By Tomas Kindler, head of clearing services, SIX Securities Services.
How can central counterparties be best encouraged to mitigate the risks deriving from their growing importance to financial markets?
The wider use of central counterparties (CCPs), particularly for clearing over-the-counter derivatives transactions, is a trend reinforced by the G20 and encouraged by regulators more broadly. The pros and cons of this trend have received numerous media airings. Taking it as a given, therefore, I would like to explore in more detail the consequences of the growing importance of CCPs in the securities landscape. Specifically, I want to address two issues: the risk implications of greater CCP use; and how best to encourage a healthy engagement with these risks by the CCPs themselves.Growth in the use of CCPs is evident across different asset classes. In the process, risk is being transferred from banks to CCPs. The International Organisation of Securities Commissions (Iosco), which is framing new standards for CCPs and other financial market infrastructures (FMIs) together with the Committee of Payment Market Infrastructures (CPMI) has already observed that “risk management, particularly the management of counterparty and credit risks, is essential to avoid the possible failure of a CCP, which could present a serious threat to financial stability.”
CPMI-Iosco’s April 2012 Principles for Financial Market Infrastructures (PFMI) already specified that CCPs must be able to withstand the collapse of their two largest members.
While many jurisdictions have yet to mandate central clearing, voluntary clearing is on the rise. At the same time, a surge in CCP numbers means the market is set to fragment further. We welcome competition, but we also need to ensure that risk mitigation is not hampered by, on the one hand, market participants having to disperse their collateral across more and more CCPs and, on the other hand, CCPs not indulging in unrealistic pricing strategies to attract business in an increasingly competitive environment.
The Financial Stability Board (FSB) has specified four guiding principles for the central clearing ecosystem: fair and open access to central clearing; cooperative oversight by regulators; a global resolution and recovery framework; and appropriate liquidity arrangements.
In October 2014, CPMI-IOSCO issued guidelines for FMI resolution and recovery regimes. Anticipating the issues arising from new default, loss allocation and recovery mechanisms, CPMI-Iosco recommended that FMIs draw up “clear processes” for managing conflicts of interests with stakeholders. FMIs must also have measures in place for an orderly wind-down, in case their recovery plan fails, and should be able to enter resolution as and when supervisors dictate.
Significant practical attention has already been given to these risks by both regulators and many of the CCPs. At SIX x-clear, for example, we have made a number of changes to our risk management processes to take greater account of liquidity and concentration risks. Although the vast majority of our volume is securities, we do see derivatives clearing as a potential growth area and have borne this in mind when implementing changes. In compliance with Swiss law, SIX x-clear has compiled a recovery and resolution plan that includes early warnings on capital or liquidity issues, detailed risk mitigation measures and an orderly wind down. X-clear is also compliant with the European Market Infrastructure Regulation (Emir), while awaiting European Commission confirmation of Swiss regulatory equivalence.
Under Emir, 25% of CCP capital must be used to absorb losses ahead of member funds. US regulators have not ruled on the issue. As a result, different approaches are evident in the market. Some clearing members have called for CCPs to put more of their capital at risk to counteract any competitive tendency to lower risk standards, and to establish a separate recapitalisation fund.
Others have suggested that if pre-agreed funds are insufficient in the event of a default, the matched book should immediately be discarded and the defaulter’s positions auctioned off to facilitate a swift return of margin to minimise end-investor losses.
We expect the focus on better oversight and regulation of CCPs to sharpen. With central clearing of interest rate swaps due to start for clearing members in Europe in early 2016, the focus on the stability and transparency of CCPs will only intensify. We should accept that regulators will lead the charge in the debate over risk models and appropriate levels of collateralisation in the event of another crisis situation presenting itself.
Although the number of CCPs may increase in the short- to medium term, some consolidation among clearing houses is inevitable in due course. Since over-the-counter transactions are not linked to a trading venue, it is up to the market participants to select their provider of choice and, together with the growing attention paid to risk management frameworks, this should result in gradual consolidation around a few providers. Those clearing houses with deep collateral reserves, wide market reach, robust risk models and viable business models will be the survivors.