IOSCO Publishes Responses to CPSS/IOSCO Consultative Report on RRP for FMI

On 8 November 2013, the International Organization of Securities Commissions (IOSCO) published links to the public responses it has received to the consultative report published jointly with the Committee on Payment and Settlement Services (CPSS) in August 2013.

Responses include:

  • The Alternative Investment Management Association (AIMA) and Managed Funds Association (AIM).
  • The European Banking Federation (EBF).
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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

FMI Recovery Continues to Take Centre Stage

On 12 August 2013, the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) published a consultative report on the Recovery of financial market infrastructures (FMI) and a cover note detailing the specific issues on which comment is sought.  The consultation period ends on 11 October 2013.

The report provides guidance to FMIs and authorities on the development of robust recovery plans. It was produced in response to requests for additional guidance following the publication in July 2012 of the CPSS-IOSCO report on Recovery and resolution of financial market infrastructures and supplements the Principles for financial market infrastructures, published in April 2012.  It should also be read in conjunction with the recent Financial Stability Board consultation regarding the Application of the Key Attributes of Effective Resolution Regimes to Non-Bank Financial Institutions (see this blog post for more detail).

The report includes an interesting high-level discussion on the design and use of recovery tools, touching on issues such as:

  • transparency versus flexibility;
  • loss allocation waterfalls;
  • mutualisation of loss versus targeting of losses;
  • the balance between pre-funded and non-prefunded resources;
  • incentivising stakeholders to:
    • manage risk vis-à-vis FMIs;
    • assist in default management processes; and
    • maintain/increase the use of an FMI rather than settle bilaterally.

Recovery tools are separated into five categories:

  • tools to allocate uncovered losses caused by member default;
  • tools to address uncovered liquidity shortfalls;
  • tools to replenish financial resources;
  • tools to allocate losses not related to participant default;
  • tools for central counterparties (CCPs) to re-establish a matched book; and
  • tools to address structural weaknesses (not addressed further in the report).

Tools to allocate uncovered losses caused by member default include:

  • cash calls on participants;
  • position based loss allocation tools;
  • variation margin haircutting; and
  • initial margin haircutting.

There is an interesting discussion as to how cash calls should be calculated – whether fixed or as a proportion of default fund contributions, volumes or positions – and the pros and cons of capped versus uncapped calls.  The potential downsides of this tool are highlighted, particularly the pro-cyclical effects they can have as well as the credit risk inherent within the application of this tool.  Position based loss allocation tools include borrowing funds owed to participants (loans, repos etc.), variation margin haircuts, reduced payouts and contractual tear-ups.  On the plus side, they are generally regarded as being a comprehensive solution to the problem of shortfalls which can be executed immediately and involve no performance risk vis-à-vis the FMI participants.  On the down side, it was noted that they can have a negative effect on participants’ confidence in the FMI.  Variation margin haircutting in particular may not allocate losses to those best able to cope with them.  Initial margin haircutting is also regarded as an effective tool and one which may facilitate access to a much larger pool of assets than variation margin haircutting.  Unfortunately, it is also one which exposes a CCP to risk during the period where initial margin is being replenished, may well have pro-cyclical effects and would likely result in a capital charge for participants (due to the initial margin not being held in a bankruptcy remote manner).

Tools to address uncovered liquidity shortfalls mainly involve obtaining liquidity – either from third-party institutions or from non-defaulting participants.  In the case of the latter, there is a discussion as to whether participants which are owed money by the FMI should be accessed first as they would not be required to pay-in money to the FMI, thus reducing performance risk associated with the use of this tool.

In the main, the discussion regarding tools to replenish financial resources focuses on cash calls on participants (see above for more detail).

Tools to allocate losses not related to participant default range from simple loss allocation, to capital raising, insurance and indemnities.  The risks inherent with respect to insurance (the time taken to process a claim, the uncertainties of a pay-out and the capped nature of most pay-outs) are noted.

Discussion with respect to the tools for CCPs to re-establish a matched book focus, in the first instance, on incentivising participants to accept unmatched contracts.  This can be achieved by making the default fund contributions associated with these trades the last to be used in a default scenario.  Whilst this is regarded as a transparent tool which mitigates the risk of a failed auction, it is accepted that it does not represent a comprehensive solution.  As such, consideration is given to the forced allocation of contracts.  Whilst this is a comprehensive solution which involves no performance risk, it is noted that it may result in contracts being allocated to participants which are unable to manage them.  The option of contract termination is also discussed.  Whilst another comprehensive and effective solution, the use of this tool exposes participants to replacement cost risk, is disruptive to the market where contracts are terminated, may actually trigger the spread of contagion and could create disincentives for firms to participate (as their hedged positions could effectively be turned into directional ones at the option of the CCP).  As such, it is questionable whether the use of this tool actually contributes to achieving the objective of continuity of key services.  The conclusion is that the use of contract termination (at least full, as opposed to partial, termination) should be avoided to the extent practicable.  Indeed, the report suggests that the use or imminent use of such a tool may itself be regarded as a trigger for resolution.

