resolution process.
These approaches may give rise to different implications on the compensation under the “no creditor worse off than in liquidation” (NCWOL) safeguard. In principle, when the resolution authority departs from the loss allocation arrangements contractually agreed in the CCP rulebook—unless such departure is contemplated in the rulebook or in the statutory resolution framework—the risk of successful compensation claims under the NCWOL safeguard may be higher. Adapting the NCWOL safeguard to resolution of CCPs is complex, given the existence for CCPs of loss allocation arrangements and the need to determine how they would interact with the safeguard and with the evaluation of the counterfactual liquidation scenario. The CCP Resolution Guidance (FSB 2017) provides that, for the purposes of determining whether a participant, equity holder, or creditor is worse off as a result of resolution measures than in liquidation of the CCP under applicable insolvency law, the assessment of the losses that would have been incurred or the recoveries that would have been made if the CCP had been subject to liquidation should assume the full application of the CCP’s rules and arrangements for loss allocation.
The question of whether the resolution authority should follow the order of allocation of losses set out in the CCP rulebook is heavily influenced by the analysis of whether the financial resources available under the CCPs’ rules and arrangements are adequate to achieve the objectives of resolution. In the CCP Resolution Guidance (FSB 2017), the FSB states that it will continue its work on financial resources for CCP resolution and determine by the end of 2018 the need for any additional guidance. On the latest developments, see the discussion paper: FSB 2018.
Singh and Turing (2017) have observed how the current policy debate has difficulty in distinguishing the two concepts of recovery and resolution. These authors propose alternative proposals to CCP resolution, which include an enhanced layer of loss-absorbing capital.
See the CCP Resolution Guidance (FSB 2017, para. 2.2).
Certain tools may also be reserved specifically for resolution processes, such as statutory cash calls in resolution. See the CCP Resolution Guidance (FSB 2017, para. 2.9).
See the Recovery Report (CPMI/IOSCO 2014, sec. 4.6).
Some CCP rulebooks, however, provide for loss allocation arrangements among CCP participants, but only for certain limited cases of nondefault losses (for example, investment losses).
Moreover, from a financial stability perspective, the imposition of losses (such as through hair-cutting variation margin payments) on those CCP participants that are in the money may have destabilizing effects.
Particularly in the absence of loss allocation arrangements, the general liability regime applicable in the relevant jurisdiction (including with respect to rules on willful misconduct, negligence, and force majeure) would be relevant to apportion any liability arising from the nondefault loss.
See the CCP Resolution Guidance (FSB 2017, para. 2.13 and 2.14). The features of a resolution cash call have not yet been fully developed. As an ex post mandatory contribution, the resolution cash call may, to some extent, resemble the function of a resolution fund in a bank resolution, with the CCP participants (as opposed to the banking industry) being levied.
For an analysis of the interaction between the CCP default management process in recovery, including through write-down of equity, and the CCP resolution, see Duffie 2014.
The Recovery Report (CPMI/IOSCO 2014) requires FMI to have “a set of recovery tools that is comprehensive and effective in allowing the FMI to, where relevant, allocate any uncovered losses and cover liquidity shortfalls.”
See the CCP Resolution Guidance (FSB 2017, para. 4.1): “[It] should be clear and transparent at which point in resolution any remaining equity would be written down, for example, no later than at the point at which prefunded and committed financial resources such as cash calls in recovery available under the CCPs’ rules and arrangements would have been exhausted.” The introduction to the CCP Resolution Guidance states that the FSB will consider the need for further guidance on the treatment of CCP equity in resolution. For the latest developments, see the discussion paper: FSB 2018.
Conversely, once the CCP has paid the final termination amounts to the relevant participants in the affected siloed clearing service, its obligations would be extinguished and the participants would have no further recourse to the CCP (International Swaps and Derivatives Association [ISDA] 2013). ISDA also examines the existence of “full recourse clearing service structures,” in which a separate legal entity is established for a specific product.
The CCP Resolution Guidance (FSB 2017, para. 5.5) recommends that the assessment of the counterfactual relevant for the NCWOL should take into account the limited recourse provisions on the segregation of clearing services.
The FMI Annex (FSB 2014, Annex 4.13 and 11.6[vii]) seems to contemplate the possibility that resolution measures could split netting sets, while recommending that the impact of that splitting on liquidity and collateral requirements is considered, and subject to, the observance of legal safeguards. A different and seemingly unexplored issue relates to selective tear-up in recovery, and to its possible enforceability in case of insolvency of the defaulting member.
See also International Swaps and Derivatives Association/The Clearing House (2016): “[I]t is important that CCPs structure clearing silos to include all contracts for which the CCP permits cross-margining or portfolio margining and that are eligible for treatment by clearing participants as a single netting set for CCP margin and regulatory capital purposes.”
Continuity of critical services, including through access to FMIs, is a key objective of resolution processes, as recognized by the Key Attributes, and efforts are underway to achieve this by aligning CCP rules and arrangements to resolution regimes. See the “Guidance on Continuity of Access to Financial Market Infrastructures (‘FMIs’) for a Firm in Resolution” (FSB 2017).
Key Attribute 7 recommends jurisdictions have in place transparent and expedited mechanisms to give prompt legal effects to foreign resolution actions, either by a recognition process or by taking measures that support the resolution actions adopted by the foreign resolution authority.
Under the PFMI (Principle 1), FMIs are required to have rules, procedures, and contracts that are enforceable in all relevant jurisdictions, and FMIs with cross-border business should identify and mitigate risks arising from any potential conflict of laws across jurisdictions. Under the concept of legal basis relevant for Principle 1, the legal framework of an FMI includes laws and regulations governing default procedures and the resolution of a CCP. Observance by FMIs of Principle 1 would therefore help ensure the cross-border effectiveness of resolution actions over a CCP.
See the Consultative Guidance (FSB 2017, sec. xx).