The Road to Non-Bank Resolution

On 6 May 2013, the EU Commission published a roadmap regarding a framework for crisis management and resolution for financial institutions other than banks (i.e. central counterparties, central securities depositories, insurance and reinsurance firms, payment systems, investment funds and certain trading venues).  The roadmap follows the consultation paper published on 5 October 2012, a summary of which is available here.

Rather than adopt a broad framework approach in terms of applicable nonbank institutions and general tools for authorities to intervene, the Commission believes that more specific provisions and tools in relation to each sectors is more appropriate due to the different types of risk to which each sector is exposed and the differing consequences their failure would have.  The Commission makes clear that any regulation will be proportionate in nature and “only entities which are big, interconnected or central enough in the financial system to cause widespread disruption should they fail” are to be subject to the regulation.

As noted in this update, the EU Commission currently expects a legislative proposal in this area to be adopted in November 2013.

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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.

EU to Adopt Liikanen Proposals and Non-Bank RRP in 2013

On 21 January 2013, the European Commission published a timetable for certain legislative proposals that it expects to adopt between 1 January 2013 and 31 December 2013, including the following:

Q3 2013:

  • Directive/Regulation on the reform of the structure of EU banks (i.e. the Liikanen reforms)

Q4 2013:

  • Framework for crisis management and resolution for financial institutions other than banks
  • Regulation on a single resolution authority and a single resolution fund within a Single Resolution Mechanism.

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.