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.