The latest responses from a Financial Stability Board consultation reveal deep divisions within the financial sector over who should pay when a clearing house fails with big losses.
More feedback from trade associations has emerged regarding proposals by the Financial Stability Board (FSB) on dealing with clearing houses’ equity in resolution, with responses revealing ongoing deep schisms in the industry.
As reported earlier by Global Risk Regulator, the FSB released a consultation on May 4 called ‘Guidance on financial resources to support central counterparty (CCP) resolution and treatment of CCP equity in resolution’ (See GRR June issue: FSB throws CCP equity on the line in resolution consultation).
Since then, more trade bodies publicly voiced their positions ahead of the feedback deadline of July 31. The responses to the consultation have revealed deep rifts in the industry over who should pay to resolve a CCP that has failed with big losses, though there is general acceptance that it should not be the taxpayer. Whatever approach the FSB settles on is bound to upset some parties.
The FSB put forward some ideas around the use of CCP equity in a resolution situation. It suggested that the equity of a CCP could be used to pay for non-default losses or even given to its members who are ultimately liable if the losses are excessively large. Many CCP members believe they should not be liable for losses even if that means CCPs holding more equity.
The FSB proposed some possible solutions to this impasse, such as resolution authorities fully or partly writing down CCP equity to then allocate remaining losses, after default management and recovery measures have taken place. That could see CCP shareholders shoulder a bigger burden of the losses – a suggestion that does not sit well with CCPs.
Threat to balance
In its response, the World Federation of Exchanges (WFE) urged caution over changing CCP resolution arrangements as it could upset the “tried and tested” balance of incentives potentially fostering systemic risk. The WFE believes the core element of a clearing house’s value is the predictability of the arrangements that underpin how it deals with pre-specified contingencies.
It was critical of the FSB’s failure scenarios, labelling them as “extreme and implausible”, and pushed back against the idea that a CCP’s equity should be on the line in the event of a custodian and settlement bank failure. It argued that this goes beyond a clearing house’s remit.
The WFE also said it was inappropriate for CCP equity to be used if it is deemed unable to deploy its recovery tools, as this would imply that it is operating in a legal framework that is unenforceable.
The Global Association of Central Counterparties (CCP12) was on a similar page. It hit back at the idea that CCPs should be exposed to even greater losses of their equity in the name of resolution planning beyond what is stipulated in a clearing house’s rule book. It said the FSB’s guidance is too granular when it comes to assessing a CCP’s equity and could conflict with existing standards and their local implementation. It also supported current CCP default management and recovery measures and didn’t think they needed changing.
Users more receptive
However, trade bodies representative of CCP members and users were more welcoming towards the FSB’s suggestions, and even built on some of them.
“Equity should be fully loss bearing in line with corporate finance principles,” was the joint response from the International Swaps and Derivatives Association, the Futures Industry Association and the Institute of International Finance.
The associations recognised that CCP equity alone is unlikely to be sufficient to absorb all the losses in the event of failure. However, they said that through the default fund and further assessments, clearing members already bear the larger part of such losses. Concentrating losses beyond that on market participants and sparing CCP shareholders would result in misaligning incentives and moral hazard, they warned, and welcomed that the FSB recognised a potential moral hazard issue.
The trade bodies complained that CCP equity is already overly shielded from losses, given that clearing houses can use variation margin gains haircutting – a cost borne by users.
They mostly agreed with points made by the Systemic Risk Council, a private sector body composed of former government officials and experts, that some elements of bank resolution should apply to CCPs. In particular, there should be a distinction between financial liabilities, such as bonds and equity and service-related liabilities, such as deposits in a bank or clearing activity for a CCP. Service-related liabilities should only be haircutted once the financial liabilities have been used.
Creditor protection
The trade bodies stated that CCP equity should not be covered by the no‐creditor‐worse‐off (NCWO) safeguard as this is designed to protect creditors, not shareholders. They said most CCP rulebooks stipulate they would have a NCWO claim if their equity was used to cover default losses in a resolution, despite them being allocated to clearing participants.
The three said market participants take more notice of what a resolution authority will do in a CCP failure situation rather than focus on each firm’s projected worst outcomes. Therefore, they said, the non‐confidential parts of resolution plans should be made public – or at least shared with market participants.
They supported resolution authorities regularly reviewing CCP rulebooks and that those resolution plans and playbooks should be routinely tested, and they called for consistency across jurisdictions in terms of default management, recovery tools, resolution processes and reporting, as this would bolster financial stability and reduce regulatory fragmentation. However, they recognised that this is a big ask.
This leaves the FSB treading a fine line between balancing the liabilities of CCPs and their users in a resolution situation, while also devising guidance that most jurisdictions feel they can follow.
