Agreeing a structure for the recovery and resolution of central counterparties (CCPs) was never going to be quick or easy. CCPs now sit at the center of the derivatives market ecosystem, with the vast majority of trades now cleared. Having a well-thought-out, robust and transparent plan for dealing with a distressed or failing clearing house is therefore essential from a financial stability perspective. Fortunately, EU legislators are within touching distance of achieving that following recent agreement on a comprehensive recovery and resolution framework.
More than three years after proposed rules were originally published by the European Commission, the package of measures agreed by the Council of the European Union and the European Parliament strikes a good balance between the positions of the two legislative bodies, and includes a number of critical safeguards. Among the most far-reaching is the decision to bolster the level of protection in the event of a clearing member default by requiring CCPs to commit a second tranche of their own capital to absorb losses.
This is a big change from existing practices, where CCPs contribute a single tranche of capital that would usually be tapped once the defaulter’s initial margin and default fund contributions are depleted. Instead, the new layer of so-called skin-in-the-game (SITG) would sit near the bottom of the waterfall, after the various clearing member resources are exhausted but before any recovery tools like variation margin gains haircutting (VMGH) can be used. By mandating a second tier of SITG, the intention is to ensure the interests of clearing houses and clearing participants are very closely aligned – both will have clear incentives to ensure the highest standards of CCP risk management and an appropriate sizing of the default fund.
Another important development is the decision to limit the list of tools available to resolution authorities so it excludes the haircutting of initial margin and the forced allocation of positions. We have long argued that these measures could actually be counterproductive by encouraging firms to exit their positions at the first sign of trouble in order to reduce the initial margin that could be subject to a haircut, potentially making default management more difficult for the CCP. Instead, authorities can choose from a list of permitted resolution measures that includes VMGH, the partial tear-up of trades, the sale of the CCP or parts of its business or the creation of a bridge CCP.
Cash calls to clearing members are also an option, but there had been concern about the potential for unlimited amounts of cash to be demanded from clearing members in the worst case – a pro-cyclical requirement that could have caused additional stress in the system. Instead, the council and parliament agreed to cap the amount at two times the default fund contribution. While the industry would have preferred a one-times-the-default-fund-contribution cap, the fact there’s a limit at all is a big step in the right direction.
While most of the framework relates to losses that arise as a result of a clearing member default, the framework also covers non-default losses – those relating to events like fraud or a cybersecurity breach, for example. Importantly, the legislation makes clear that losses should be absorbed by regulatory capital instruments and should be allocated to shareholders, rather than being absorbed by default resources contributed by clearing members and their clients.
There are some areas where further changes could have been made, however. For example, some market participants had argued that the regulation should allow for clearing members and their clients to receive compensation for any losses they rack up as a result of the recovery and resolution process – a measure that was only included in the agreed council/parliament text in a very restricted form.
Despite this, the legislation is a landmark development that will help ensure stability in the event a systemically important CCP is in distress. We commend EU legislators for bringing this to fruition, and we look forward to providing input as regulators now turn to fleshing out the technical details of the rules.
Join a virtual conference on the EU CCP recovery and resolution regulation on August 4. Click here for details.
 ISDA’s comment letters on the legislation cover the positions of our members on the buy and sell side. They do not reflect the views of many CCPs, and many of the CCPs are in disagreement with the views
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