European Commission, Director, Financial Markets Directorate
Bank of England, Executive Director, Resolution
Danuta Maria Hübner
European Parliament, MEP, Committee on Economic and Monetary Affairs & Chair of the Committee on Constitutional Affairs
Banque de France, Deputy Director General for Financial Stability and Operations
European Securities and Markets Authority, Executive Director
ICE Clear Europe, Director of Regulatory Policy
HSBC Bank plc, Director CCP
JP Morgan Chase & Co, Chief Regulatory Affairs Officer
The Depository Trust & Clearing Corporation, Vice Chairman
Detailed SummaryThe Chair introduced the discussion as focusing on three main themes: the present situation of CCPs and their resilience; the recovery and resolution framework proposed by the EU Commission (EC); and the future for European CCPs in a post Brexit scenario.
1. Ensuring CCP resilience
1.1. Implementation of the Principles for Financial Market Infrastructures (PFMI)1 in EU CCPs
An official explained that the market sees CCPs concentrating an increasing amount of liquidity and credit risk, which is part of the arrangements put in place after the crisis for the purpose of having a safe global financial system. CPMI together with IOSCO devised a specific three level approach to monitor the implementation of PFMIs. Level one is to check the actual implementation of the PFMIs in the local legal framework; level two is to check the consistency of local rules with the PFMIs; and level three is to check the consistency of the local rules.
Last year CPMI/IOSCO issued a level three assessment of the situation of 10 CCPs representing eight jurisdictions, including European CCPs. The review focused on a number of areas: governance and risk management, credit and liquidity risk, stress testing of liquidity and credit risk, the coverage of credit and liquidity risks, margin practices, collateral issues and recovery planning. The outcome was satisfactory, but there were still shortcomings. One is a lack of clear arrangements regarding liquidity stress testing. Another is that there are cases where the CCPs do not fulfil the requirements for the coverage of credit and liquidity resources. These issues do not concern European CCPs, which are doing well except for recovery planning, which is an issue for all CCPs and which will be improved with the upcoming implementation of the CCP recovery and resolution (CCP R&R) framework.
An industry representative confirmed that European CCPs are implementing PFMIs and they are doing well in terms of resilience, mostly thanks to EMIR. Some things could be done better, on a global basis, such as the transparency of CCPs.
Recovery is still a work in progress. Some European CCPs already have the tools and rulebook implemented; others are either in the process of doing so or waiting for the outcome of future regulation.
1.2. CCP stress tests
A regulator stated that last year ESMA conducted the first EU wide CCP stress test. CCPs are required under EMIR to perform daily stress tests of their portfolio in particular, but there had been no previous investigation of the interconnectivity between CCPs and how they would deal with certain stresses, together with the clearing members. In particular, ESMA looked at how the CCPs would be affected by counterparty and credit risk issues.
The lessons learned from ESMA’s first stress tests will be used in looking at how to improve the 2017 exercise, to which liquidity stress will be added. They will be examining the different functions or entities that are relevant to the liquidity profile of the CCP, including clearing members, liquidity and other service providers.
ESMA aims to capture the systemic dimension of liquidity risk in addition to the analysis of the resilience of the individual CCPs, which will enable them to identify potential shortcomings with systemic implications across different CCPs. They have worked closely with the ESRB, which has provided internally consistent market stress scenarios that ESMA is now implementing into the stress test. Considering the additional challenge from the extension of the scope to include liquidity risk, ESMA has also redesigned and strengthened the validation process of the data received from the CCPs to closely involve the national competent authorities (NCAs) in ensuring they ultimately have a dataset and results that are properly quality checked.
The new exercise will cover the 17 authorised EU CCPs and all cleared products. The analysis will be complemented by a reverse stress test, where ESMA will increase the number of defaulting entities and the severity of any shocks beyond what would be considered the base case scenario in order to better identify the breaking point of the system.