Bail-in and the Central Clearing of Derivatives

Pursuant to Article 38(3) of the original EU Commission proposal for a EU Directive establishing a framework for the recovery and resolution of credit institutions and investment firms (the “RRD”), resolution authorities may exclude derivatives transactions from the scope of the Bail-in tool if that exclusion is “necessary or appropriate” to:

  • ensure the continuity of critical functions; and
  • avoid significant adverse effects on financial stability.

Much has already been written as to whether derivatives should be in- or out-of-scope as far as the Bail-in tool is concerned.  The practical difficulties of implementing bail-in in relation to portfolios of derivatives transactions is generally recognised.  In addition, whilst excluding derivatives from the scope of bail-in creates a clear regulatory arbitrage in the way in which deals can be structured between counterparties, this risk is mitigated by the fact that firms which are subject to the RRD will be required to maintain a minimum amount of bail-inable debt at all times.

In many ways, the greater risk lies not in whether derivatives themselves are in- or out- of scope, but in the fact that Member States are given discretion to choose whether they are or not.  The extent to which this is really consistent with the concept of a single market is unclear, and some commentators have questioned whether this aspect of the EU Commission draft would survive the EU trialogue process under which the EU Commission, EU Parliament and the Council of Ministers thrash out their differing opinions with respect to proposed legislation with a view to arriving at a compromise position.  However, this question was largely answered on 5 June 2013, when the EU Parliament’s Economic and Monetary Affairs Committee published a report which sets out the Parliament’s proposed amendments to the RRD, in anticipation of the beginning of the trilogue process.  Within the EU Parliament document, the concept of Member State discretion in determining whether derivative transactions are in- or out-of-scope for the purposes of the bail-in tool remains intact and so seems unlikely even to arise during the trilogue discussions.

Interestingly, the EU Parliament has taken matters a step further, suggesting a different amendment which would, if passed, require that cleared derivatives are treated as more senior than non-cleared derivatives in a bail-in situation.  In other words, non-cleared transactions stand to be bailed-in before cleared transactions.  This is understandable in the context of the drive towards central clearing.  However, it will potentially change the risk associated with counterparties which are subject to the RRD and are established in jurisdictions where derivatives are within the scope of the Bail-in tool.  It will also potentially impact on the price at which such trades are executed.  It remains to be seen just how this provision interacts with another exclusion from the scope of the Bail-in tool – that relating to secured liabilities.  It may be that only uncollateralised non-cleared transactions would be affected.  Moreover, in light of requirement to enact the BCBS/IOSCO “Margin requirements for non-centrally cleared derivatives” in Europe, there may not be much of this trading activity taking place in the future.  Of course, excluding secured derivatives from the scope of the bail-in regime would likely defeat the point of bailing in derivatives in the first place.  In this scenario the discretion afforded to Member States may be more illusory than real.  Either way, as we don’t currently have answers to any of these questions we’ll be monitoring how this conversation develops, so watch this space.

CCP Loss-Allocation Rules Under the Microscope

This is a link to an article in risk magazine regarding CCP recovery planning, and specifically loss allocation rules.

The article highlights differing views within the market regarding the extent to which loss-allocation rules within a recovery (but not necessarily a resolution) scenario should be flexible or prescriptive in nature.  The article points to a paper published by the Bank of England in April 2013, which states that loss-allocation rules should provide a full and comprehensive description of the way in which losses would be allocated and be capable of being implemented quickly.

CCP loss-allocation rules play an important part in the recovery of financial market infrastructures, such as CCPs.  However, as the CPSS/IOSCO paper on Recovery and resolution of financial market infrastructures makes clear, they are not one and the same thing.  General recovery planning options must remain flexible in nature so as to allow firms to respond appropriately to financial stress scenarios the exact nature of which are impossible to determine before the event.  Nonetheless, account must be taken of clearing members, given their systemic importance and the need for them to be able to effectively manage their own risks.  As such, it must surely be the case that CCP loss allocation rules applied as part of the recovery process must provide a clear, detailed and transparent description of the way in which clearing members which would be liable for shortfalls at the CCP.

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.

Recovery and resolution of financial market infrastructures

Introduction

On 31 July 2012, the Committee on Payment and Settlement Systems (“CPSS”) of the Bank for International Settlements (“BIS”) and the International Organization of Securities Commissions (“IOSCO”) published a joint consultation document on the recovery and resolution of financial market infrastructures (“FMI”s), i.e. systemically important payment systems, central securities depositories, securities settlement systems (“SSSs”), central counterparties (“CCPs”) and trade repositories (“TRs”).

