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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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.

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.

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.