Both Dodd-Frank and the European Union’s Bank Resolution and Recovery Directive (BRRD) demand systemically important banks have in place Living Wills to enable an orderly wind-down in a crisis event with limited contagion on the broader financial markets. The systemic importance of CCPs – given the massive volumes of over-the-counter (OTC) derivatives they are now clearing post-Dodd-Frank and European Market Infrastructure Regulation (EMIR) – should also be obliged to have Living Wills.
“I believe Living Wills need to be introduced for CCPs and these should clearly outline what they would do in a crisis situation. Admittedly, it can be very difficult to plan for all scenarios, but a number of adverse situations can be accounted for. CCPs should formalise what they would do in a crisis situation and have a concise recovery and resolution plan in place. Most CCPs already have this to an extent but it would be a positive step if it became more formalised,” said Dennis McLaughlin, chief risk officer at LCH.
Living wills would not just be welcomed by regulators, but clearing members too. “Our clearing members include banks who must have their own Living Wills through Dodd-Frank or the EU’s BRRD. Clearing members often come to us when they are writing their Living Wills and ask what our recovery plans are, and whether we have a formal document outlining them. As such, a formalised Living Will assists CCPs in meeting these client demands,” commented McLaughlin.
A number of factors could precipitate a CCP failure. An LCH paper – “Recovery and Resolution: A Framework for CCPs” – identified clearing member default; liquidity shortfalls arising through a clearing member default; investment losses accrued through exposure to the repo market or to a repo market counterparty; investment losses due to CCP exposure to a bond issuer; operational risks such as a cyber-threat, fraud or margin call error; legal risk; failure of a custodian or settlement platform; failure at a settlement bank or concentration bank; Central Bank bond buying and quantitative easing programmes distorting the risk premium in markets and potentially putting downward pressure on margins thereby weakening CCPs; and a failure by a vendor, service provider or IT supplier.
“Discussions about the failure of a CCP have broadly focused on what would happen if a clearing member failed. This is a mature and well developed discussion, and many CCPs would point out that they have defences like initial and variation margin, guarantee funds, and other risk waterfalls to mitigate this. The paper set out to highlight some of the other risks and solutions,” said McLaughlin.
In addition to Living Wills, some have urged CCPs to put more skin in the game or raise further capital. The European Commission, for example, has encouraged CCPs to increase their Total Loss Absorbing Capacity (TLAC) should they burn through their default waterfalls. The Committee on Payments and Market Infrastructure (CPMI) and International Organisation of Securities Commissions (IOSCO) stated CCPs should be allowed to replenish funds it uses after an adverse market event which could be through raising equity capital or additional cash calls from members.
J.P. Morgan published a paper in 2014 demanding CCPs put more of their own capital into the guarantee fund. It advised CCPs contribute more than 10% of member contributions or the largest single clearing member contribution into the guarantee fund so as to ensure enhanced risk management. It also said CCPs and their members should boost capital in a re-capitalisation fund, a resource that could be deployed if the risk waterfall’s capital has been exhausted. Papers by the buy-side including Pimco and Blackrock have made similar recommendations. However, CCPs – under EMIR – must contribute at least 25% of their regulatory capital and this will be deployed ahead of any contributions from non-defaulting clearing members in a crisis.
“CCPs already have a number of policies to ensure interests are aligned. For example, senior management at a CCP are financially incentivised to prevent losses over a certain amount in terms of skin in the game. CCPs are not trading houses. Forcing CCPs to hold more of their own capital would lead to reduced Return on Equity (ROE). This would mean CCPs may be unable to meet their shareholders’ obligations and it would be difficult for a CCP to operate in the private sector. The alternative would be that CCPs may have to become public sector bodies if such capital requirements are imposed. This would be contrary to various governments’ promises that public money will not be used in any future crises,” said McLaughlin.
All of this comes following comments by the Bank for International Settlements (BIS) and IOSCO that CCP stress testing did not devote enough attention to potential liquidity squeezes. BIS and IOSCO also suggested some CCPs did not have sufficient capital to keep operating during market crises. BIS and IOSCO have advised changes be implemented at CCPs by the end of the year. Nonetheless, BIS and IOSCO did not recommend Living Wills be created.