ESMA will also assess the possibility of second round effects on non defaulting members via loss sharing arrangements and run a network analysis to assess the degree of interconnectivity of the CCPs, through common participants. The results will give insight into the overall resilience of the system and help to determine the potential need for further recommendations that they, as regulators, can make to the CCPs to further improve their resilience and preparedness.
ESMA expects to publish the final report on the second stress test exercise by the end of 2017 and will detail at that time how the European CCPs have fared in the enlarged stress test that also looks at liquidity.
An industry representative commented that stress test scenarios are very differentiated and not sufficiently unified at the global level. IOSCO observed that and produced additional guidance last year, which should help to bridge the gap. Of particular interest are the rules to let participants be involved in the review of the model and of risk management framework changes, which should also improve transparency. There is also more detailed guidance for margin framework stress testing in particular.
2. The CCP recovery and resolution (CCP R&R) framework proposal
The Chair commented that, although EU CCPs appear to be in good shape, a failure can never be totally excluded, which is why the EC still saw the need for a proposal to better define the framework for recovery and resolution.
Speakers on the panel generally commended the EC for its proposal and commented on different aspects of the proposed framework.
A regulator stated that having a debate on this proposal is important in order to get it right. It is the first proposal which, on a regional basis, tries to implement some of the standards that have been developed at a global level regarding the recovery and resolution of Financial Market Infrastructures (FMIs). The hope is that the market will never enter a situation where these tools are needed, but they are important to have available in advance of any potential failure.
A public representative was grateful for the international work (conducted by CPMI IOSCO and the FSB) that underpins the EU CCP R&R framework and emphasised that the EC proposal appropriately takes into account the international standards that have been defined, putting them into an appropriate framework. The proposal will now be run through Parliament and Council. The Parliament does not want to deviate too far from what has been defined. Safeguards are the key objective. One issue however is that the EC has put into annexes certain elements that are important. An annex is not a good place for substantial pieces of legislation, so the Parliament’s influence will most likely move them back into an article, which will give them much more substance and power. Improvements will be made, but hopefully they only be tweaks.
2.1. The risk of failure of a CCP in the EU is very remote
An industry representative explained that given the existing lines of defence of CCPs, a failure is not impossible, but is a very remote risk and this should be taken into account in the discussion about the recovery and resolution of CCPs.
CCPs have coped well with a number of major insolvencies, without using guarantee funds or other recovery tools. Some claim that CCPs are more unstable because of the introduction of OTC clearing, but that is false. OTC clearing is not new business. The greater part of activity at the dealer level was already cleared. There is this constant undertone that CCPs need more conservatism and resources, but this is not supported by the facts.
Another industry representative emphasised that before reaching any recovery or resolution scenario, a CCP will already have been through a Cover 2 default fund (i.e. a fund covering the default of the 2 largest clearing members of the CCP). Furthermore, there is also a one time incremental assessment of a size at least equivalent to that of the default fund. If the basic maths are done, this would correspond to Cover 4, which is substantial. In addition, given that the first clearing member is usually two to three times larger than the second largest clearing member, the reality is that they are able to cover six clearing member defaults with those two components (effectively Cover 6).
Much will therefore have occurred by the time they reach the tools described in the new CCP R&R proposal. Almost 50% of the losses should be covered in a context where the stress testing is correct. Those resources would be committed by clearing members.
A third industry speaker commented that at the point when the six largest clearing members have left a CCP, the fate of that CCP and the rules of the CCP would be the last concern of the public authorities because by then the whole financial system would be ‘a wreck’ and the authorities would be focusing on how to survive this chaos. Although this is quite an implausible scenario the speaker believed that the tools that would be used in that context need to be reconsidered.
An official stated that suc tools are in fact Cover 6 plus TLAC. The largest clearing members in CCPs are G SIBs who are subject to resolution planning. FMIs were already insulated in 2008 from failure by public bailouts of their clearing members. In the new regime, FMIs will be insulated from failure by the bail in of their clearing members. Alongside the debate on the adequacy of recovery and resolution resources within CCPs, an equally important part of the discussion is focused on how to provide for continuity of access in CCPs and FMIs for G SIBs going through resolution processes.
