Firms face options before the introduction of European mandatory clearing
By Tomas Kindler, head of clearing services, SIX Securities Services.
How can central counterparties be best encouraged to mitigate the risksderiving from their growing importance to financial markets?
The wider use of centralcounterparties (CCPs), particularly for clearing over-the-counter derivatives transactions,is a trend reinforced by the G20 and encouraged by regulators more broadly. Thepros and cons of this trend have received numerous media airings. Taking it asa given, therefore, I would like to explore in more detail the consequences of thegrowing importance of CCPs in the securities landscape. Specifically, I want toaddress two issues: the risk implications of greater CCP use; and how best toencourage a healthy engagement with these risks by the CCPs themselves.
Growth in the use of CCPs is evident acrossdifferent asset classes. In the process, risk is
being transferred from banks to CCPs.
The International Organisation of Securities Commissions (Iosco), whichis 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, particularlythe management of counterparty and credit risks, is essential to avoid thepossible failure of a CCP, which could present a serious threat to financialstability.”
CPMI-Iosco’s April 2012 Principles for Financial MarketInfrastructures (PFMI) already specified that CCPs must be able to withstandthe collapse of their two largest members.
While many jurisdictions have yet to mandatecentral clearing, voluntary clearing is on the rise. At the same time, a surge in CCP numbers meansthe market is set to fragment further. We welcome competition, but we also needto ensure that risk mitigation is not hampered by, on the one hand, marketparticipants having to disperse their collateral across more and more CCPs and,on the other hand, CCPs not indulging in unrealistic pricing strategies toattract business in an increasingly competitive environment.
The Financial Stability Board (FSB) has specifiedfour guiding principles for the central clearing ecosystem: fair and openaccess to central clearing; cooperative oversight by regulators; a globalresolution and recovery framework; and appropriate liquidity arrangements.
In October 2014, CPMI-IOSCO issued guidelines forFMI resolution and recovery regimes. Anticipating the issues arising from newdefault, loss allocation and recovery mechanisms, CPMI-Iosco recommended that FMIs draw up “clear processes” for managingconflicts of interests with stakeholders. FMIs must also have measures in placefor an orderly wind-down, in case their recovery plan fails, and should be ableto enter resolution as and when supervisors dictate.
Significantpractical attention has already been given to these risks by both regulatorsand many of the CCPs. At SIX x-clear, for example, we have made a number ofchanges to our risk management processes to take greater account of liquidityand concentration risks. Although the vast majority of our volume issecurities, we do see derivatives clearing as a potential growth area and haveborne this in mind when implementing changes. In compliance with Swiss law, SIXx-clear has compiled a recovery and resolution plan that includes earlywarnings on capital or liquidity issues, detailed risk mitigation measures andan orderly wind down. X-clear is also compliant with the European MarketInfrastructure Regulation (Emir), while awaiting European Commissionconfirmation of Swiss regulatory equivalence.
Under Emir,25% of CCP capital must be used to absorb losses ahead of member funds. USregulators have not ruled on the issue. As a result, different approaches areevident in the market. Some clearing members have called forCCPs to put more of their capital at risk to counteract any competitive tendencyto lower risk standards, and to establish a separate recapitalisation fund.
Others have suggested that if pre-agreed funds areinsufficient in the event of a default, the matched book should immediately bediscarded and the defaulter’s positions auctioned off to facilitate a swiftreturn of margin to minimise end-investor losses.
We expectthe focus on better oversight and regulation of CCPs to sharpen. With centralclearing 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 onlyintensify. We should accept that regulators will lead the charge in the debateover risk models and appropriate levels of collateralisation in the event ofanother crisis situation presenting itself.
Although thenumber of CCPs may increase in the short- to medium term, some consolidationamong clearing houses is inevitable in due course. Since over-the-counter transactions arenot linked to a trading venue, it is up to the market participants to selecttheir provider of choice and, together with the growing attention paid to riskmanagement frameworks, this should result in gradual consolidation around a fewproviders. Those clearing houses with deep collateral reserves, wide marketreach, robust risk models and viable business models will be the survivors.
