CCP Loss Allocation Rules

This is a link to an interesting paper published by the Bank of England relating to CCP loss allocation rules (first spotted over on The OTC Space).  The paper explains the reasons why CCPs must maintain a matched book at all times and the process typically followed on the occurrence of a clearing member default.  It also provides a useful discussion of the pros and cons associated with various loss-allocation options (particularly around cash calls from clearing members, margin haircutting and contract tear-up) as well as a helpful summary of existing loss-allocation rules of various CCPs, presented in tabular form.

Although it doesn’t provide any answers, the paper does proffer a set of principles, designed to guide CCPs in designing loss-allocation rules.  It notes that the Bank of England will have regard to these principles in assessing the suitability of CCPs’ loss-allocation rules.  In summary, the principles state that:

  • loss-allocation rules should provide a full and comprehensive description of the way in which losses would be allocated – they should be clear, transparent and capable of being implemented quickly;
  • tear-up of contracts should be a last resort to prevent the disorderly failure of the CCP;
  • where tear-up is used, it should as far as possible be isolated to the affected clearing services so as to limit the risk of contagion;
  • loss-allocation rules should positively incentivise participation by clearing members (for example in auctions) and avoid incentives to resign membership (which may prove to be destabilising);
  • loss-allocation rules should not disincentivise effective risk management by CCPs, for example by imposing losses solely on participants and not shareholders; and
  • loss-allocation rules should not compromise the CCP’s risk management of open positions, for example by ensuring the replacement of initial margin which has been made subject to a haircut.

EU Commission Publishes Summary of Responses to Non-Bank RRP Consultation

Introduction

On 8 March 2013, the EU Commission published a summary of the responses (67 in total) it received to its October 2012 consultation on a possible recovery and resolution framework for financial institutions other than banks.  There is also a set of links to individual responses.

The summary addresses views expressed on the three categories of financial Institutions considered in the consultation, being:

  • financial market infrastructures (“FMI”) i.e. central counterparties (“CCP”) and central securities depositories (“CSD”);
  • insurance companies; and
  • other non-bank entities and institutions e.g. payment systems.

Financial Market Infrastructures

There was general agreement on the need for recovery and resolution plans (“RRP”) for FMIs, due to their systemic importance.  Although resolution measures for all FMIs should focus on ensuring the continuity of essential services, the RRP regimes for CCPs and CSDs should be tailored, reflecting the general view that CCPs are more systemically important than CSDs.  Both the RRP regimes for CCPs and CSDs should be different from the current proposals regarding RRP for banks, although powers to transfer operations of a failing FMI to a purchaser or bridge entity would still be required.  There was little common ground on the application of loss allocation to FMI beyond the need for predictability, clarity, preciseness, transparency and parity.

Insurance and Reinsurance Firms

There was a wide-spread recognition that insurance companies are less systemically important that banks and that Solvency II will enhance supervisors’ powers of intervention.  Nonetheless, except amongst insurers, there was general support for further investigation into the scope for resolution tools which could protect policyholders as well as financial stability in the event of an insurer’s failure. However, even outside of the insurance industry, there was no conclusive support as to the need for a detailed RRP framework.  The insurance industry objected to insurance-specific RRP proposals, arguing at a high-level that there is no evidence that RRP is needed and specifically that:

  • as yet, no sources of systemic risk in insurance have been identified;
  • consistency with international developments must be ensured before the EU legislates;
  • the current framework is sufficient, particularly in light of Solvency II; and
  • bank RRP is not suited to the insurance industry.

Other non-bank financial institutions

The majority of respondents expressed the view that payment systems currently do not require further consideration from an RRP perspective due to the fact that they are subject to central bank oversight.

EIOPA Responds to EU Commission Consultation on RRP for Non-Banks

Introduction

On 5 December 2012, the European Insurance and Occupational Pensions Authority (EIOPA) published its response to the EU Commission Consultation on a possible recovery and resolution framework for financial institutions other than banks.

RRP for Insurers

EIOPA supports the principle of RRP for insurers, but emphasises that (re)insurers are believed to have a more stable business model, are less interconnected and, in some cases, are more substitutable than banks.  As such, it claims that the financial stability argument for resolving insurers is not as persuasive as for banks.  It recognises that some insurers are rightly regarded as systemically important but warns that this should not be the sole motivating factor for developing RRP for insurance companies.  Rather, the importance of policyholder protection must be recognised alongside the more general goal of ensuring financial stability and further work is required in order to determine the hierarchy of these objectives.

