Battle Lines Drawn Over CCP Resolvability

Introduction

In the context of the continuing industry and regulator discussion regarding CCP resolvability, last week ISDA published a position paper entitled “CCP Loss Allocation at the End of the Waterfall”.  The paper addresses two scenarios:

  • “Default Losses” – i.e. losses that remain unallocated once the ‘default waterfall’ is exhausted following a clearing member (“CM”) default; and
  • “Non-default Losses” – i.e. losses that do not relate to a CM default but exceed the CCP’s financial resources above the minimum regulatory capital requirements.

Default Losses

ISDA recognises the importance of central clearing for standard OTC derivatives, the difficulty of achieving optimal CCP recovery and resolution and the fact that no loss allocation system can avoid allocating losses to CMs.  It takes the view that residual CCP losses should be borne not by the taxpayer, nor solely by surviving CMs who as guarantors have no control over losses.  Rather, ISDA believes that all CMs with mark-to-market gains since the onset of the CCP default should share the burden of CCP losses.  Accordingly, ISDA is an advocate of Variation Margin Gains Haircutting (“VMGH”) being applied at the end of the default waterfall.

Under a VMGH methodology, the CCP would impose a haircut on cumulative variation margin gains which have accumulated since the day of the CM default.  In doing so, ISDA believes that:

  • losses fall to those best able to control their loss allocation by flattening or changing their trade positions;
  • CMs with gains at risk are incentivised to assist in the default management process; and
  • in the event that the CCP runs out of resources, VMGH mimics the economics of insolvency.

ISDA believes that a VMGH methodology should not have an adverse impact on the ability of a CM to net exposures or gain the appropriate regulatory capital treatment for client positions held at the CCP[1].  In contrast to contractual tear-up provisions or forced allocation mechanisms, VMGH allows a CM to assume that its portfolio of cleared transactions outstanding as of any given date will be the same as of the point of a CCP’s insolvency (because there is no mechanism by which they can be extinguished prior to any netting process).  As such, because it has certainty with respect to its legal rights in the CCP’s insolvency, the CM should be able to conclude that netting sets remain enforceable.  In addition, to the extent that VMGH provides incremental resources to the CCP, ISDA believes that it effectively protects initial margin held at a CCP and therefore strengthens segregation.

In theory, VMGH should always be sufficient to cover a defaulting CM’s mark-to-market losses in the same period.  However, if in practice this was not the case (e.g. because the CCP was not able to determine a price for the defaulting CM’s portfolio) and in the absence of other CMs voluntarily assuming positions of the defaulting CM, ISDA advocates a full tear-up of all of the CCP’s contracts in the product line that has exhausted its waterfall resources and has reached 100% haircut of VM gains.  ISDA contends that there should be no forced allocation of contracts, invoicing back, partial non-voluntary tear-ups, or any other CCP actions that threaten netting.  Furthermore, prior to the point of non-viability, ISDA believes that resolution authorities should not be entitled to interfere with the CCP’s loss allocation provisions (as detailed within its rules) unless not doing so would severely increase systemic risk.

Non-default Losses

An example of Non-default Loss (“NDL”) would be operational failure.  ISDA views NDL in a different light to Default Losses believing there to be no justification for reallocating NDL amongst CMs and other CCP participants.  Accordingly, it does not believe that VMGH (or similar end-of-the-waterfall options) are appropriate for allocation of NDL.  Rather, it considers that NDL should be borne first by the holders of the CCP’s equity and debt.

Conclusion

The ISDA paper is a useful contribution to the ongoing discussion around CCP resolvability.  It suggests a sensible CCP default waterfall,[2] but is probably most noteworthy for its opposition to initial margin (“IM”) haircutting as a resolution tool.  In ISDA’s view, IM haircutting would distort segregation and “bankruptcy remoteness”.  In doing so it would have significant adverse regulatory capital implications and would create disincentives for general participation in the default management process.  In this sense, it adopts the opposite position to that detailed by the Committee on Payment and Settlement Systems (“CPSS”) and the International Organization of Securities Commission (“IOSCO”) in their recent consultative report on the Recovery of financial market infrastructures (see this blog post for more detail).  CPSS/IOSCO see IM haircutting as an effective tool which may facilitate access to a much larger pool of assets than VMGH.

There is general agreement on the principle that the taxpayer should never again have to pick up the tab following the failure of a systemically important firm.  On this basis alone, one suspects that IM haircutting will ultimately be included in the suite of resolution tools, if only to act as additional buffer between derivatives losses and the public purse.  In fairness, it’s difficult to see how a general tear-up of contracts is consistent with one of the underlying goals of CCP resolution – to ensure the continuity of critical services.  Ultimately, however, we will have to wait to see whether the contagion which may result from ISDA’s tear-ups outweighs the regulatory impact associated with CPSS/IOSCO’s IM haircutting.


[1] Pursuant to Article 306(1)(c) of the Capital Requirements Regulation, a CM will likely have to be able to pass on the impact of a CCP default to its clients in order to attract the appropriate regulatory capital treatment

[2] See page 8

HM Treasury Publishes Summary of Responses to Consultation on Non-bank resolution

Introduction

On 17 October 2012, HM Treasury published a summary of responses received to its August 2012 consultation paper, entitled “Financial Section Resolution: Broadening the Regime” (the “Consultation Paper”).  Broadly, the Consultation Paper had proposed the widening of resolution regimes to systemically important non-banks, specifically:

  • Investment firms and parent undertakings;
  • Central counterparties (CCPs);
  • Non-CCP financial market infrastructures (non-CCP FMIs); and
  • Insurers.

For a full summary of the Consultation Paper, please see our previous blogpost “HM Treasury Consultation:  RRP for Financial Market Infrastructures” dated 8 August 2012.