A public representative agreed that the situation is unlikely and that if it happens, it is likely to be in a globally catastrophic situation. In that context the one thing that is desired is legal certainty and that may be provided by the CCP R&R framework.
2.2. Relative importance of risk management, recovery and resolution
2.2.1. Recovery vs resolution
A public representative explained that in 2013 when the EU Parliament wrote an own initiative report on the recovery and resolution of CCPs, R&R was presented as ‘the last piece of the jigsaw”, which needs to be put it in place in order to keep all the incentives aligned all the way back up the chain. Ultimately, if that piece of the jigsaw is in place it is less likely to be needed, because legal certainty will be provided. If the incentives are correctly aligned, people will participate correctly at the default waterfall level and it should not be necessary to go further.
Ensuring that incentives remain aligned all the way through requires safeguards. The EU Parliament will want to put safeguards on when a taxpayer bailout can be used in particular. Currently, there is no indication as to when that could be used and the speaker would not want an authority to use it early in a recovery process.
An industry representative considered that the debate about CCPs was not being addressed in the right way. The emphasis should be placed on the recovery phase and not the resolution. The recovery framework has been refined over the four last years by CPMI/IOSCO in conjunction with the industry and recovery rules have been implemented by the speaker’s organisation for both default and non default losses. If they ever reached recovery, and possibly upstream from there, it is clear that resolution authorities would be in constant contact with them. For financial stability reasons it is necessary to assume that resolution authorities always stand ready to trigger resolution. But from a CCP perspective, they would like to make sure that there is not an excessive concentration on resolution which may undermine the possibility of addressing the problem at the recovery stage, with a sound recovery framework developed consistently with CPMI IOSCO principles. Care should be taken not to create an inevitable momentum towards resolution which would be detrimental for all stakeholders.
Another industry representative agreed that the CCP R&R regulation is ‘fairly light’ on recovery and focuses more on resolution. Previously much has been done to get recovery right. Resolution tools are exactly the same as the recovery ones in the CCP rulebook, the difference is who operates them. Although who operates the tools probably does not make a significant difference to the end result, having an impartial authority (the resolution authority) in charge of resolution is important. The market may indeed not be comfortable if the pain of resolution is applied by the entity that is at the same time fighting for its survival, because the incentives would not be right. Moreover the market needs to know through the resolution plan how the authority is going to operate.
The industry representative was also in favour of an earlier entry of the resolution authority into the process; otherwise the resolution authority may not have enough resources at its disposal. Earlier entry may give resolution more chance to succeed.
An official stressed that clarity is needed on what is at stake, which is avoiding that the cost of failure of a privately owned and run enterprise should be borne by taxpayers. Additionally, if public authorities are pushing for credible resolution arrangements to be in place, this is not intended to interfere with private property rights but to encourage the market to solve its own problems in recovery. The representation that resolution is overstepping the mark in order to frustrate recovery is a misrepresentation; it is there to support recovery and help it work.
Recovery arrangements are in place in part because CPMI/IOSCO have decreed that loss allocation arrangements in CCPs need to be comprehensive, so that every liability in the CCP is involvedd in recovery, bar the equity of the CCP owner, which is protected at that stage. If the CCP has failed, then that position is clearly unsustainable. A cardinal principle of resolution is that losses are absorbed starting at the bottom of the credit hierarchy, which means equity, and then work their way up.
Putting those things together, the question arises of what the relationship is between recovery and resolution, the official stated. One would only step in to resolve a CCP if it was clear that recovery was not working. That means that the defaulting member’s positions have been auctioned and there is no clearing price for the auction, and no prospect of that price working its way down the waterfall. There is therefore a line at which the likelihood of entry into resolution gets higher, which is the point at which one chooses whether to do e.g. gains haircutting or a partial tear up. Currently however, because of the requirement for comprehensive loss allocation, these tools are included in the CCP recovery arrangements.
