Dealers and legislators left disappointed by CPSS-Iosco recommendations

Proposals on risk management by CCPs should be more detailed, say participants

A long-awaited set of recommendations for central counterparties (CCPs) that clear over-the-counter derivatives was published last month, but dealers and policy-makers have expressed concern the proposals don’t go far enough to create robust and consistent regulation of CCPs internationally.

On May 12, the Basel-headquartered Committee on Payment and Settlement Systems (CPSS) and the Madrid-based International Organization of Securities Commissions (Iosco) published 15 recommendations for CCPs, alongside a set of considerations for trade repositories, covering issues such as participation requirements, margin setting, default procedures and governance.

But dealers have complained the report – the result of nearly a year’s work – merely identifies the key issues rather than making firm recommendations on the standards CCPs should meet across those 15 areas.

One of their biggest worries is the issue of margin, and the long-held concern that, as more OTC derivatives volume is pushed through central clearing, commercially operated CCPs might undercut each other on margin to win business, threatening the stability of the system.

In a recent interview with Risk, LCH.Clearnet chief executive Roger Liddell criticised newer US rival International Derivatives Clearinghouse for its “reckless” behaviour in setting low margin to win business (Risk May 2010, page 9). Liddell, along with many other market participants, had hoped CPSS-Iosco would take a firm line to ensure such behaviour cannot take place.

But the report only says CCPs clearing OTC derivatives may need “more complex models and methodologies” to calculate risk exposure and margin requirements. It adds the margin methodology “should be reviewed periodically by a qualified, independent internal group or third party”.

“There are good intentions here but little substance – it is very vague and lacking in any specific recommendations. It is difficult to say whether we are on safer ground. CCPs make the likelihood of a disastrous event more remote, but the magnitude of such an event bigger, so we have to ensure the nuclear bomb will never be detonated. Looking at this document, I have little reassurance we would be in a safer place,” says Riccardo Rebonato, head of front-office risk management and quantitative analytics at Royal Bank of Scotland in London.

CPSS-Iosco standard setters have tried to soothe such fears, insisting the document is simply the first iteration of a set of recommendations being worked on as part of a broader review of standards for all payment, clearing and settlement systems commissioned by the Financial Stability Board in late 2009. The results of that review are not due to be published until early next year.

“The general review will go far beyond what is in this report and we will consider the outcome of the consultation as a first input from the market on the content of the standards. That is a good thing, as we will have an idea of what the market wants, and whether we are omitting anything really important, even before we launch a consultation on the final standards next year,” says a senior official on the CPSS-Iosco working group.

But the general review will be of little use to policy-makers who expect to have OTC derivatives legislation very well advanced by the time it is published. The European Commission (EC), which is expected to vote on draft legislation within weeks, has already said its text will include a wide range of stringent requirements for CCPs that clear derivatives, and will go far beyond the high-level CPSS-Iosco recommendations.

“We do not need higher principles – we need granular regulation. This doesn’t mean high-level international standards don’t have a part to play, but there is a necessity for more consistency at a more granular level,” said Patrick Pearson, head of the financial markets infrastructure unit at the EC in Brussels, at a conference in London on May 18.

Pearson warned clearing houses should never be allowed to compete on margin, adding that differences in risk management practices among CCPs located in different jurisdictions must be ironed out.

“In no way should CCPs be allowed to compete with each other on risk – it is a self-defeating exercise and threatens the stability of the system. Therefore, all the differences that exist in the risk management processes of different CCPs, including how exposures are measured, margin call processes, back testing, stress testing and default management processes, need to be harmonised. It makes no sense to have differences,” he said.

Rumours of CCPs competing on margin have horrified many regulators and central bankers who worry about the moral hazard associated with commercially operated clearing platforms competing to win business by lowering margin charged to clients.

“We think of CCPs as serving a utility-like function and so they need to be run and risk-managed as such – we have been concerned about commercial interests being put first. Some CCPs operate as user-owned co-operatives but our concern would be when they are stapled on to a profit-orientated exchange. That is a slippery slope we don’t want to walk down,” says the head of financial stability at one European central bank.