Summary of Responses

HM Treasury received 45 responses to the Consultation Paper prior to the 24 September 2012 deadline.  Broadly, respondents were supportive of the original position of the Government, which reconfirmed its intention to develop the UK regime in advance of European legislation.  The main changes to be implemented in light of the Consultation Paper are set out below.

Investment firms and parent undertakings

The Government proposes:

  • to narrow the definition of investment firms which are subject to the resolution regime proposals so as to promote consistency with the Recovery and Resolution Directive by excluding small investment firms that are not subject to an initial capital requirement of €730,000; and
  • an extension of stabilisation powers to group companies in order to facilitate resolution, but subject to certain conditions, such as limiting such powers to financial groups (rather than financial elements of any group that contains a bank, as was proposed in the Consultation Paper).

Central Counterparties

The Government proposes to include an additional objective for intervention in a failing CCP, which seeks to maintain the continuity of critical services.  It notes the mixed response from the industry regarding the intervention power generally but continues to regard this as justified given the systemic consequences which closure of a CCP’s critical functions could have, particularly where there are no obvious substitutes for the CCP.  However, the Government also accepts that recognised clearing houses that do not provide central counterparty clearing services should be excluded from the regime altogether, meaning that they are likely to be covered by proposals relating to non-CCP FMIs.

The Government also noted the strong industry opposition to its proposal to allow resolution authorities to impose on the clearing members of a CCP any losses which were above and beyond those dealt with by the CCP’s existing loss allocation provisions.  It was felt that this proposal would cause uncertainty, could potentially lead to distorted incentives such as the early termination and exit of members, might put UK CCPs at a competitive disadvantage and could have capital and liquidity implications for clearing members.  In light of this, the Government has decided not to pursue the proposal, but remains of the view that taxpayers should not be expected to meet the cost of restoring a failed CCP.  As such, it proposes to make loss allocation rules mandatory for the purposes of authorisation as a Recognised Clearing House within the UK and will re-consult on this new proposal in due course.

Non-CCP FMIs and Insurers

The government accepts that the case for a full resolution regime for Non-CCP FMIs or insurers is less clear cut.  Most Non-CCP FMIs have no financial exposure, similar to those faced by CCPs, and any failure is more likely to be operational or technological in nature.  In addition, there seems to be a general recognition that traditional insurance activities – whether general or life insurance business – do not generate or amplify systemic risk.  In contrast, non-traditional insurance and non-insurance activities (such as derivative trading) are regarded as sources of systemic risk.

It seems that the Government accepts that a strengthening of the existing regimes appears to be the most appropriate option and will engage in further dialogue to determine how best this can be achieved.

Next Steps

The changes to proposals regarding investment firms and their parent undertakings, deposit taking institutions and CCPs will be effected by changes to the Financial Services Bill that is currently before Parliament.  For non-CCP FMIs and insurers, the government will take further time to consider the arguments presents by respondents to the Consultation Document and decide the best way to proceed.

CPSS/IOSCO Consultative Report on RRP for FMI

I have been asked whether we have a summary of the CPSS/IOSCO consultation on RRP for FMI that was published in July of this year.  We do, and it is provided below.

All the best

Michael.

Introduction

On 31 July 2012, the Committee on Payment and Settlement Systems (CPSS) and the Board of the International Organization of Securities Commissions (IOSCO) published a consultative report on the recovery and resolution of financial market infrastructures (FMIs), i.e. systemically important:

  • payment systems;
  • central securities depositories (CSDs);
  • securities settlement systems (SSSs);
  • central counterparties (CCPs); and
  • trade repositories (TRs).

FMIs play an essential role in the operation of the global financial system.   The commitment of the G20 at the Pittsburgh Conference in September 2009 that all standardised over-the-counter (OTC) derivatives should be cleared through CCPs will increase yet further the importance of FMIs, as well as the systemic risk associated with their failure, particularly that of CCPs.   As such, the creation of an effective resolution regime for FMIs represents an important link in ensuring the continuity of services which are critical to the financial system.

The purpose of the report is to outline the features of effective recovery and resolution regimes for FMIs in accordance with the “Key Attributes of Effective Resolution Regimes for Financial Institutions” (the “Key Attributes”) published by the Financial Stability Board (FSB) on 4 November 2011.  The report also develops further the thinking of the CPSS and IOSCO as first detailed in the “Principles for financial market infrastructures” (the “Principles”) published in April 2012.

Broadly speaking, the report concludes that:

  • it is vital that robust arrangements exist for the recovery and resolution of FMIs;
  • the Principlesset out a framework for the recovery and resolution of FMIs;
  • regulators will need to ensure that such a framework is put in place; and
  • the Key Attributesprovide a framework for a statutory FMI resolution regime.

The deadline for responses to the report closed on 28 September 2012.  However, FMI resolution remains an aspect of the regulatory reform agenda.  A more detailed summary of the report’s conclusions is provided below.

Relationship with the Key Attributes and the Principles

The report identified six areas for avoiding and mitigating systemic risk through strong recovery and resolution capabilities:

Preventive measures and recovery planning

The stability of FMIs relies on them:

  • maintaining a sufficient amount of liquid financial resources;
  • developing a sound process for replenishing financial resources as necessary; and
  • designing effective strategies, rules and procedures to address losses.

Oversight and enforcement of preventive measures and recovery plans

FMIs should be required to create and maintain RRP which are consistent with the Principles.

Activation and enforcement of recovery plans

Relevant authorities should have the power to require implementation of recovery measures, impose fines and require management changes, as appropriate.

Beyond recovery

Resolution authorities must have the power to ensure the continuation of an FMI’s critical services in a resolution scenario and to allocate losses across participants or other creditors of the FMI.