Objectives of the consultation paper

The Financial Stability Board’s “Key Attributes of Effective Resolution Regimes for Financial Institutions” (the “Key Attributes”) requires that FMIs establish resolution regimes appropriate to their critical role in financial markets.  The main purpose of the CPSS-IOSCO consultation paper is to outline the issues that should be considered for different types of FMIs when putting RRP regimes in place in accordance with the Key Attributes and the CPSS-IOSCO “Principles for financial market infrastructures” (the “Principles”).

 Conclusions of the consultation paper

 In summary, the consultation document concludes that:

  • the fundamental aspect of RRP as applied to FMIs is ensuring the continuance of critical operations and services;
  • it is vital that robust arrangements exist for the recovery and resolution of FMIs;
  • the Principles set out a recovery framework for FMIs;
  • regulators will need to ensure that appropriate rules and policies are put in place;
  • In the event of recovery failing, the Key Attributes provide a framework for resolution of FMIs. The methodology for assessing compliance with the Key Attributes, currently being prepared by the Financial Stability Board, will need to contain FMI-specific elements.

 The consultation paper is broken down into five sections:

  • Introduction;
  • Relationship and continuity between the Key Attributes and the Principles;
  • Recovery and resolution approaches for different types of FMI;
  • Important interpretations of the Key Attributes when applied to FMIs; and
  • Cooperation and coordination among relevant authorities.

A summary of the consultation paper is provided in the Schedule below.  The consultation itself is open for comments until 28 September 2012, with further work on this issue is to be published later in 2012.

Schedule

 1. Introduction

The consultation document makes clear that the fundamental aspect of RRP as applied to FMIs is ensuring the continuance of critical operations and services of the FMI during a financial crisis.

2. Relationship and continuity between the Key Attributes and the Principles

Six areas for avoiding and mitigating systemic risk through strong recovery and resolution capabilities are identified within the consultation document.

2.1 Preventive measures and recovery planning

Authorities should ensure that FMIs develop comprehensive plans that identify:

  • critical operations and services;
  • scenarios that may potentially prevent the FMI from continuing as a going concern, and
  • the strategies and measures necessary to ensure continued provision of critical operations and services should those scenarios occur.

2.2 Oversight and enforcement of preventive measures and recovery plans

Authorities should continually assess the adequacy of an FMI’s recovery plans and, where deficiencies exist, have the power to enforce observance of the Principles.

2.3 Activation and enforcement of recovery plans

Authorities should oversee and have the power to enforce the execution of recovery plans by FMIs, including the power to:

  • issue orders;
  • impose fines or penalties; and
  • force a change of management.

2.4 Beyond recovery

In order to ensure the continuation of critical operations and services, resolution regimes covering FMIs should be specifically incorporated into law due to the fact that traditional bankruptcy procedures do not have the preservation of financial stability as an objective.

2.5 Resolution planning

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

2.6 Cooperation and coordination with other authorities

RRP preparation and implementation should be supported by ex ante and “in the moment” cooperation and coordination amongst authorities.

3. Recovery and resolution approaches for different types of FMI

The consultation document draws a distinction between FMIs that take on credit risk as principal (such as 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 performance guarantees), and those that do not (such as TRs).

3.1 FMIs that do not take on credit risk

3.1.1 Recovery

All FMIs should have minimum levels of capital resources as well as recovery plans to manage circumstances in which those reserves prove inadequate.

3.1.2 Resolution

Even where an FMI does not take credit risk, authorities should have the power to:

  • transfer some or all of the FMI’s operations to one or more third parties; and
  • place the FMI into some form of administration, with power to suspend or renegotiate contractual arrangements entered into by the FMI.

3.2 FMIs that take on credit risk

3.2.1 Recovery

A CCP, and any other FMI that faces credit risk, should establish rules that address how credit losses in excess of available financial resources are to be allocated.  Typically, this may be achieved via the application of haircuts to the margin and collateral owing to surviving participants.

3.2.2 Resolution

Where the resolution triggers of an FMI are satisfied, in order to ensure that critical services are protected, the resolution authority should have available to it a broad range of resolution tools relating, inter alia, to:

  • loss allocation;
  • transfers; and
  • stay on termination rights.

Loss allocation

Prior to resolution, the rules of the FMI may impose losses on some participants ahead of equity. Once in resolution, further loss allocation amongst creditors should follow the ranking in insolvency, meaning that equity should typically be written down ahead of debt.  Authorities should also have loss allocation powers which go beyond that contemplated by the rules affecting participants in the FMI, including the power to;

  • haircut margin; or
  • enforce outstanding obligations under the FMI’s rules to replenish default funds or make cash calls.

