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.

AIMA Questions Systemic Importance of Funds

Introduction

On 11 January 2013, the Alternative Investment Management Association (“AIMA”) published its response to the EU Commission’s Consultation on a Possible Recovery and Resolution Framework for Financial Institutions Other than Banks (the “Consultation”).

Identifying Systemic Importance

AIMA supports the introduction of a robust and effective framework for dealing with the recovery and resolution of systemically important non-bank financial institutions, but believes that neither hedge fund managers nor asset managers are systemically important given their nature, size, activities and structures, as well as the regulatory environment in which they operate.  In contrast, it agrees that central counterparties (“CCPs”) are, in general, systemically important and that national insolvency laws are not adequate to address CCP failures.

Resolution Objectives

AIMA proposes that an alternative resolution objective be adopted in place of the main objective currently within the Consultation i.e. maintenance of critical functions. This alternative objective would stress the need to ensure the rapid and efficient liquidation of all open positions of all CCP members and the timely return of client monies.

Resolution Tools

AIMA is concerned that the tools designed for the resolution of banks or large investment firms are not suitable for CCP resolution.  It also advocates that certain aspects of the Recovery and Resolution Directive (“RRD”) be revisited, proposing that:

  • all CCP clearing members be subject to the RRD;
  • the main objectives of resolution under the RRD are amended to include the continuity of CCP services; and
  • haircuts not be applied to open derivative positions or to margin held by CCPs or clearing members.

AIMA regards the sale of business and asset separation tools as potentially unsuitable for CCPs primarily due to the lack of substitutability between CCPs and the practical difficulties in effecting a transfer of a failed CCPs services to a private sector purchaser.  With respect to the bridge institution tool, AIMA expresses concerns that the sheer operational complexity of CCP activities reduces the likelihood of a successful application of the tool.

AIMA also regards traditional bail-in as being unsuitable to a CCP resolution.  It believes that loss allocation mechanisms for CCPs must avoid the bail-in of open derivative positions held by CCPs and clearing members.  It also regards the haircutting of margin as undesirable, particularly the haircutting of variation margin for ‘in the money’ participants which it views as entirely arbitrary.  It considers that specific liquidity calls on clearing members implies unlimited liability (which may result in higher capital and liquidity charges on clearing members), may exacerbate pro-cyclicality and will potentially promote contagion.  Instead, AIMA stresses the importance of robust pre-failure capitalisation measures and the use of ex-ante resolution funds in order to avoid the need to apply such loss allocation/recapitalisation tools.

Conclusion

AIMA is right to question the application of this legislation to asset managers and hedge fund managers, although its argument that the use of ‘gates’ and ‘side pickets’ are factors which reduce systemic importance is a little difficult to follow at times.  In general, it is not easy to see how funds can legitimately be regarded as systemically important.  However, ‘gates’ and ‘side pockets’ are generally regarded as mechanisms allowing the manager of a fund to manage its liquidity risks, rather than reducing systemic relevance per se.  Indeed, the use of ‘gates’ and ‘side pockets’ can actually amplify systemic risk – particularly in the case of institutional investors unable to redeem investments from affected funds.

With respect to some of the other AIMA proposals, CCP membership itself is not a definitive indicator of systemic importance.  Moreover, whilst AIMA makes a number of valid observations on the subject of loss allocation, there needs to be a recognition that, if ex-ante arrangements fail, losses must be allocated somewhere.  The haircutting of margin, particularly variation margin, is indeed unpalatable.  However, in the absence of an ultimate backstop provided by the taxpayer, we are yet to see a better solution.

An Introduction to RRP for FMI

Background

Broadly, the term ‘financial market infrastructure’ (“FMI”) refers to:

  • central counterparties (“CCPs”);
  • payment systems;
  • central securities depositories;
  • securities settlement systems; and
  • trade repositories.

FMIs contribute to maintaining and promoting financial stability.  However, they also concentrate risk and their disorderly failure could have systemically important consequences.  This brings into focus the issues of how to determine the systemic significance of an FMI as well as the design of recovery and resolution (“RRP”) regimes for FMIs that are determined to be systemically important.