Resolution planning

FMIs should be required to provide authorities with specifically identified data and information needed for the purposes of resolution planning.

Cooperation and coordination with other authorities

Ex ante and “in the moment” cooperation procedures must be agreed between relevant home and host authorities.

Recovery and resolution approaches for different types of FMI

A key distinction exists between FMIs that take credit risk, such as CCPs, and those that do not, such as TRs.

FMIs that do not take credit risk

Recovery

All FMIs, including those that do not assume credit risk, have the potential to fail.  As such, they should be required to maintain minimum levels of capital and produce recovery plans which, inter alia, are capable of ensuring that critical functions continue to operate and additional resources can be raised from participants or shareholders.

Resolution

Given that there are often few (if any) substitutes for, or alternative service providers to, a particular FMI, this may limit the utility of the sale of business tool within resolution and increase reliance on a transfer to a bridge institution on an interim basis.  An alternative may be some form of statutory management, the primary purpose of which would be the continuation of the FMI’s critical functions until they could be transferred or wound down in an orderly manner.

FMIs that take on credit risk

Recovery

FMIs that assume credit risk include CCPs, SSSs that extend credit, and payment or settlement systems that operate on a deferred net settlement basis and in which the system operator provides guarantees to participants due to receive funds or other assets.  This type of FMI typically employs a “waterfall” mechanism which allocates losses in the following order:

  • margin;
  • collateral;
  • defaulting party’s default fund contributions;
  • FMI contribution (often capped);
  • non-defaulting parties’ default fund contributions.

The Principlesrequire a CCP, and any other FMI that faces credit risk, to establish rules and procedures that address how credit losses in excess of the above would be allocated.  The suggestion is that this would be achieved by haircutting the margin of the CCP’s clearing members.

As they do not take directional positions, CCPs must also maintain a matched book at all times.  Following a member default, this is normally achieved via an auction process which seeks to replace the defaulter’s positions.  However, in a stressed scenario, the auction may receive no bids, or those bids that are received may be at prices which would not allow the CCP to remain solvent.  In these circumstances, an alternative solution would be for the CCP’s rules to permit for the termination and settlement of any unmatched contracts that could not be sold in auction.  All other contracts would remain in force but would potentially be subject to haircutting of margin if in-the-money so as to balance the books of the CCP.

Selective termination would undoubtedly alter the risk exposure of affected participants to the CCP, but is considered preferable to the alternative of insolvency, with the effect that this would have on all contracts cleared by the CCP as well as the wider systemic problems this might cause.

Resolution

A resolution framework for FMIs is still required due to the possibility that losses could still exceed the limits of the contractual loss mutualisation rules.  Of the tools available to a resolution authority, statutory loss allocation is likely to remain key in ensuring the continuation of critical services.  It is assumed that this would be implemented through haircutting of margin and by enforcing outstanding obligations to replenish default funds or respond to cash calls.

This raises questions as to the consequences of each loss allocation strategy, and whether the liability of participants should be limited.  In practice, enforcing obligations to replenish default funds or meet cash calls may prove difficult during times of market stress.  In this respect, haircutting of margin may represent a more speedy solution.  However, both potential solutions may act as a source of contagion if clearing members have the right to pass on losses to indirect members.  Statutory loss-allocation could also be extended to include any issued debt or borrowings of a FMI or any intragroup balances.  However, in reality, it is unusual for FMI to have such debt, at least in significant amounts.

Wherever possible, loss-allocation within resolution should follow the normal insolvency ranking, meaning that equity should suffer losses before debt.  However, a degree of flexibility may be necessary in order to contain the spread of risk where, for example, the owner of the FMI operates not only the service under resolution, but also other critical FMI services.

A stay on early termination rights may be a useful tool in mitigating stress on the FMI associated with a possible mass close-out of positions and maintaining a “matched book”.  It may also be of benefit in circumstances where the FMI is reliant upon services provided by an external third party for continuity of critical services, such as IT services.

Interpretation of the Key Attributeswhen applied to FMIs

Resolution authority (Key Attribute 2)

An effective resolution regime requires a designated resolution authority to implement it.  The statutory objective regarding the protection of depositors (Key Attribute 2.3 (ii)) is not applicable with respect to resolution of FMIs.

Tools for FMI resolution (Key Attribute 3)

Resolution authorities should have available the broad range of resolution tools specified within the Key Attributes, although there are a few exceptions that require an FMI-specific interpretation, as detailed below.

Entry into resolution (Key Attribute 3.1)

The triggers for FMI resolution are likely to be similar to those for other types of financial institution.

Payment Moratorium (Key Attribute 3.2 (xi))

The enforcement of a payment moratorium with respect to an FMI is likely to risk continuing or even amplifying systemic disruption, defeating the objective of continuity of critical services.  As such, it is likely to be of little relevance.

Appointment of an administrator to restore FMI viability or effect an orderly wind-down (Key Attribute 3.2 (ii) and (xii))

Placement of an FMI into some form of statutory administration is likely to be suitable only for those types of FMI whose critical operations can be continued during a general moratorium on payments to creditors. Therefore, this may not offer a credible resolution strategy for many FMIs.

Transfer of critical functions to a solvent third party (Key Attribute 3.3)

For some FMIs there may be few (if any) alternative providers of its critical services to which operations can be sold.  Even if an alternative provider does exist, there may be a number of practical issues that would prevent a prompt transfer, including:

  • different participants and participation requirements;
  • IT system compatibility;
  • differing access criteria; and
  • legal barriers (such as antitrust or competition laws).