The above options result in losses being distributed in a different manner.   Enforcing outstanding default fund contributions and cash call obligations is likely to affect clearing members only.   In contrast, margin-haircutting solutions are likely to involve losses falling on the clients of clearing members as well as clearing members due to the fact that, typically, client contracts include provisions for any losses suffered by a clearing member to be passed on to the client.

Transfers

Resolution authorities will need the power to transfer operations/assets to a third party purchaser/bridge institution.

Stay on Early Termination Rights

Resolution authorities should have the power to impose a stay on exercising termination rights (but not other contractual obligations):

  • against participants of an FMI, as the exercise of early termination rights in these circumstances could prevent the FMI from continuing critical operations and services and/or, in the case of a CCP, result in an  “unmatched book”; or
  • where an FMI is reliant upon services provided by an external third party for continuity of critical services (e.g. IT services).

4. Important interpretations of the Key Attributes when applied to FMIs

When interpreting the Key Attributes in the context of RRP for FMIs, the following should be borne in mind:

  • Deposits (Key Attribute 2):  the protection of depositors will not usually be relevant due to the fact that FMIs typically do not receive deposits;
  • Suspension of payments (Key Attribute 3.2(xi)): the suspension of payments by an FMI is likely to perpetuate or even amplify systemic disruption.  It could result in the full or partial stoppage of the system, possibly defeating the objective of continuity of critical operations and services;
  • Appointment of an administrator to effect an orderly wind-down (Key Attribute 3.2 (ii) and (xii)): the power to conduct an orderly wind-down of a firm may not be a credible resolution strategy for FMIs for which making payments is integral to their critical services;
  • Transfer of critical functions (Key Attribute 3.3):  the ability to transfer the ownership/assets/liabilities of an FMI to a transferee may be of limited value as:
    • there may be few (if any) alternative providers of its critical operations/services; and
    • there may be a number of practical issues that would hinder or prevent any transfer e.g. different participation requirements, IT system incompatibility or legal barriers (such as antitrust or competition laws);
  • Bridge institution (Key Attribute 3.4):  transfer to a bridge institution may be a more attractive option when resolving an FMI in that a bridge institution could more readily ensure continuity and stability while avoiding 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, most FMIs typically do not issue debt securities, limiting the utility of bail-in as a resolution tool;
  • Setoff, netting, collateralisation, segregation of client assets (Key Attribute 4): it is particularly important for an FMI to create legal certainty regarding the legal framework governing setoff rights, contractual netting and collateralisation agreements, and the segregation of client assets;
  • Stays on early termination rights (Key Attributes 4.3 and 4.4): a stay on the termination rights of participants, other counterparties and third party service providers is an important resolution tool with respect to an FMI, particularly a CCP;
  • Safeguards (Key Attribute 5): the principal of “no creditor worse off than in liquidation” continues to apply.  However, with respect to FMIs, this concept should be assessed on the basis of creditor claims as they exist following the FMI’s ex ante rules and procedures for addressing uncovered credit and liquidity needs and the replenishment of financial resources;
  • Funding of FMIs in resolution (Key Attribute 6): Resolution regimes for financial institutions should include cost recovery frameworks so as to minimise taxpayer exposure.  However, for certain types of FMI, participant-based arrangements, such as CCP default arrangements, may be more appropriate.  The provision of temporary funding is possible but should be exceptional and subject to strict conditions that restricts moral hazard and ensures the right to recover any such funding;
  • Resolvability assessments (Key Attribute 10): resolution authorities are expected to regularly undertake resolvability assessments for global systemically important financial institutions.  However, resolvability assessments of an FMI should take into account FMIs’ specific role in the financial system and consider such aspects as:
    • the impact on FMI participants and linked FMIs; and
    • the ability of participants and linked FMIs to retain access to the FMI’s critical operations and services;
  • Recovery and resolution planning (Key Attribute 11):  an FMI should develop and maintain comprehensive plans addressing recovery, orderly wind-down and resolution issues within its governance, risk management and operational arrangements that:
    • identify scenarios that may threaten its ability to continue as a going concern;
    • include a substantive summary of key recovery strategies;
    • identify critical operations and services; and
    • describe measures needed to implement key strategies;
  • Access to information and information-sharing (Key Attribute 12): jurisdictions should ensure that no legal, regulatory or policy impediments exist that hinder the appropriate exchange of information.

5. Cooperation and coordination among relevant authorities

The international nature of many FMIs may mean that several supervisory and resolution authorities have responsibilities for an individual FMI.  Consequently, cooperation and coordination among and between these authorities is necessary in order to ensure that their respective responsibilities can be fulfilled efficiently and effectively at all times.