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:
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.
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.
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:
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:
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.
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:
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.
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:
Q4 2013:
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”).
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.
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.
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:
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.
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.
Broadly, the term ‘financial market infrastructure’ (“FMI”) refers to:
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.
The key factors in identifying systemic importance in the context of FMIs are generally considered to be:
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 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:
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.
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Bail-in Option |
Advantage |
Disadvantages |
| Haircutting of initial margin |
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| Haircutting of variation margin |
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| Enforcing FMI rules to replenish default funds/make cash calls |
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| Specific clearing member liquidity calls |
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| Establishment of ex-ante resolution fund |
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| CCP right to terminate contracts with non-defaulting clearing members for an amount equivalent to that of the defaulter |
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| Issuance of CoCo bonds by CCPs |
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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.
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:
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.
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.
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.
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.
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.
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.
ISDA believes that the ultimate success of any RRP initiative is dependent on the creation of a globally consistent standard.
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.
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.
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”.
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.
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.
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.
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.
EIOPA considers that the following resolution tools are applicable to traditional insurance:
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.
Recovery and Resolution Plans 