Bridge institution (Key Attribute 3.4)

This tool may represent an attractive option, as a speedy transfer to a bridge institution can help facilitate the maintenance of critical services whilst avoiding (at least temporarily) the legal and operational impediments that may arise with an outright transfer to a third party.

Bail-in within resolution (Key Attributes 3.5 and 3.6)

Unlike banks or investment firms, FMIs rarely issue subordinated debt instruments.  However, some FMIs, such as CCPs, do have access to financial resources in the form of initial margin, variation margin and default fund contributions which could be made subject to a haircut in a resolution situation, with creditors being given equity in the FMI in return.  The haircut would respect the creditor hierarchy and would apply to collateral and margin only where it was held in a way that meant that it would bear losses if the FMI became insolvent.

Setoff, netting, collateralisation, segregation of client assets (Key Attribute 4)

Effective resolution of an FMI requires that the legal framework governing setoff, netting and collateralisation agreements, and segregation of client assets should be clear, transparent, understandable and enforceable.

Stays on early termination rights (Key Attributes 4.3 and 4.4)

In order to ensure that the commencement of resolution cannot be used as an event of default to trigger termination and closeout netting, an FMI should have the ability to stay the termination rights of its participants or service providers.  Due to the risks associated with running an unmatched book, this is particularly important where the FMI is a CCP.

Safeguards (Key Attribute 5)

The principle of “no creditor worse off than in insolvency” should apply to FMIs.  However, the starting point for calculating whether, ultimately, a creditor is ‘worse off’ should be claims as they exist following the FMI’s ex ante rules and procedures for loss allocation.

Funding of FMIs in resolution (Key Attribute 6)

The provision of temporary funding should be highly exceptional, and limited to those cases where:

  • it is necessary to foster financial stability;
  • will facilitate orderly resolution; and
  • private sources of funding have been exhausted or cannot achieve an orderly resolution.

Resolvability assessments (Key Attribute 10)

Resolvability assessment must take account of an FMIs’ specific role in the financial system, including the impact on its participants and linked FMIs (such as CCPs which are subject to interoperability arrangement), in particular, their ability to retain continuous access to the FMI’s critical operations and services during resolution.

Recovery and resolution planning (Key Attribute 11)

An FMI should develop comprehensive recovery plans that identify and analyse scenarios which are specific to its role in the financial system and which may threaten its ability to continue as a going concern.

Access to information and information-sharing (Key Attribute 12)

There should be no impediments to the appropriate exchange of resolution information. However, being market neutral, the concept of sensitive trading data does not apply to FMIs in the same way as to other financial institutions.  Nonetheless, position information specific to individual members should be subject to confidentiality arrangements.

Cooperation and coordination among relevant authorities (Key Attributes 7, 8 and 9)

The resolution of FMIs should also be supported by transparent and expedited processes to give effect to foreign resolution measures.

EU Commission publishes consultation paper on RRP for non-banks

Introduction

On 5 October 2012, the European Commission published a consultation paper on a possible recovery and resolution framework for financial institutions other than banks.  The aim of the consultation is to ensure that all nonbank financial institutions the failure of which could threaten financial stability are capable of being resolved in an orderly manner and with minimal cost to taxpayers.  Responses are requested by 28 December 2012.  A more detailed summary of the consultation paper is provided below.

Defining ‘Systemic Risk’

The consultation paper concludes that, with the exception of central counterparties (CCPs) and central securities depositories (CSDs), it is difficult to establish in advance which nonbanks are likely to be sources of systemic risk.  As such, it is necessary to have a framework that applies to all firms, both those identified as systemic ex ante and after an event of failure.  As to the question of when a specific institution might be considered as being a source of systemic risk, the following are identified as key factors:

  • size;
  • inter-connectedness; and
  • substitutability of services.

Financial Market Infrastructures (FMIs)

Central Counterparties

The Commission notes that there is a high risk of contagion associated with CCPs as:

  • they are strongly inter-connected with other FMIs and other financial institutions;
  • they often operate on an almost quasi-monopolistic basis; and
  • clearing members of a CCP are often also clearing members of other CCPs, with the effect that losses suffered by a clearing member on the failure of a CCP could indirectly impact other CCPs (if these losses triggered a default vis-a-vis the other CCPs).

The consultation paper makes reference to measures employed by CCPs which act as safeguards with respect to the risks they face:

Risk

Safeguard 

Credit risk and liquidity risk
  •   Initial margin
  •   Variation margin
  •   Default fund contributions
  •   Own capital
Operational risk
  • Contingency arrangements such as   those required by Article 34 of EMIR
Market risk
  • Investment restrictions such as   those required by Article 47 of EMIR
  • Haircuts

 Central Securities Depositories

The principal risks to which CSDs are exposed are operational and legal in nature, with legal risks being particularly relevant given the cross-border nature of some CSD activities.  However, the services provided by CSDs are characterised by their high levels of interconnection and their low degree of substitutability.  Therefore, if managed in a disorderly fashion, the failure of a CSD could have considerable effects on the financial system.

Recovery and resolution of CCPs and CSDs

The most critical element of CCP/CSD resolution is to ensure the continuation of systemically important functions and services.  This is achieved through a combination of recovery and resolution plans.  Authorities should also be able to intervene in the business of a firm prior to the triggering of a resolution condition, if it is in breach of its regulatory requirements.  However, resolution of an FMI must be conducted in a manner which preserves the principle of ‘no creditor worse off than in insolvency’.  In addition, the normal hierarchy of claims in insolvency and pari passu treatment of creditors of the same class should be respected.

Resolution triggers for CCPs and CSDs are the same as for banks and should be set at the point when a firm is no longer viable or likely to be no longer viable, and has no reasonable prospect of becoming so.  A further condition for resolution is that its failure and the disruption of its services must have systemic implications.  The balance between the need for flexibility in triggering resolution on the one hand and the need for clarity as to the level of the trigger on the other hand are both recognised.