An industry player agreed that having a credible resolution framework makes it less likely that it will have to be used. Clearing members and CCPs should work hard not to reach that position in the first place.
2.2.2. The importance of risk management and governance for ensuring CCP resilience
An audience participant considered that there should be a strong focus on ongoing, aggressive and proactive supervision of CCPs. Whilst it is better to focus on recovery rather than resolution, it is better still to focus on risk management than recovery. The participant hopes that having a recovery and resolution plan does not undermine the incentive to have robust and ongoing supervision of CCPs so that when one clearing member even starts to tremble the supervisor is already involved, so that they do not reach the stage of being in recovery and then resolution.
An industry representative agreed. Much attention should be going upfront to the actual governance of how risks are brought on to the CCP given their central role in the financial system. It should be ensured that there is appropriate consistency regarding the collateral accepted, the way clearing members are involved and also concerning appropriate margins. It is fundamental not to have competition on risk management.
If the underlying quality of the collateral being liquidated is high, there will be no such thing as a failed auction. A failed auction can only occur when broad swathes of collateral are taken or when the margining is not appropriate. That means that given the quantum of derivatives clearing occurring in the EU, upfront risk management is essential.
A regulator mentioned that the core focus of EMIR is strong risk management and ensuring in the first place that the CCP is resilient, able to manage its risk, has the right collateral in place, and the waterfall is well defined.
Aggressive supervision is not the only important issue. Supervisors will become more involved as more potential risks face a CCP, and they will become deeply involved in the recovery process. Furthermore, not having competition on risk management is particularly important, in both a European and a global context. EMIR allows CCPs to compete, but this should not be on risk management. This principle is essential also at the global level.
Another industry representative mentioned, regarding competition on risk management, that major clearing members never tell a CCP, when doing a due diligence, that they are collecting too much margin; it is always the other way round.
A third industry speaker added that the difference between for profit and mutualised CCPs in their governance and relationship with their members and clients needs to be considered when working on R&R and a clear distinction must be made. The range of instruments available changes dramatically depending on the governance structure. In the mutualised world, all members are also shareholders, so the incentives are aligned, including for non default losses, because the members of the CCP are involved with the day to day management of the CCP.
2.3. Appropriateness of the toolbox proposed and of the related incentives
Members of the panel shared their views on the tools proposed in the CCP R&R framework and their appropriateness. They generally considered that the toolbox proposed makes sense, but that care should be taken of their potential implications, notably in terms of financial stability and achieving an appropriate alignment of interests.
An industry player considered that for many of the tools proposed (e.g. partial tear ups or variation gains haircutting), there needs to be more clarity regarding the implications for clearing members or other participants. There should be compensation, as part of the process through e.g. bail in debt or a piece of equity from the new organisation. Those impacted should become a senior claim creditor and step ahead of anyone else who might have a claim, in retribution for the money that has been committed to attempting to save the CCP. This would allow the maintenance of an alignment of interests.
Moreover care must be taken about the pro cyclical nature of these tools, all the more so that given the commonality of clearing members across all the CCPs around the globe, the failure of a given CCP will probably not happen in isolation, which requires considering interconnectedness carefully.
Another industry player added that clearing members are often those who are asked to contribute to recovery and resolution processes and it is not clear whether that always makes sense. The problem is partly that some tools do not help, and partly that too much burden is put on clearing members.
An official agreed that some tools have financial stability implications in the way they transmit the problem and risk management from inside the CCP out into the market in a rather unpredictable way. The CPMI-IOSCO approach recognises that before recovery tools are used, the public authorities should be consulted and have a right of veto. In the same way, public authorities should think hard as to whether they should allow recovery to run on using those tools or whether they should put a CCP into resolution at that point. That means staunching the bleeding in the sense that the defaulted members’ positions need to somehow be closed out probably through partial tear up. Then the CCP needs to be returned to a flat book and the default fund replenished, so that there is continuity for the cleared market within two or three days at the latest after the problem occurred. In the speaker’s view, some of the resources (i.e. cash call or gains haircutting resources) should be thought of as being cash compensation covering the cost for those subject to partial tear ups. In financial resources terms, they should not be left unbalanced.