Determining Systemic Significance

The key factors in identifying systemic importance in the context of FMIs are generally considered to be:

  • size;
  • inter-connectedness; and
  • substitutability of services.

Sometimes a distinction is also drawn between FMI which take credit risk and those that do not.  On this basis, non-CCP FMIs such as payment systems are generally regarded as being non-systemic in importance on account of the fact that they tend not to have financial exposure to the same degree as, say, a CCP, and because any failure would likely to be of a more operational or technological nature.  In contrast, and particularly in light of the move towards mandatory clearing of OTC derivatives, CCPs are usually regarded as the most important type of FMI, often to the point where their systemic significance is assumed.  Given their importance and the fact that CCP resolution requires an understanding of all of the issues which are of relevance to FMI resolution generally, CCP resolution constitutes the main focus of this article.

RRP for Systemically Important FMI

RRP for FMIs can trace its roots back to the G20 Pittsburgh summit in September 2009 in which it was declared that all “systemically important financial firms should develop internationally-consistent firm-specific contingency and resolution plans…to help mitigate the disruption of financial institution failures and reduce moral hazard”.  This was followed in October 2011 by the FSB’s “Key Attributes of Effective Resolution Regimes for Financial Institutions” (the “Key Attributes”), which not only set out the core elements considered necessary for effective resolution regimes but also provided sector specific guidance on how these elements apply to FMIs.  Subsequently, the high level principles laid down in the Key Attributes were overlaid with more detailed guidance in the CPSS-IOSCO “Principles for Financial Market Infrastructures”, published in April 2012 (the “Principles”) which identified a number of specific recovery measures that FMIs should take.  By the time of the G20 Los Cabos Summit in June 2012, RRP for FMI had become a major focus, with the leaders’ declaration providing guidance on the future timetable for financial sector reform in this area.  Subsequent work has included the CPSS-IOSCO consultative report on RRP for FMI published on 31 July 2012, followed swiftly on 1 August 2012 by HM Treasury’s consultation document entitled “Financial Sector Resolution: Broadening the Regime”.  On 5 Oct 2012 the EU also published a consultation paper on RRP for non-banks and on 17 Oct 2012 HM Treasury published a summary of responses to its August consultation paper.

Viewed in the aggregate it is clear that the overriding concern in designing resolution regimes for FMIs is to maintain continuity of critical FMI functions.  In this context, each of the elements detailed within the Key Attributes continues to be relevant, but the following take on a particular level of importance:

  • bail-in;
  • transfer of critical functions; and
  • suspension of contractual rights.

Bail-in

It is generally accepted that all FMIs should hold minimum levels of liquid resources, above and beyond those held to cover normal participant defaults, in order to ensure an ability to continue to operate as a going concern.  The Principles suggests that this minimum should equate to at least six months of current operating expenses.  Nonetheless, losses could, in theory at least, still exceed available financial resources, meaning that some form of statutory bail-in for the purposes of loss allocation (and also recapitalisation), must also be considered.

Traditional bail-in involves the write-down of existing debt and/or its conversion into equity.  Unfortunately, unlike banks or investment firms, most CCPs typically do not issue debt securities, limiting the utility of traditional bail-in as a resolution tool.  Moreover, whilst loss-allocation mechanisms such as CCP default funds already exist, these arrangements are primarily concerned with loss-allocation rather than recapitalisation.  A number of CCP-specific bail-in proposals have been suggested, particularly focused on the ability to apply a haircut to margin.  Each has certain advantages and disadvantages, and can result in a very different distribution of losses, as detailed below.