In the context of FMI resolution, authorities should have the power to:

  • remove and replace a firm’s senior management;
  • appoint an administrator;
  • operate, restructure and/or wind-down a firm;
  • transfer or sell specified assets or liabilities;
  • establish a temporary bridge institution;
  • separate non-performing assets into a distinct vehicle;
  • recapitalise an entity by amending or converting specified parts of its balance sheet;
  • override rights of shareholders;
  • impose a temporary stay on the exercise of early termination rights;
  • impose a moratorium on payment-flows; and
  • effect an orderly closure/wind-down.

With respect to the resolution tools at the disposal of authorities, the difficulties of applying the Sale of Business tool is recognised, due to:

  • the relative lack of firms in the industry;
  • the different nature of an FMI’s assets and liabilities;
  • operational constraints such as IT system incompatibility; and
  • the competition issues which may flow from ownership structures.

In addition, as the core assets of an FMI (its technical facilities and processes, infrastructure and know-how) do not tend to cause losses in the way a bank’s assets might, they do not merit being transferred to a separate ‘bad’ asset management vehicle under the Asset Separation Tool.  In turn, these facts increase the importance of the Bridge Institution Tool as a method of resolving a failed FMI due to the fact that this will enable authorities to ensure the continuity of critical services whilst a private sector purchaser is identified.

Of most interest is the discussion of the use of the Bail-In Tool with respect to FMIs.  FMIs typically do not issue debt which can be made subject to a haircut or converted into equity for the purposes of loss allocation or recapitalisation.  It is noted that loss-allocation mechanisms, for example CCP default funds, already exist for some FMIs. However, these arrangements are primarily concerned with loss-allocation rather than recapitalisation.  With respect to the resolution of a CCP, the following options were identified:

Bail-In Option

Advantages

Disadvantages 

Applying haircuts to initial margin
  • Funds are available for immediate use
  • Initial margin levels may need   to increase across the board
  • Possibility that this departs from the principle of ‘no creditor worse off than in insolvency’
Applying   haircuts to payments of variation margin
  • Funds are available for immediate use
  • Does not have pro-cyclical effects for out-of-the-money payors
  •  Has pro-cyclical effects for in-the-money payees
  • Possibility that this departs from the principle of ‘no creditor worse off than in insolvency’
Specific   liquidity calls on clearing members
  • Avoids random allocation of losses resulting from margin haircuts

 

  • Increased pro-cyclicality due to the fact that all clearing members are called for funds
Establishment   of ex-ante resolution funds
  • Avoids negative countercyclical   impact
  • Difficulty in calculating appropriate levels of contribution
Issuance of CoCo bonds by CCPs
  • Burden would not fall on clearing members
  • Uncertainty as to market for CoCo bonds

The Commission also noted that the industry has considered providing CCPs with a right to terminate contracts with non-defaulting clearing members for an amount equivalent to the contracts held on behalf of the defaulter so as to return the CCP to a balanced net position.

Insurance and Reinsurance Firms

Defining Systemic Importance

The consultation paper notes that most insurance business is unlikely to be systemically important due to its competitive nature and relatively low barriers to entry.  Traditional insurance is considered to be the least risky to the financial system.  In contrast, non-traditional insurance, such as bond insurance, implies a higher degree of risk as a result of its non-standard characteristics that makes it more interconnected with the rest of the financial system.  Non-insurance activities, such as entering into derivatives (particularly as sellers of credit protection) carry the greatest risk.  Although derivatives transactions are generally undertaken through different legal entities, they tend to be connected through a common parent, which sometimes acts as guarantor, meaning that an insurance entity in this position can be both a source or recipient of financial contagion for other entities in its group.

Applying these generalisation to specific areas of the insurance industry, the Commission concludes that short-term funded insurers (which issue commercial paper and reinvest the funds in assets offering a higher return or enter into repos in relation to securities comprised within their investment portfolios) could be systemically risky, but only if the practice is indulged in to an excessive extent and with inadequate liquidity and collateral management.  Similarly, any contagion from the failure of a reinsurer would be limited to its direct customers due to the “comparatively limited” nature of its connections.  However, other types of insurance are considered to have a greater potential to be systemically important due to their high inter-connection with the real economy and the fact that they do not constitute readily substitutable services.  Examples include:

  • compulsory insurance such as motor insurance, employers’ liability insurance, professional indemnity insurance and warranty insurance; and
  • trade credit insurance, by which a business receives protection against losses incurred by late payment or failure to pay by its buyers.

Recovery and resolution of insurance companies

In the case of systemic insurers, it is critical to ensure the continuity of policyholder protection, in relation to which recovery and resolution plans will play an important role.  Triggers to resolution and resolution powers also remain the same as for CCPs/CSDs.  However, with respect to resolution tools, the Commission notes that existing legislation is primarily designed to protect policyholders and is not designed to contain the wider effects associated with the failure of a systemic insurer.  Traditional resolution tools include:

  • run-off;
  • portfolio transfer;
  • insurance guarantee scheme;
  • bridge institution;
  • restructuring of liabilities; and
  • compulsory winding-up.

These tools are generally considered to be effective in conserving the value of an insurer’s assets and protecting policyholders from unnecessary losses.  However, in order to avoid the disruption to financial markets and the real economy associated with the failure of a systemically important insurer it is necessary to have a variety of alternative ways to carry out resolution, such as the ability to separate the systemically important non-traditional activities of the insurer from the traditional activities.