A public representative emphasised that safeguards also need to be put in around the tools, and how and when they may be used. Politicians can certainly begin to put safeguards around the toolbox and notably VMGH (variation margin gains haircutting). Regarding investor money, there needs to be certainty as to who can use each tool and when it will be used. The speaker prefers investor money to be the last tool rather than the first.
Comments were made on specific tools proposed in the CCP R&R framework.
Regarding loss allocation tools, an industry representative emphasised that forced allocation of losses should not be part of the discussion because these losses would then go across the board to all participants in the CCP. A participant could end up in a position that it is not equipped to risk manage notably in the context of the failure of six of the largest clearing members of that CCP. That is an extraordinary risk, likely to be unmanageable and it could trigger a catastrophe.
Concerning gains haircutting, the industry speaker considered that, in the context of a resolution plan, this is taking resources that the CCP is not entitled to. Notably, the initial margin haircutting, which should be completely off the table, would be inconsistent with the ring fencing approach that exists in the bilateral environment. There is a possibility for VMGH in a limited way, but this should be a very specific usage and under the jurisdiction of the resolution authority, and should occur only after the CCP’s resources and equity have been exhausted.
Another industry representative added that VMGH is automatically a resolution tool if the resolution authority enters early, but the speaker disagreed with the incentives this would provide, since by construct it only incentivises individuals on one side of the transaction to close their positions and these are usually the ones who help the CCP to close the defaulter’s portfolio.
An official stressed that keeping initial margin haircutting in the toolbox runs the risk of providing the wrong incentives and may dis incentivise CCPs and clearing members from doing their own work and running adequate risk management frameworks and governance, and may even encourage some to refrain from clearing. This would go against the objective of increasing the share of central clearing in the market.
Finally, partial tear ups need to be carefully considered, an industry speaker emphasized. In the case of contract tear up, the CCP steps out of the middle and then there is a sudden open exposure to another counterparty. Partial tear-up can probably be used in a limited way to rebalance the book and get back to a matched book, and can likely be used at the tail end of the auction process, but who sets the pricing in the proposal has to be defined very specifically. The pricing can only be set by the resolution authority, otherwise interests are not aligned.
2.4. Flexibility vs predictability of the framework
Panellists stressed that having an appropriate balance between predictability and flexibility of the CCP R&R framework is essential.
An official emphasised that two things are needed: sufficient flexibility to react to unpredicted crises; and providing the right incentives for market participants and institutions. From the speaker’s perspective, the current proposal addresses the balance between predictability and flexibility in a satisfactory way, and, in principle, provides the right incentives. Moreover the flexibility conferred by the toolbox is fine. However, although it is quite acceptable to be able to use the tools depending on where the stress is, flexibility also means that, at some point, somebody has to decide what kind of tools need to be used. That imposes a significant responsibility on the shoulders of the resolution authority.
Another official considered that although some individuals advocate either predictability or flexibility, in truth, they are in ‘shades of grey’ territory.
The EC proposal strikes the right balance between flexibility and predictability, the speaker felt. It has the presumption that the resolution authority will apply the contractual waterfall. But deviation is permitted if the resolution authority considers it necessary on financial stability grounds, subject to a well drafted, robust no-creditor-worse-off (NCWO) standard in the proposal.