Bail-in Option

Advantage

Disadvantages

Haircutting of 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’
  • Does not necessarily follow insolvency   rankings
  • Losses may also fall on the clients of   clearing members
Haircutting 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’
  • Does not necessarily follow insolvency   rankings
  • Losses may also fall on the clients of   clearing members
Enforcing FMI rules to replenish default funds/make   cash calls 
  • Avoids random allocation of losses resulting   from margin haircuts
  • Increased pro-cyclicality as all clearing members are called for fund
Specific clearing member liquidity   calls
  • Avoids random allocation of losses resulting   from margin haircuts
  • Increased pro-cyclicality as all clearing   members are called for funds
Establishment of ex-ante resolution   fund
  • Avoids negative counter-cyclical impact
  • Difficulty in calculating appropriate levels   of contribution
CCP right to terminate contracts   with non-defaulting clearing members for an amount equivalent to that of the   defaulter 
  • An immediate solution
  • Random, and therefore potentially unfair   loss allocation
  • Potential to amplify systemic effect
Issuance of CoCo bonds by CCPs
  • Burden would not fall on clearing members
  • Uncertainty as to market for CCP CoCo bonds

A number of industry participants have opposed proposals to allow resolution authorities to impose excess losses on a CCP’s clearing members.  It was felt that this would cause uncertainty, potentially lead to distorted incentives such as the early termination and exit of members, result in competitive disadvantage and could have capital and liquidity implications.  In light of this opposition, the UK government has recently decided to shelf its plans in this area.  Instead, it intends to establish a requirement that loss allocation rules be made mandatory for the purposes of authorisation as a Recognised Clearing House within the UK.  However, in general, it seems clear that some form of bail-in for CCPs, probably based on the haircutting of margin, will be the norm, as evidenced by the recent EU consultation paper on RRP for non-banks.

Transfer of Critical Functions

There is a general recognition of the difficulty of successfully applying the business transfer tool to an FMI in general and to a CCP is particular, due, inter alia, to:

  • the relative lack of firms which could act as alternative providers of a failed FMI’s critical operations/services;
  • the different nature of an FMI’s assets and liabilities;
  • operational constraints such as IT system incompatibility;
  • competition issues which may flow from ownership structures; and
  • national political agendas, such as those currently driving the fragmentation of central clearing of OTC derivatives.

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, it is arguable that they do not merit being transferred to a separate ‘bad’ asset management vehicle under an asset separation tool.  All of these factors tend to increase the importance of both bail-in and the bridge institution tools as a method of resolving a failed FMI.  This should enable authorities to ensure stability and the continuity of critical services whilst a private sector purchaser is identified, whilst simultaneously avoiding the legal and operational impediments that may arise with an outright transfer to a third party.

Suspension of contractual rights

The ability of resolution authorities to suspend contractual rights is seen as a necessary pre-condition to achieving the transfer, and therefore the continuity, of critical FMI functions.  It is recognised that the suspension of payments by an FMI is likely to perpetuate or even amplify systemic risk and could defeat the overriding objective of ensuring continuity of critical operations and services.  However, a stay on the termination rights of participants, other counterparties and third party service providers is regarded as an important resolution tool with respect to an FMI, particularly a CCP.

By way of safeguards, 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.

Conclusion

RRP for FMI is just one of a number of current initiatives focused on entities that could contribute to the build-up or transmission of systemic risk.  These include RRP for insurance companies, domestic systemically important banks (“DSIBs”), investment funds and certain trading venues.  However, RRP for FMI is of particular importance given, firstly, the central role played by FMIs (and particularly CCPs) in providing the plumbing for financial markets and, secondly, the emphasis placed on bail-in as a tool in FMI resolution.  Bail-in is undoubtedly the most powerful of the resolution tools, capable of delivering immediate and significant results.  Unfortunately, the very nature of this power means that, if applied incorrectly, bail-in is just as likely to kill as save.  Ultimately, the success of RRP for FMI will lie in striking a delicate balance between the political imperative of ending taxpayer guarantees on the one hand and the economic imperative of securing the financial system on the other.  Detailed guidance on the resolution of FMI will begin to emerge in the first half of 2013.  At that point, we will have a better understanding of whether the attempts of EMIR and Dodd-Frank to harness the potential of FMIs have merely resulted in the creation of a time bomb which RRP cannot defuse.

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.

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.

Derivsource Guide to RRP

Attached is a link to a guide to RRP written by Derivsource and yours truly.  There is also an accompanying podcast on the subject of RRP for financial market infrastructures.  I hope that you enjoy them – and feel free to share the links!

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.

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.