Again, “bail-in” in the context of insurance companies is of most interest.  This would entail the recapitalisation of an insurer by writing down debt and converting claims to equity, either in a bridge institution or in the original firm.  In doing so, it would be possible to ensure the continuation of critical services and provide sufficient time to facilitate the orderly reorganisation or wind-down of the failed insurer.  The consultation paper notes that bail-in could potentially apply to all liabilities of the institution with the exception of:

  • secured liabilities;
  • insurance policies;
  • client assets; and
  • other liabilities such as salaries, taxes or payments due to commercial partners.

Payment Systems And Other Nonbank Financial Institutions/Entities

Two types of entity are identified:

  • Payment Systems (such as TARGET2 or CHAPS), and
  • Payment Institutions (PIs) and Electronic Money Institutions (EMIs).

The Commission concludes that neither merits further consideration in the context of the consultation due to:

  • the vital nature of payment systems, and their specific relationship with and oversight by central banks; and
  • the fact the neither the failure of a PI nor an EMI is likely to represent a significant risk from a systemic point of view.

Other nonbank financial institutions

The consultation paper identifies other financial institutions, including investment funds and certain trading venues, which have not previously been discussed  and which could contribute to the build-up or transmission of systemic risk.  The Commission believes that the resolution of such entities is likely to be very similar to those for banks, investment firms, insurance companies and other entities captured by the consultation.

Defining the Clearing Threshold for Non-Financial Counterparties Under EMIR

If you have an interest in regulatory reform matters beyond simply RRP and CASS RP, you may be interested in a new post regarding the clearing threshold for non-financial counterparties under EMIR that has just been published on my other blog, which has been recently lauched – please see here.

All the best

Michael

HM Treasury Consultation: RRP for Financial Market Infrastructures

On 1 August 2012, HM Treasury published a consultation document entitled “Financial sector resolution: broadening the regime”.  Citing the collapses of Bear Stearns (an investment firm) and AIG (an insurer), the UK Government is reviewing the need to establish a resolution regime framework for non-banks on a more accelerated timetable than that currently envisaged in ongoing international work.

The consultation is open for responses until 24 September 2012.  It asks for views on the most appropriate type of policy response with respect to systemically important firms, specifically whether existing administration/run-off arrangements should be extended/strengthened or whether a new comprehensive resolution regime should be introduced.  The consultation paper addresses four broad sectors:

  • investment firms and parent undertakings;
  • central counterparties (CCPs);
  • non-CCP financial market infrastructures (non-CCP FMIs); and
  • insurers.

HM Treasury considers that each of the above categories may be systemically important.  In addition, it does not preclude the possibility that other types of non-bank financial institution may also be systemically important, specifically referring to hedge funds.  However, it accepts that the case against insurers in “less clear cut” and recognises that, in practice, it is likely that only some, if any, of each type of entity within a category will actually be systemically important.

The UK Government expects the benefit of taking action pursuant to a formal resolution regime to exceed the costs of disorderly failure.  As such, it believes that there is a strong case for introducing powers earlier than is expected as part of any European process.  However, it does not propose to introduce stabilisation powers for insurers, non-CCP financial market infrastructure or shadow banking entities at this stage.  A more detailed summary of the consultation paper is provided in the schedule below.

 SCHEDULE

1. Investment Firms

The consultation paper notes that the UK Special Administration Regime (“SAR”) introduced under the Banking Act 2009 has strengthened the UK’s ability to manage the failure of investment firms.  However, due to the fact that the resolution powers established under the Banking Act 2009 only apply to deposit-taking institutions, it believes that there is no suitable regime for managing the failure of:

  • systemically important investment firms;
  • parent undertaking(s) of systemically important investment firms; or
  • parent undertaking(s) of deposit-taking institutions.

As such, the UK Government intends to legislation in order to plug this gap.

1.1 Investment firms that would be subject to the new resolution regime 

The UK Government believes that it would be inappropriate to apply a prescriptive definition of ‘systemic investment firm’ due to the fact that:

  • some factors which will be relevant in assessing systemic importance will inevitably change over time; and
  • too restrictive a definition may make it difficult to take action to resolve a non-systemic firm before it actually reaches the point of failure.

As such, all UK incorporate investment firms will be subject to the new resolution regime.  For these purposes, an ‘investment firm’ means a UK institution which is an investment firm for the purposes of the Capital Adequacy Directive.[1]  However, it is important to note that the proposed stabilisation powers would only be exercisable with respect to a systemic investment firm.  Nonsystemic firms would be entered into the existing SAR.

1.2 The application of the new resolution regime to parent undertakings

Certain restrictions will apply to the use of stabilisation powers with respect to parent undertakings:

  • the intended legislation will only provide resolution powers for UK firms and parent undertakings;
  • the proposed stabilisation powers will only be exercisable in relation to financial elements of the holding company; and
  • where there is an overall parent holding company which owns both financial and non-financial subsidiaries and an intermediate holding company which owns the systemic financial subsidiary, stabilisation powers will only be exercised at the intermediary level.

1.3 Trigger conditions for intervention

Intervention will only be possible with respect to a systemically important firm, and will require the relevant firm’s regulator to be satisfied that the firm is failing, or likely to fail, its regulatory threshold conditions and that it is not likely that action (other than resolution action) will be taken to enable the firm to meet its threshold conditions.

1.4 Objectives for the resolution of investment firms and parent undertakings

The objectives for resolution of a systemically important investment firm and its parent undertakings will largely mirror the objectives for resolution of a deposit-taking institution, but will include the following additional objectives:

  • protection of client funds and client assets; and
  • avoiding unnecessary interference with the operations of financial market infrastructure.

