CCP resolution plans start to take shape

LCH.Clearnet's credit default swap (CDS) clearing service, CDSClear, has become the second central counterparty (CCP) to adopt a new loss-sharing practice – a last line of defence if one or more clearing members default and other financial resources have been exhausted. The mechanism is designed to allow a CCP to get back on an even keel before a decision is taken to either close it down or replenish its resources, and could become a key element in regulation on clearing house resolution.

Regulators have become increasingly vocal about the need to ensure CCPs are subject to a set of rules enabling them to be wound up in an orderly fashion without imposing losses on the state. Last October, Paul Tucker, deputy governor of the Bank of England, warned the lack of a resolution regime was a gap in the regulatory architecture that could result in "greater mayhem than if the biggest dealers and banks in the world go bust". At sister publication Risk's annual summit in London in March, Patrick Pearson, the head of the financial markets infrastructure unit at the European Commission (EC), said regulators are looking at the issue – but at that point had no answers.

The loss-sharing mechanism at CDSClear could end up being part of that answer, says Charlie Longden, chief executive of CDSClear, which launched internationally on May 15. Prior to that date, it was clearing for four French member firms only, but has now been joined by 10 new banks.

"The loss-distribution mechanism is an idea that is consistent with broader discussions between the market and regulators. It will be used, based on specific and objective criteria, to absorb losses arising from the default of a CDSClear member in the remote scenario where losses exceed the default fund either during a crisis of unprecedented magnitude or where a series of defaults has already occurred in rapid succession. This is effectively achieved by haircutting the variation margin and product-related cashflows of all net gainers in the service on a given day, subject to caps, and is intended to rebalance the CCP in this specific circumstance before any further decisions are taken to either close out the CDSClear service or replenish the CCP's resources," he says.

A similar approach has also been adopted by the Japan Securities Clearing Corporation for CDS clearing in Japan. In both cases, the mechanism is only activated once all other resources in the waterfall have been exhausted.

The loss distribution mechanism is an idea that is consistent with broader discussions between the market and regulators

At CDSClear, this includes the defaulting member's variation and initial margin, the defaulter's default fund contribution, juniorised default fund contributions, the CCP's own capital and reserves, the surviving members' default fund contributions, and pre-agreed top-up contributions to the fund. If losses still need to be absorbed beyond that point, the margin accounts of every remaining member firm that is a net receiver of margin will take a haircut on the variation margin received, according to a set formula. Put simply, members that have a net in-the-money position will waive their right to a portion of their margin to help the clearing house back on its feet.

Market participants say CCPs and member firms are moving towards the loss distribution mechanism as a way of pre-empting regulatory requirements on clearing house resolution – rules that would hopefully enable stricken CCPs to be wound up without sparking a wider crisis.

"The EC, the Bank of England and other regulators have been looking at CCP resolution in a big way, and this idea has been bubbling away for a while. It is a pre-emptive response to forthcoming regulatory requirements. If the CCP were to fail, this mechanism allows for an orderly resolution," says one OTC clearing expert at a US bank.

The mechanism is also discussed at length in a letter written by the International Swaps and Derivatives Association on April 30 to the Bank of England – which had participated in a call with Isda in March. The letter argues that clearing house users should bear the final loss if a CCP's resources are exhausted, rather than the state.

"Some loss-allocation mechanism must exist. We consider it would be desirable for the loss-allocation mechanism to be equitable and fair, and fall on the clearing members and clients down to the beneficial owner. The rules for the default management process and the use of resources in a CCP default waterfall need to be encoded into a CCP's operating rules," states the letter.

It goes on to argue that broad loss distribution would be an effective way to stabilise financial markets, because each individual stakeholder could reasonably expect to lose only a small fraction of its assets. But Isda also says the process must be subject to a cap, otherwise CCP membership could be seen as exposing a firm to unlimited liability in the event of its default. "Variation margin haircutting is only the last gasp of breath for the CCP," the letter states.

Along with the adoption of the loss-distribution mechanism, CDSClear has also revamped its default auction model, which is designed to ensure all members of the clearing house are incentivised to bid on the portfolio of a defaulting member.

"The auction model is unique to the cleared CDS market. The idea is for all surviving CDSClear members to be able to absorb a part of the defaulting member's portfolio, pro-rata the share of risk they hold in the clearing house. If a member fails to participate in the auction, or its bid price deviates materially from the auction clearing price, then we have the ability to juniorise its default fund contribution so it lies ahead of other members' contributions," says CDSClear's Longden.

This article was first published on www.risk.net.