Year-end deadline for fixing CCP recovery plans 'not realistic'

Some central counterparties are unable to maintain a continuous 'cover two' standard

Race against time: CCPs are under pressure to fix recovery plans before the year end

Clearing houses could struggle to meet a year-end deadline to fix deficiencies in risk management and resolution planning identified by regulators in a report published on August 16.

"I don't think a December 31 target for remedying some of the shortcomings is a realistic target," says Willa Bruckner, a partner specialising in derivatives at law firm Alston & Bird in New York.

The Bank for International Settlements' Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (Iosco) laid down the December 31 deadline in an August 16 progress report on the implementation of a set of risk management standards for central counterparties (CCPs) issued in 2012, known as the Principles for financial market infrastructures (PFMIs).

The report found uneven progress in implementing the PFMIs. The regulators were unusually forthright in identifying "serious issue[s] of concern", and numerous "gaps and shortcomings" in the financial risk management and recovery practices of the 10 derivatives CCPs they assessed as part of the exercise.

The report reveals that while nine of the 10 CCPs seek to maintain prefunded financial resources sufficient to withstand the default of their largest or two largest clearing members – the so-called 'cover one' and 'cover two' standards – some CCPs may not be able to meet the latter on an ongoing basis.

A CCP's prefunded resources include clearing member margin and default fund contributions. The report did not name the CCPs falling short of regulators' expectations.

I think most people take it at face value when CCPs say they have enough resources to withstand a cover two event, but the CCPs don't go into any more detail than that
Claude Brown, Reed Smith

Some CCPs also lack a clear recovery plan to swiftly replenish their resources and restore the clearing house to a sure footing if the cover two standard is breached, according to the report.

The report's findings come as little surprise to some clearing experts, who note that while CCPs insist they can withstand the simultaneous default of their two largest members, they provide scant evidence to back up the claim.

"I think most people take it at face value when CCPs say they have enough resources to withstand a cover two event, but the CCPs don't go into any more detail than that," says Claude Brown, a partner in the global derivatives practice at law firm Reed Smith in London. "These comments in the report don't surprise me, because it's not at all clear that the cover two standard is being adhered to in all stages of the economic cycle in all circumstances, or whether it takes into account any connectivity between the two failing clearing members."

The implications for a CCP will differ, depending on whether a cover two event involves the failure of two US banks or a European bank and an Asian bank, says Brown. However, CCPs do not detail how they would fare under such scenarios.

"If you scratch the surface, you will probably be able to find a set of circumstances where a CCP might buckle if they are not able to deal with a cover two standard in a given set of circumstances," he says. "It is also not clear that CCPs have ever conducted war games when they try to simulate what would happen if clearing members A and B collapsed at three CCPs at the same time."

Such concerns have fuelled calls for standardised stress testing of CCPs, similar to the US Federal Reserve's annual Comprehensive Capital Analysis and Review for large banks. In a progress update published alongside the report, the CPMI and Iosco confirmed they have begun work on a supervisory framework for the stress testing of CCPs. A draft proposal is expected in the first half of 2017.

The observations in the report about CCP recovery plans raise the most concerns, because the CCPs themselves are acknowledging their recovery plans and orderly wind-down plans are not sufficient
Willa Bruckner, Alston & Bird

The CPMI-Iosco report was scathing in its assessment of CCP recovery plans, which detail how a clearing house would cover shortfalls exceeding its prefunded financial resources in stressed scenarios.

CCPs have made slow progress in implementing recovery plans, according to regulators, and while some have completed them to a detailed degree, "relatively few considered their plans to be fully consistent with the PFMIs" and are planning enhancements.

"The observations in the report about CCP recovery plans raise the most concerns, because the CCPs themselves are acknowledging their recovery plans and orderly wind-down plans are not sufficient," says Bruckner of Alston & Bird. "We don't know what the impact will be on the market if a CCP faces significant liquidity issues or losses without a proper recovery plan or orderly wind-down plan in place. The impact could be more destabilising than the events of 2008."

The report also found not all CCPs have the ability to allocate losses among clearing members through variation margin gains haircutting and special assessments on surviving participants to restore a matched book. In the absence of these loss-allocation tools at a CCP, the regulators question whether recovery plans could credibly address uncovered credit losses.

Clearing houses are expected to address shortcomings in their recovery plans and other weaknesses identified in the report by December 31. CPMI-Iosco will conduct a follow-up review of CCPs' progress during the first half of 2017.

The 10 clearing houses reviewed in the report were: ASX Clear Futures in Australia; BM&FBovespa in Brazil; The Clearing Corporation of India; CME; Eurex Clearing; Ice Clear Credit; Japan Securities Clearing Corporation; LCH SA; LCH Ltd, and SGX Derivatives Clearing in Singapore.

FSB consultation paper

The PFMI implementation report was accompanied by the release of a consultation paper from the Financial Stability Board (FSB) soliciting comments on developing effective resolution strategies and plans for CCPs. The consultation seeks comments on when resolution authorities should assume control of a failing CCP and the international co-ordination of resolution efforts between regulators.

The FSB also revealed the Basel Committee will be publishing a proposal to revise the design and calibration of the leverage ratio by the end of this year.

The multi-agency derivatives assessment team will publish a new report on clearing incentives after the introduction of margin requirements for non-cleared derivatives next month.

The first report, published in 2014, sought to test claims it would be cheaper to trade cleared than non-cleared derivatives, but it was sharply criticised for failing to consider the impact of the leverage ratio. Work on the follow-up report will begin in the first quarter of 2017, although there is no deadline for its publication.