On May 28, ISDA and the Futures Industry Association (FIA) published a paper regarding partial-tear up (PTU). The paper includes a comparison between PTU and other rebalancing tools and how PTU could evolve.
Under business-as-usual conditions, the central counterparty (CCP) is the seller to every buyer and buyer to every seller and therefore has a matched book. For every position/contract with a member, there is an equal and opposite position/contract with another member. This means the CCP has no market risk. If a member of a CCP defaults, this member cannot service its positions anymore and the CCP no longer has a matched book and consequently now is exposed to market risk. With every market move, the CCP will have to pay or receive variation margin on behalf of the defaulter.
The CCP will, as part of its default management process, try to sell the defaulter’s positions/contracts. This can be done either via a central limit order book, by using a broker, by a direct sale, by running an auction, or by a combination of these approaches. Under all these options, the positions/contracts in the defaulter’s portfolio will be sold and a market price established.
It is possible that the CCP may find it difficult to re-establish a matched book. In this very extreme situation, there are a number of possible tools for derivatives the CCP can use to restore a matched book: partial tear-up and forced allocation, invoicing back and possibly cash settlement.
This paper describes the tools to restore a matched book and reviews these tools against some key principles and criteria:
Equitable risk distribution
Impact on financial stability
Incentives for participants
ISDA and FIA conclude that PTU is the fairest tool with the best incentive structure. However, the associations believe that, depending on the asset class, PTU could be adapted and improved and propose potential improvements.
The considerations in this paper need to be evaluated based on the nuances of specific products, such as physically-settled repos, cash equities, foreign exchange and swaps, subject to compression, as well as market depth, market liquidity, open interest and maturity of products, etc.