Some degree of predictability is favoured because it is good for, and incentivises recovery, and some predictability in the resolution planning also addresses any concern about balancing interests and not entering into a situation where ESMA is confronted with mediation and has minutes to do it. In addition there is an advantage with predictability in the rulebook in terms of there being clarity as to how the credit hierarchy applies to the CCP and who will bear losses, by what means, and in what order. It is not the statutory credit hierarchy that applies in these circumstances; it is the R&R rulebook. The rulebook also contains the standard against which the NCWO principle (i.e. the creditor safeguard as to what the resolution authority can do in resolution) is measured and it is essential that this should be set out in a full and clear way in the rulebook. With this there is less risk of NCWO claims, and this is important because speed is essential when resolving a CCP.
Predictability does not mean however that everything is mechanical and there is no discretion. The resolution authority should have some discretion over the timing of entry into resolution and the choice of tools at that point, whether to partially tear up or to try another auction. The resolution authority will most likely determine the scope and price of any partial tear up. Additionally, once back to a flat book and once the default fund is replaced, the resolution authority will then have to make decisions about restructuring and reorganising the CCP as it moves forward.
However, the need for flexibility is, to some extent, exaggerated, the official believed. The liabilities in the CCP are quite well defined and the losses need to be met somewhere. If not covered by taxpayers, they need to be paid for somehow, and there are limited choices. Cash calls on clearing members could be skipped, going directly to gains haircutting; this is an element of flexibility that is asked for by those who fear that cash calls may undermine clearing members and may lead to a negative outcome from a financial stability perspective. It is however important that if flexibility is to be exercised, it should be done with a strong NCWO safeguard.
Some industry representatives however stressed that prescriptiveness and having a presumptive path in addition to flexibility is essential.
An industry representative emphasised that given the importance of CCPs in the financial market infrastructure, defining a more specific and presumptive path in recovery and resolution, as to who has which powers, when, and which aspect of the waterfall is essential.
To the extent that it is possible for clearing members who bear the major portion of losses to measure the impact for them of coming onto the default loss waterfall, the question comes down to whether the cost is manageable. In the resolution plans of the speaker’s institution, they have to ensure that the resources are sufficient for them to be able to contribute if a CCP ultimately has default waterfall losses. Therefore the resources needed cannot be uncapped, with unlimited assessments, because that would be the equivalent of an open chequebook from one set of shareholders in support of another set; this is the case for for profit CCPs, but not the mutualised ones.
2.5. Issues associated with resolution colleges
Remarks were made regarding the functioning and decision making process in resolution colleges.
An official commented on the way resolution colleges operate in the European context. Resolution colleges sometimes have more than 20 members. One member can call for the binding intervention of ESMA, as long as it is agreed in the decision of the national authority. That power can make a resolution impracticable. There is probably a need to revise those types of arrangements and introduce some sort of quorum so as not to give so much power to a single member of the resolution college.
A regulator explained that the proposal tries to carefully balance who needs to be around the table, who can make decisions on which tools to use and how to use them. The national resolution authority ultimately takes the lead and makes decisions; however, these decisions potentially have huge implications for financial stability in other countries. It is not time efficient to involve too many people in the decision, but key people cannot be left out either. Getting the balance right is an essential issue.
The second issue is that there is a balance to be struck on mediation. If a participating member of the college sees that the tools being proposed by the national resolution authority would fundamentally undermine financial stability in their country, it is important for them to have the opportunity to fully voice that view. If that means first aligning other members of the college with their position, it could cost time. Again, there is a balance to be struck on having the right people around the table whilst ensuring that quick decisions can be taken. Ultimately it will be the responsibility of the Council and Parliament to get the balance right.
An audience participant emphasised that there are also issues about the resolution authority in the US. Two different regulators deal with supervision and resolution and having a whole new regulator come in, try to figure out a CCP, and then resolving it, is a risk.
2.6. Non default losses
An industry representative asked what the recovery and resolution plan should be when losses occur solely under the purview of the CCP management team itself relating for example to operating, cyber, investment and liquidity risks. Non default losses are distinct from the responsibility of any clearing members and they are an important piece of work on which more focus is needed. Questions include: where the resources are from a shock absorbency and basic capital perspective; whether they are the right size; whether enough work has been done collectively to ensure they are appropriate; whether they should be used; and where recapitalisation can come from in that case. Another question is whether there ought to be instruments that can support bail in ability related to those risks.
