The Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) have published a consultative report on the Recovery and resolution of financial market infrastructures (FMIs).
The bodies note that given their importance in the functioning of the global financial system, the failure of an FMI can lead to severe systemic disruption if it causes markets to cease to operate effectively. Hence these infrastructures should be subject to regimes and strategies for recovery and resolution.
The latest report follows CPSS-ISCOs April publication of Principles requiring that FMIs have effective strategies, rules and procedures to enable them to recover from financial stresses. The Financial Stability Boards Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes) published in 2011 further require that jurisdictions establish resolution regimes to allow for the resolution of a financial institution in circumstances where recovery is no longer feasible.
The purpose of the report released today is to outline the issues that should be taken into account for different types of FMIs when putting in place effective recovery plans and resolution regimes that are consistent with the Principles and Key Attributes. The report also seeks views on a number of technical points related to these issues.Paul Tucker, deputy governor, Financial Stability of the Bank of England and CPSS Chairman said: The vital role of the financial systems infrastructure makes it essential that credible recovery plans and resolution regimes exist. FMIs need to be a source of strength and continuity for the financial markets they serve.This is even more important as a safeguard given the commitment made by G20 Leaders in 2009 that all standardized OTC derivatives should be cleared through central counterparties, added Masamichi Kono, vice commissioner for International Affairs, Financial Services Agency, Japan and Chairman of the IOSCO Board.
Amongst its conclusions, the report states that the Key Attributes will provide a framework for resolution of FMIs under a statutory resolution regime.
The report notes six important general areas for avoiding and mitigating systemic risk through strong recovery and resolution capabilities:
– Preventive measures and recovery planning – These preventive and recovery measures include plans for allocating uncovered credit losses and liquidity shortfalls, as well as maintaining viable plans for restoring an FMIs ability to operate as a going concern or to wind down its operations in an orderly manner. An FMI needs to develop comprehensive, substantive plans that identify critical operations and services, scenarios that may potentially prevent the FMI from being able to continue as a going concern, and the strategies and measures necessary to ensure continued provision of critical operations and services should those scenarios occur.- Oversight and enforcement of preventive measures and recovery plans under the principles, an FMI is required to draw up recovery plans. An FMIs direct supervisor, regulator or overseer is responsible for ensuring complains with this requirement and for monitoring and assessing the plans adequacy. Where an FMI is systemically important to multiple jurisdictions or is subject to the authority of multiple supervisors, regulators or overseers, cooperation among the authorities is also needed to carry this out effectively- Activation and enforcement of recovery plans if, despite preventive measures, an event occurs or escalates so as to threaten the continuation of an FMIs critical operations and services, the FMI will need to execute its recovery plans designed to address the threat, for example to replenish financial resources, and to maintain observance of the Principles. Relevant supervisory, regulatory and oversight authorities should oversee the executionof these plans, co-ordinationg iwht the authority designated with responsibility for exercising resolution powers as necessary.-Beyond recovery – because the traditional bankruptcy process does not have the preservation of financial stability as an objective and could cause a systemic disruption through delays or cessation of and FMIs critical functions, it is necessary to also have a resolution regime available for use on FMIs.-Resolution planning – the FMI should be required to provide the authorities with specifically identified data and information needed for the purposes of timely resolution planning. Authorities should review the plans with the FMI to the extent necessary, but they may decide not to disclose them, or parts of them, to the FMI-Cooperation and coordination with other authorities Each of the above elements is enhanced by ex ante and in the moment cooperation and coordination between an FMIs regulatory, supervisor or overseer, an FMIs resolution authority and other relevant authorities, including resolution authorities of the FMIs participants and relevant authorities for the markets that the FMI supports.
The report suggests recovery and resolutions approaches for different types of FMI. For FMIs that do not take credit risk, but still exposed to general business risks such as revenues shortfalls or unexpected costs the principles require all FMIs to have minimum levels of capital resources to address general business risk as well as recovery plans to manage circumstances in which these reserves provide inadequate, for example by raising additional resources from participants or shareholders. In terms resolution tools appropriate for these tasks will include the use of transfer powers to transfer some or all of the FMIs operations to one or more third parties. Given that there are often few (if any) substitutes for or alternative service providers to a particular FMI, this may limit the number of transfer options available to authorities in resolution and increase their reliance on transfer to a bridge institutions pending eventual sale back to private hands. Alternatively, the resolution authority may determine that its resolution objectives can be met by placing the FMI into some form of public administration such as statutory management, administration or conservatorship, perhaps under the direct or indirect control of the resolution authority.
FMIs that do take on credit risk, for example CCPs and payment or settlement systems that operate on a deferred net settlement basis, are particularly exposed to risks from default by their participants, and perhaps also to losses on investments that the FMI holds on its own balance sheet as part of providing its services and for the return of which it is liable to participants (for example, investment of cash margin), says the report. The principles require FMIs to have effective and clearly defined rules and procedures to manage a participant default. A CCP, for example, will typically collect margin, maintain a default fund, and maintain liquid resources to cover its current and potential future exposures and liquidity needs. In the event of a participant default, the CCP can activate its default management process, utilize available resources in order to meet its settlement obligations, and allocate any losses as provided for in its rules and procedures.
The Principles also require a CCP, and any other FMI that faces credit risk, to have rules and procedures that address how credit losses in excess of these financial resources would be allocated. That may be through haircuts applied to the margin and collateral owing to surviving participants, and perhaps other participant. That may be through haircuts applied to the margin and collateral owing to surviving participants, and perhaps other participants.
In the case of a CCP, enabling it to recover from a member default requires not only loss allocation but also re-establishing a matched book. Reestablishing a matched book is normally achieved by replacing the defaulters positions, for example, selling long position to (or buying short positions from) surviving participants through an auction process. If an auction process is not possible, an alternative solution in this scenario would be for the CCPs rules to permit for the termination of any unmatched contraction that could not be sold in auction, with cash settlement of them based on a valuation of the gains/ losses (known as tear-up) to allow for the CCP to remain solvent.
Where the triggers for taking the FMI into resolution are satisfied, the resolution authority should have available to it a broad range of resolution tools. Among these, loss allocation supported by statutory powers is likely to be an essential tool if critical services are to be continued.
The CPSS and IOSCO are seeking comment on the report by Sept. 28 2012.
(JDC)