Resolution Authorities

EIOPA believes that a clear delineation between the mandates of supervisory authorities and resolution authorities is required in order to smooth the transition from recovery to resolution and so avoid “inaction bias” and the “cliff effect”.  Supervisory authorities should have discretion to provide “breathing space” to failing firms as this can lead to better outcomes and avoid pro-cyclical actions that might arise as a result of immediate enforcement.  However, excessive forbearance is to be avoided.  As such, a balance must be struck between the need to act early in the interests of maintaining critical functions and preserving financial stability and the need to protect private property rights.  This balance should be based on a graduated approach to trigger conditions referencing factors such as authorisation requirements.  The graduation would reflect the severity of a breach.  For example, a trigger allowing the appointment of a Special Manager or Administrator would be less onerous and further from the point of balance sheet insolvency than a trigger authorising asset separation or forced sales/transfers.

Resolution tools

EIOPA considers that the following resolution tools are applicable to traditional insurance:

  • Run-off;
  • Portfolio transfer;
  • For non-life mutual and mutual-type associations with variable contributions, the ability to call for supplementary member contributions;
  • Recourse to Insurance Guarantee Schemes to secure continuity of insurance policies by transfer to solvent insurers or compensation of beneficiaries/policyholders;
  • Restructuring of liabilities to ensure that losses are fairly distributed among policyholders/creditors;
  • Appointment of an Administrator/Conservator or Special Manager; and
  • Compulsory winding-up.

However, there is a recognition that the effectiveness of these tools in the resolution of a large, complex insurance group with extensive cross border operations (or the failure of several smaller insurers within a single jurisdiction) is as yet untested and may prove to be inadequate.   In addition, EIOPA believes that some resolution tools, such as the imposition of a moratorium on payments, are primarily designed to protect creditors and so may not provide optimal outcomes for policyholders.  As such, it welcomes the initiative to consider expansion and development of the resolution toolkit to address broader objectives.

With specific reference to the Asset Separation tool, EIOPA sees the merits of being able to separate non-insurance related assets/activities in order to affect resolution of an insurance group but questions the practical relevance of such a power given that non-insurance activity conducted by a solo insurance undertaking is likely to be limited.  Moreover, to the extent that insurance liabilities are matched by assets, it is not clear to EIOPA how such a power would be used.

EIOPA would support measures to broaden the availability of the Bridge Institution tool, especially in the context of dealing with multiple failures.  Similarly, it views the ability to appoint an Administrator or Special Manager options as being useful if capable of being triggered at a suitably early stage.

EIOPA considers that the Bail-In tool is relevant to the insurance industry, but suggests that policyholders should not be subject to its terms.  In addition, development of a Bail-In tool for insurance would need to take account of the fact that the insurance sector is primarily equity funded with unrestricted Tier 1 funds accounting for in excess of 80% of own funds.  In these circumstances, Bail-In may be less effective as a tool than is the case for the banking industry.

EBA Responds to EU Commission’s Consultation on RRP for Non-Banks

On 21 December 2012, the European Banking Authority (EBA) published its response to the EU Commission’s “Consultation on a Possible Recovery and Resolution Framework for Financial Institutions Other Than Banks”.

In general, the EBA believes it important that RRP regimes should be harmonised so as to avoid regulatory arbitrage across borders and between industries such as banking and insurance.  Clear guidance should also be provided on the circumstances and extent to which FMIs which also hold banking licences will be subject to bank or non-bank resolution proposals.  Ultimately, it may be necessary to extend the non-bank RRP proposals to include ‘shadow banking’ entities such as money market funds and hedge funds.

The EBA agrees that the objectives of a resolution regime for FMIs should be aligned with those of banks, namely the continuation of critical functions and the maintenance of financial stability.  Cross-border co-ordination in the form of supervisory Resolution Colleges should also be encouraged.

With respect to resolution tools, the EBA supports the proposal concerning the transfer of critical functions of a failing FMI to a surviving FMI.  In order to facilitate such a transfer, the EBA suggests that ex-ante operational arrangements between FMIs should be established and specifically endorses the actions referred to in the FSB “Key Attributes” paper, namely:

  • A centralised repository for all FMI membership agreements;
  • Standardised documentation for payment services;
  • Draft transition services agreement; and
  • A ‘purchasers’ pack’ including key information on payment operations and credit exposures, and lists of key staff.

With respect to loss-allocation tools, specifically the haircutting of margin held on behalf of clearing members of a failing FMI, the EBA believes that more consideration should be given to the specific circumstances of the clearing member and their ability to actually absorb losses so as to avoid the possibility of financial contagion.  Moreover, any loss-allocation mechanism which goes beyond normal pre-funded loss mutualisation measures (i.e. the guarantee fund) should be closely coordinated with authorities responsible for the supervision and oversight of the clearing members.

On the subject of group resolution of FMIs, the EBA is of the opinion that any recovery and resolution framework should aim to maintain the ‘healthy’ parts of the FMI in question.  In order to protect these ‘healthy’ parts, it may be necessary to wind up or even ‘tear up clearing’ of specific instruments.  In addition, it may be prudent to allow for one part of an FMI group to provide temporary financial support to an FMI in difficulty, provided that this does not risk contagion or involve lending to an insolvent entity.

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

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.