An official echoed the point on non default losses. Currently, the CCP equity would bear non default losses and, if unable to contain them, the CCP would enter an insolvency process. The recovery and resolution debate having highlighted that, is one of its benefits.
3. Possible need for specific requirements post Brexit regarding euro denominated clearing
The Chair then moved to the final question on whether there is a case, from a financial stability perspective, for Eurozone location requirements for euro denominated clearing activities.
An official believed that the location of euro denominated clearing activities is a relevant issue from a financial stability perspective. At present 30% of repos in euros are carried out in the UK; this proportion is more than 40% for CDS and more than 90% for OTC interest rate swaps. Clearing is crucial for the safe and smooth functioning of financial markets. After Brexit, the European authorities need to be able to exercise their financial stability mandate, in order to ensure that the financial system, including clearing activities and their impact on other segments of the market, function well in a smooth and safe way.
The question is how to ensure that, with clearing activities taking place in an offshore centre such as the UK the supervision powers of the different authorities concerned can be coordinated to ensure good cooperation post Brexit.
The speaker suggested a thought experiment. We are in the middle of a crisis under great stress. The CCP runs its models to calculate its margins, so there is a huge increase in margin to address the situation. In doing so, for a given sovereign debt in Europe, there may be the need to raise the credit risk spreads, which may have a pro cyclical effect, increasing the margin of the CCP. That situation is not theoretical, but happened in 2012 when they faced the huge stress in European sovereign bond markets. In that situation it is not certain that the interest of the European authorities is aligned with the interest of the UK authorities. The question arises of how to ensure that alignment of interest and whether it is possible. The speaker doubted that that would be possible because experience shows that it does not always work, hence the need for relocation.
The question is then how to organise the relocation of these activities. There are two aspects. One is the regulatory framework. Article 25 of EMIR, which concerns the question of the equivalence of third countries, could be changed to introduce the following requirement: CCPs could be recognised by the EU, provided that their clearing activity is denominated in an EU currency and does not go beyond a certain threshold. The statute of a qualifying CCP would be granted only to those that fulfil this requirement. The clearing members of the CCPs that do not respect the threshold would be subject to higher capital requirements. Overall, it is feasible from a purely regulatory and legal perspective.
There are other more operational aspects, which are how to organise the transfer of activity. There may be market participants particularly on the sales side saying that they will lose in terms of netting collateral. That requires further analysis, notably because the netting that is done at present across currencies can be replaced by portfolio margining between different types of instruments. All this needs to be further analysed, but is feasible, the official stated.
Some other panel members suggested that alternative solutions to location requirements should be considered.
For a public representative, a location policy is irrelevant in the current global financial market. What is needed is good governance and oversight, and cooperation between regulators is critical. Cooperation and oversight on key infrastructure is important, but there are ways to structure that without having to move and fragment liquidity, which would be a ‘retrograde step’ causing cost and risks to increase by taking activity back to one jurisdiction.
Talking about relocating on a geographical basis seems irrelevant at a time when the market is on the cusp of major technological changes, the public representative emphasized. There is much talk about distributed ledger technology (DLT) and how it might apply to settlement, clearing and post trade generally. The cloud and other technologies will also potentially improve efficiencies in the post trade space. Discussions should focus instead on governance, and how to cooperate globally to ensure that everyone is comfortable that the people overseeing the critical entities or market infrastructures concerned are doing the job correctly.
A regulator understood the concern expressed by the first speaker from the perspective of EU27 financial stability, and how that will work in the future. That needs to be recognised first and one cannot be satisfied by promises of future cooperation. Something specific is needed from a financial stability and currency perspective.
