Battle Lines Drawn Over CCP Resolvability


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.


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

Bail-in Highlights Need for CDS Reform

Here is a link to an article which reports that ISDA has drafted a proposal to add a new credit event for financial credit default swaps.  The proposal is in response to the:

  • introduction of the European Commission’s bail-in framework (part of a package of legislation aimed at bolstering bank recovery and resolution) which will enable governments to write down – or “bail-in” – bank debt of failing institutions in order to avoid bankruptcies and ensure bondholders shoulder bank losses rather than taxpayers; and
  • performance of credit default swaps in the lead-up to the nationalisation of SNS Reaal earlier this year.

The new credit event would be triggered in the event of a government authority using a restructuring and resolution law to write down, expropriate, convert, exchange or transfer a financial institution’s debt obligations.  The trigger would be subject to minimum thresholds in terms of the amount of debt affected, but once exceeded, the protection buyer would be able to deliver the:

  • written-down bonds (as valued on their outstanding principal amount prior to the write-down); or
  • proceeds or other instruments received following application of the ‘bail-in’ tool (provided that these would have qualified as ‘Deliverable Obligations’ immediately prior to the triggering event.

Senior debt will be subject to the EU bail-in provisions from 2018 although recent comment from the EU suggests that this could be brought forward to 2015.  ISDA’s proposals will now undergo consultation with new credit definitions expected by the end of 2013.

ISDA Responds to EU Commission Consultation on RRP for Non-banks

On 23 December 2012, ISDA published a letter sent in response to the EU Commission’s Consultation on a possible recovery and resolution framework for financial institutions other than banks.

ISDA’s response focuses mainly on RRP for Central Clearing Counterparties (CCPs).  It believes that a common resolution framework should apply to all FMIs (and not just to those which exceed specific thresholds in terms of size, level of interconnectedness etc.).  To the extent that an FMI is also a credit institution, ISDA believes that this framework should apply above and beyond the RRP requirements applicable to banks.

ISDA agrees that the general objective for the resolution of FMIs should be continuity of critical services and that any RRP framework should emphasis the issues of recovery and continuity over that of resolution.  More specifically, ISDA emphasises that any RRP initiative should be consistent with seven key principles as set out below.

1. CCP loss allocation procedures must be certain, transparent and avoid unlimited liability for Clearing Members

ISDA asserts that limited liability for clearing members will promote financial stability as it will reduce incentives to “rush for the exits” during a period of stress.  Loss allocation procedures which are not consistent with this principle, such as forced tear-ups and uncapped default fund liability should be avoided.  In addition, ISDA believes that it is unrealistic to think that indirect participants and clients of clearing members can be shielded from losses, although it believes that the specifics of this aspect are best dealt with as a matter of direct agreement between counterparties and to relevant conduct-of-business regulations.

2. CCP loss allocation rules should be respected and applied prior to implementation of resolution

ISDA believes that resolution should only be triggered after an FMI’s agreed and documented recovery arrangements have been given the opportunity to succeed an only after consultation (however brief) with market participants.

3. Any framework must be consistent with CPSS-IOSCO FMI RRP principles

ISDA believes that the ultimate success of any RRP initiative is dependent on the creation of a globally consistent standard.

4. The relationship between recovery and resolution of CCPs must be clear, predictable and transparent

Resolution should only occur when it is where it is ‘necessary’ (rather than merely ‘desirable’) to address a serious threat to financial stability.  This arises when an FMI has reached the point where there are no realistic prospects of recovery over an appropriate timeframe, when all other intervention measures have been exhausted, where additional losses arise from a source for which there are no CCP rules, and when winding up the institution under normal insolvency proceedings would risk causing financial instability.

In the interests of predictability, there should be no ability for authorities to intervene before an FMI meets the conditions for resolution.  Rather pre-resolution actions of a supervisor should be limited to providing guidance and ensuring the effective implementation of the FMI’s own procedures.

5 Robust procedures for the transfer of membership agreements and positions must exist

Procedures regarding the porting of positions to a solvent FMI must be established before the event and tested periodically.  In addition, any transfer must be done in a way that does not interfere with members’ existing rights to net exposures against a CCP.  More specifically, ISDA believes that the power to impose a temporary stay on the exercise of early termination rights is not necessary in the context of a failing FMI.  Moreover, it regards the ability to enforce a moratorium on payments beyond a “very limited grace period” as a potentially “dangerous” tool, which should only be available on an exceptional basis when a CCP has non-cash collateral which it is unable to convert into cash as quickly as necessary.  However, as a last resort only, ISDA regards it as “entirely appropriate” for CCPs to include within their recovery provisions the possibility of terminating a particular product set if this is necessary in order to restart a particular market or avoid the effects of contagion.

6 Co-operation and co-ordination between authorities is essential

ISDA agrees that strong cross-border cooperation and coordination, both before and during resolution, are essential to the successful resolution of a failed FMI, with the failing FMI’s national resolution authority taking the lead coordinating role.  Fundamentally, however, it believes that the CPSS, IOSCO and FSB should move beyond existing international RRP standards and adopt a substantive international convention on the resolution of cross-border financial institutions, such as was recommended by the International Institute of Finance in its June 2012 paper entitled “Making Resolution Robust – Completing the Legal and Institutional Frameworks for Effective Cross-border Resolution of Financial Institutions”.

7 Safeguards: Netting and collateral arrangements must be protected throughout resolution

ISDA believes that intervention powers cannot be unfettered or apply retrospectively.  Rather, they should contain restrictions on the transfer of part only of a CCP’s business in a way that interferes with members’ netting rights.  In addition, it is essential that the hierarchy of claims in insolvency be respected and that creditors should not be worse off than in insolvency.