1.5 Design of stabilisation powers

The powers to resolve a systemically important investment firm and/or its parent will be broadly similar to those contemplated in the draft Recovery and Resolution Directive (the “RRD”) i.e. transfer to a third party purchaser or a bridge institution.  However, the following powers will not be implemented separately from the RRD process:

  • bail-in;
  • transfer to an asset management vehicle; and
  • a stay on the exercise of early termination and close-out netting rights in financial contracts held by counterparties of a failed firm.

1.6 Safeguards

Safeguards to protect property rights affected as a result of the exercise of property transfer powers will be established by secondary legislation.

2. Central counterparties

2.1 Scope of the intended resolution regime

The Government’s proposed resolution regime for CCPs would capture any clearing house  incorporated in the UK and recognised under Part 18 of FSMA 2000. However, only systemically important CCPs would be subject to the resolution powers.  Before being able to exercise a stabilisation power to resolve a failing clearing house, the Bank of England would have to be satisfied that the exercise of stabilisation powers is necessary in pursuance of specified public interest aims. The powers would be similar to the stabilisation powers proposed for investment firms albeit that it is not envisaged that HM Treasury would have the power to transfer a clearing house into public ownership.

2.2 Trigger conditions for intervention

Conditions for intervention in order to ensure the continuity of clearing services would be triggered where a clearing house had breached, or is likely to breach, the conditions which the clearing house must meet in order to be, and continue to be, a recognised clearing house.  Two further preconditions to intervention would be that:

  • it is not likely that other actions would enable the clearing house to once again meet its authorisation conditions; or
  • notwithstanding that other actions would restore the clearing house to compliance with its authorisation conditions, such actions would undermine the continuity of clearing services.

2.3 Resolution Powers over CCPs

2.3.1 Power to direct clearing houses

The Bank of England would have the power to direct the actions of a clearing house if it was satisfied that this is in the public interest with respect to:

  • protecting, or maintaining confidence in, the UK financial system; or
  • protecting or maintaining the continuity of the services provided by the CCP or the CCP itself.

This power would enable the regulator to direct a CCP to take, or refrain from taking, action to address risks to its solvency or any other matter.  Specifically, a CCP could be required to amend/activate its rules or introduce emergency rules.

2.3.1 Power of Direction over an Administrator

The resolution authority would have power to direct the administrator of a failed CCP (subject to certain conditions) to take action to address risks to financial stability and ensure the continuity of services in support of an acquirer of the CCP’s business.

2.4 Objectives for operation of a resolution regime for CCPs

The objectives of the authorities with respect to the resolution of clearing houses would closely follow those already applicable to deposit-taking institutions under the Banking Act 2009 but would include an additional objective reflecting the need to maintain the continuity of the provision of critical central counterparty clearing services. As such, the set of resolution objectives would be as follows:

  • to maintain the stability of the financial systems of the United Kingdom;
  • to protect and enhance public confidence in the stability of the financial systems of the United Kingdom;
  • to maintain the continuity of the provision of central counterparty clearing services;
  • to protect public funds; and
  • to avoid interfering with property rights in contravention of the Human Rights Act 1998.

2.5 Stabilisation powers for CCPs

The stabilisation powers applicable to CCPs would broadly follow the design of existing stabilisation powers for banks, namely enabling the transfer of securities, property, rights and liabilities to a private sector purchaser or a ‘bridge’ CCP.  In order to ensure that clearing services remain uninterrupted, the Bank of England would also have power to:

  • temporarily suspend termination rights and ensure that any application of the stabilisation powers did not constitute an event of default with respect to any of the CCP’s contracts;
  • transfer membership agreements and clearing member positions and transfer and/or amend the rules of operation of a failed clearing house for a specified period of time or until a specified event occurred;
  • direct the actions of any insolvency practitioner appointed in relation to a clearing house; and
  • impose liabilities on shareholders and/or members of a CCP (potentially subject to a liability cap), to require them to contribute funds to restore a clearing house to viability.

2.6 Safeguards

Safeguards will include:

  • requirements that creditors are not discriminated against on grounds of nationality;
  • compensation arrangements for those affected by the exercise of stabilisation powers; and
  • measures to protect against partial property transfers.

3. Non-CCP financial market Infrastructures

3.1 Improving the regulatory framework for managing the failure of non-CCP FMIs

Non-CCP FMIs include:

  • central securities depositories and securities settlement systems;
  • payment systems;
  • exchanges and trading platforms; and
  • trade repositories.

There is currently no resolution regime for non-CCP FMIs, which are subject to ordinary UK insolvency law.  However, the failure of a non-CCP FMI would likely result in the cessation of critical services.  As such, the UK Government believes there is a need to legislate in this area and identifies two broad approaches:

  • strengthening the existing insolvency arrangements to ensure that the available insolvency mechanisms are adequate; and
  • developing a new, comprehensive resolution framework.

The trigger for intervention seems likely to occur when a firm is failing, or likely to fail, to continue to meet its regulatory recognition/authorisation/operational requirements, with no reasonable prospect of remedial action to address this.

Under the first approach, a modified administration regime is contemplated under which an administrator would have the specific objective of ensuring the continuity of services, supplemented by additional powers to enforce a stay on early termination rights and a moratorium on payments to creditors.

Under the second approach, a new resolution regime would be put in place, supplemented by appropriate powers such as:

  • the power to transfer some or all of a non-CCP FMI’s operations to a third party provider or to a bridge institution;
  • loss allocation or cash-call powers under which the system’s owners or members/users could be required to bear losses and/or provide additional funding; and
  • step-in powers under which the authorities could take over the management of the FMI, irrespective of any insolvency proceedings.