At the same time, the impact of a possible location policy for the ordinary functioning of the market and liquidity pools needs to be considered. Fragmenting a global market by location carries huge risks. This needs to be thoroughly assessed and other possible solutions besides relocation need to be considered. EU authorities rightly need oversight and supervision possibilities for entities that are clearing such a large part of the EU market. That needs to happen because in reality regulators have different incentives and possibilities of looking at things. There will always be a natural drive for national regulators first to focus on their primary objectives, related to their specific markets, and this needs to be considered. The US model is one that should be examined further. We will be in the case of a CCP from a third country, i.e. a foreign country needing to be recognised and supervised. Of course in that model there is a need to rely a great deal on the other regulator conducting the supervision on a home country basis, but there is the possibility of getting information and intervening if necessary.
An industry representative acknowledged the importance of the issues to be addressed and emphasised that location of clearing should not be a requirement, but a choice depending on the objectives pursued.
The clearing currently happening in the UK spans more than sterling and euro and includes USD, AUD and yen, so there are similar questions regarding other jurisdictions and currencies than the Euro. 90% of AUD interest rate swap clearing for example occurs in the UK, as well as a significant proportion of USD clearing. This activity clearly requires the right framework with transparency, registration and appropriate oversight to be in place.
Centralised clearing was put in place after the financial crisis to address risk management transparency, identify where risks hide in the system and create a framework for potential oversight. That also brought the benefits of better understanding risk, as well as providing more efficiency regarding risk management, collateral and liquidity management. These benefits are important for the clients of financial institutions who use derivatives to hedge their portfolios and manage their risks; they want to operate in a safe and sound environment and benefit from the lowest possible cost for these activities.
Fundamentally, given the business of CCPs, it must be ensured that there is appropriate margining throughout the cycle. Volatility in pro cyclical approaches should be avoided. In order to achieve the objectives of minimising risk, maximising netting and delivering best value to underlying participants in the marketplace, the right choices need to be made.
Regarding Brexit, there are major decisions to be made. It is not acceptable for the marketplace to come to a sudden halt or for capital to increase dramatically; otherwise the ability to conduct activity will decline. If the choice was made to move euro trades into the Eurozone, that would involve a major effort concerning contracts, operational issues and making sure that there is a coordinated reporting of positions so that the leg of transactions is not broken.
Most importantly, the participants must consider the possibility of having to double the default fund. Clearing members have to put up the default fund and, if CCPs run in parallel for a period of time because of a location requirement, that will double. Some initial estimates show that the move of euro trading onto the continent would increase collateral requirement by $77 billion. There are many aspects to take into account, but, the most important ones are risk management and the underlying purpose of what markets are supposed to be doing.
Another industry representative emphasised that supervisors need to ensure ex ante that CCP models are not pro cyclical. Regarding the location policy, the speaker considered it to be a ‘blunt tool’. It is costly and may also increase risks. If the initial margin, which a proxy for risks, increases overall, it means that the risk has increased. Netting is a powerful risk mitigation tool. If netting goes down, then there is less risk mitigation. Netting is something that should not be given up easily. There are different ways of dealing with the situation created by Brexit. The US clears a large amount of their USD swaps at LCH and this is accepted by the US authorities because there is appropriate supervision. Perhaps the way to go is to increase direct supervision. This could make sense because the current equivalence rules in EMIR do not give EU supervisors enough visibility and power. They can assess the situation at the beginning when they recognise the CCP, but this is more difficult going forward, and this is something that maybe needs to be changed.
A third industry representative suggested that there is a different way of looking at this issue. On the point of USD denominated interest rate swaps being traded in London, it is likely that USD, euros, sterling and AUD are traded in the UK because of liquidity factors. Moving to another location may disturb the liquidity of the marketplace, which would not be good for financial soundness and stability.
1. The PFMIs contain international standards for payment, clearing and settlement systems, including central counterparties. Issued by CPMI-IOSCO, these standards are designed to ensure that the infrastructures supporting global financial markets are sufficiently robust and thus well placed to withstand financial shocks.