The International Swaps and Derivatives Association (ISDA), The Futures Industry Association (FIA) and the Institute of International Finance (IIF and, together with ISDA and FIA, the Associations) represent the largest number of participants in national and global clearing, banking and financial markets. This incentive analysis is following the Associations’ response to the FSB discussion paper “Financial resources to support CCP resolution and the treatment of CCP equity in resolution” (the discussion paper).
This analysis covers the positions of our members on the buy-side and sell-side. The paper does not reflect the views of many CCPs, and many of the CCPs are in disagreement with the views expressed herein.
When considering recovery and resolution of CCPs, it is important not to look at CCP recovery and resolution in isolation, but to ensure the stability of the whole market and that incentives are aligned between all actors across both phases. In this paper we will review tools and processes around CCP recovery and resolution and analyze the incentives and disincentives they would each create for actions by
Clearing members and
We will also review how these tools may be effected based on various legal structures, especially regarding CCPs with several clearing silos in one legal entity.
We have not covered the impact of tools for recovery and resolution on continuity of critical clearing services following resolution. We agree with the assessment in the discussion paper that those services can and should be covered by service contracts that include resolution, and that these topics will have to be addressed during resolution planning and resolvability assessments.
The analysis confirms that no tool is without trade-offs and disadvantages. That being said, however, there is strong support from members of the Associations, both sell-side and buy-side firms, that initial margin haircutting (IMH) and forced allocation raise significant concerns for market stability. As for variation margin gains haircutting (VMGH), which should only apply to suitable products, there are differences in members’ views. Some members believe that due to, among other things, the potentially pro-cyclical and destabilizing nature of VMGH, it should be reserved for use on a very limited basis by the resolution authority (RA). Other Association members believe that a CCP should have the flexibility to use VMGH in recovery, subject to regulatory oversight by the CCP’s supervisor, and that restricting use of the tool in recovery could result in the need for earlier entry into resolution, which they believe would also be destabilizing.
A resolution cash call might provide additional resources to the RA. However, incentives among the stakeholders listed above do not align very well if this tool is available, and many members believe cash calls are not suitable for CCP recapitalization (particularly if clearing members were to receive nothing in exchange for their cash).
The size of “skin-in-the-game” (SITG), the tranche of CCP funds in the default waterfall, is still being debated between clearing participants (clearing members and their clients) and CCPs, but we believe that the general incentives provided by SITG to align interests between CCP and participants are not disputed.
Members also strongly support providing compensation to clearing participants who bear losses in excess of clearing member default fund contributions and (capped) assessments and believe that compensation would provide an equitable solution as well as incentives for clearing participants to support the default management process, recovery and resolution.
Finally, the Associations wish to highlight the request made in their response to the discussion paper that the FSB re-evaluate the appropriateness of extending the no creditor worse off than in liquidation (NCWOL) safeguard to equity. The safeguard originated as a means of reducing the likelihood of litigation by creditors challenging a RA’s deviation from the requirement of pari passu treatment of similarly situated creditors, and it is not at all clear why equity holders should be entitled to anything more than the residual value of a remnant CCP, after the payment of all creditor claims (including compensation claims of clearing participants). At the very least, the FSB should clearly articulate what the legal basis would be for litigation by a CCP’s equity holder, and if it is unable to do so, it should limit the safeguard’s coverage to creditors.