4. Insurers

4.1 Improving the regulatory framework for managing the failure of insurers

The UK Government broadly accepts that disruption to core insurance activities in themselves is unlikely to cause financial instability.  However, it is of the opinion that insurance institutions can still have a degree of systemic potential depending on:

  • the complexity of business models, particularly interconnectedness with banks;
  • dependencies and inter-linkages with other financial institutions (including through undertaking non-traditional insurance activities);
  • institution size; and
  • market share in insurance products that are necessary, or compulsory, for the functioning of economic activity.

As such, the Government wants to ensure that, on the failure of any insurer:

  • an orderly market exist can be facilitated; and
  • an appropriate degree of policyholder protection should be achieved, including, where appropriate, though continuity of cover.

The UK does not have a specific resolution regime for insurers.  Presently, failed insurance firms are dealt with through ‘run off’.  However, this process can result in the effective subordination of longer-dated policyholders.  With the goal of ensuring the continuity of payments and protection for policyholders, particularly (though not exclusively) long-term policyholders, the consultation paper identifies two possible options for managing the failure of insurance firms:

  • reviewing the adequacy of existing insolvency arrangements; and
  • assessing whether evidence exists to justify the establishment of a comprehensive set of resolution stabilisation tools specifically for the insurance industry, including the power to transfer assets and liabilities from a failing insurer to a third party.


[1] Directive 2006/49/EC

The Draft RRP Directive: A CCP’s Perspective

Introduction

On 25 July 2012, the European Association of Central Counterparty Clearing Houses (“EACH”) published a response document to the EU proposal for a directive on bank recovery and resolution (the “RRP Directive”).  The response document provides an interesting insight into the aspects of RRP which are of significance to a CCP.

EACH fully supports the RRP Directive, but feels that the proposal undermines the objectives of EMIR by weakening the risk protections of CCPs in the areas detailed below.

“Sale of Business Tool” and “Bridge Institution Tool”

These resolution tools state that the purchaser (in the case of the Sale of Business Tool – see Article 32.10) or the bridge institution (in the case of the Bridge Institution Tool – see Article 34.8) is to be “considered to be a continuation of the institution under resolution, and may continue to exercise any…right that was exercised by the institution under resolution in respect of the assets, rights or liabilities transferred, including the rights of membership and access to payment, clearing and settlement systems.”

EACH has concerns with respect to the situation where the institution under resolution is a clearing member of a CCP.   In these circumstances, EACH claims that it is vital for the safe operation of a CCP that the purchaser/bridge institution remains capable of fulfilling all of the membership requirements of the CCP as well as all resultant obligations.  Moreover, EACH maintains that the relevant CCP itself must retain the right to determine whether a purchaser/bridge institution meets these criteria so as to avoid unnecessary risk to the stability of the CCP.

“Bail-in Tool”

Article 38(4) of the proposed RRP Directive empowers the EU Commission to consider, under certain circumstances, whether exclusions to the scope and use of the Bail-in Tool are necessary in order to ensure that the resolution objectives specified in Article 26(2) of the proposed RRP Directive are protected.  One of the circumstances specifically contemplated in Article 38(4)(b)(ii) is the possible effect that the application of the debt write-down tool to derivatives that are cleared via a CCP would have on the operation of the CCP itself.

In these circumstances, EACH considers it vital that the CCP retains the right to call the institution under resolution into default.  This would allow the CCP to trigger its default procedures, potentially close-out or transfer positions, and enforce against collateral held by the CCP.  If this is not the case, EACH believes that the CCP’s survival could be threatened.

“Resolution Powers”

Article 62 of the Draft RRP Directive provides for the temporary power of resolution authorities to restrict the ability of creditors of an institution under resolution from enforcing against security interests.  However, CCPs are specifically excluded from this restriction.

Article 63 of the draft RRP Directive enable resolution authorities to temporarily suspend certain rights of a counterparty to an institution under resolution to terminate financial contracts.  Although all reasonable efforts must be made to ensure that margin and collateral calls are met, again, there is no express exclusion to recognise the unique position of CCPs.

Article 61 of the RRP Directive provides for the power to temporary suspend payment and delivery obligations of an institution under resolution, with no exemption being applied to recognise the unique situation of CCPs at all.

This, claims EACH, runs counter to the recommendations of the FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions” published in October 2011, specifically paragraph 3.2(xi) which recognises that “Resolution authorities should have at their disposal a broad range of resolution powers, which should include powers to…Impose a moratorium with a suspension of payments to unsecured creditors and customers (except for payments and property transfers to central counterparties (CCPs) and those entered into the payment, clearing and settlements systems) and a stay on creditor actions to attach assets or otherwise collect money or property from the firm, while protecting the enforcement of eligible netting and collateral agreements”.

RRPs for CCPs within the EU by the end of 2012

On 26 June 2012, the FSA published a speech on the issue of derivatives reform given by David Lawton, Acting Director of Markets, to the IDX International Derivatives Expo in London.

Mr Lawton noted that good progress had been made in reforming derivatives markets, but that issues were outstanding in four main areas:

  • rules for bilateral collateralisation of uncleared trades;
  • recovery and resolution plans for central counterparty clearing houses (CCPs);
  • promoting consistent cross-border application of requirements; and
  • ensuring the readiness of firms, both financial and non-financial, which are not currently clearing OTC derivative trades.

Mandatory clearing will increase the amount of risk concentrated in CCPs.  In turn, this brings into focus the importance of effective recovery and resolution planning for CCPs, which will be the subject legislation at an EU level before the end of 2012.  In addition, the Committee on Payment and Settlement Systems (CPSS) and International Organisation of Securities Commissions (IOSCO) are due to publish a consultation paper on this issue.  This is likely to be based on the FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions”, which were published in October 2011.  The consultation paper will seek to identify whether and how each Key Attribute applies to a Financial Market Infrastructure (FMI) and what special guidance may be needed for FMIs, authorities and other parties.

The text of the speech is available here.