Skin in the game at CCPs
The announcement by Intercontinental Exchange (ICE) that it is to infuse a chunk of its own capital into some of its default funds across the world is welcome news as a growing percentage of the notional $700 trillion over-the-counter (OTC) derivatives market is pushed onto centralised clearing houses (CCPs) as mandated under the Dodd-Frank Act in the US and the European Market Infrastructure Regulation (EMIR).
The initiative by ICE not only helps improve its risk mitigation procedures but also provides clearing members with potential cost savings, which will ultimately (hopefully) be passed down to end users such as institutional investors and fund managers. The risks associated with CCPs should not be underestimated. The volume of OTC transactions being cleared has skyrocketed over the last few years making them one of the most – if not the most – systemically important financial institutions (SIFIs) in the marketplace today. In other words, a CCP failure would be catastrophic for financial institutions worldwide given their global reach and significance.
There are a number of hypotheses circulating as to what could facilitate a CCP failure. CCPs – by their nature – can only accept high-grade collateral (usually cash or government bonds) as initial margin, and only cash as variation margin. Were there to be a “race to the bottom” in terms of collateral eligibility, a CCP with lower collateral requirements could find itself in trouble. There have been calls for CCPs to ease their collateral eligibility standards so as to avoid a collateral shortfall or squeeze, but these have broadly been rejected by regulators and CCPs. Some have urged high grade corporate bonds be accepted by CCPs albeit with haircuts. This again presents risks given the volatility of some corporates - even highly rated corporates. Note that corporate bonds in the likes of Enron, Lehman Brothers or American International Group (AIG) prior to their respective downfalls could probably have been classified as eligible collateral.
Another threat to CCPs’ operating model could be if CCPs start clearing OTC derivatives that are too esoteric for clearing, and which should be transacted only bilaterally. Perhaps the most significant risk to a CCP is if a large clearing member failed, an event that could lead to contagion at multiple CCPs across multiple jurisdictions. There are historical precedents of this occurring. The Paris-based Caisse de Liquidation des Affaires en Marchandises (CLAM) collapsed in 1974 when traders were unable to meet margin calls while the Kuala Lumpur Commodity Clearing House in Malaysia failed following defaults by six brokers trading palm oil contracts on the Kuala Lumpur Stock Exchange. A clearing member default today would present a far more substantial threat to capital markets because of the higher OTC volumes.
As such, papers by regulatory bodies, banks and the buy-side have advocated CCPs have better protections in place to guard against failure. A paper published by the Bank for International Settlements (BIS) and the International Organisation of Securities Commissions (IOSCO) recommended CCPs have recovery plans in place, and advocated CCPs be allowed to replenish any funds it uses after a stress event, including demanding additional cash calls from clearing members or raising further equity capital.
A white paper published by J.P. Morgan in September 2014 demanded CCPs put more of their own balance sheet capital into their guarantee funds. J.P. Morgan’s paper said CCPs should contribute more than 10 per-cent of member contributions or the largest single clearing member contribution in order to better align interests and ensure proper risk management and governance. It urged CCPs and clearing members to top-up a re-capitalisation fund, which could be accessed if the CCP uses all of the capital available in its risk waterfall. This should enable the CCP to keep operating during bouts of extreme market stress. There have been calls also for CCPs to undertake mandatory standardised stress tests not too dissimilar to the banks, a point also made in the J.P. Morgan paper.
These thoughts have been echoed by large asset managers including Blackrock and Pimco. A report by Pimco urged the minimum contribution from CCPs to be the highest of 5 per-cent, $20 million or the third largest clearing member contribution. “We believe that requiring a minimum contribution from the CCP to the guarantee fund will help to incentivise the CCP to manage its risk appropriately and provide a systemic safeguard should there be simultaneous failures of its clearing members,” read the Pimco paper. Regulators have taken interest. The Commodity Futures Trading Commission (CFTC) has also confirmed it is reviewing the issue of CCPs putting skin in the game per say. Patrick Pearson, head of market infrastructure at the European Commission, speaking at the Global Custody Forum in London, an event co-hosted by Thomas Murray in December 2014, confirmed regulators were assessing whether CCPs required another layer of total loss absorbing capacity (TLAC).
TLAC is already imposed on banks and stipulates the minimum amount of capital and liabilities that can be written off so as to prevent the use of taxpayers’ money to provide a bail-out. The Bank of England recently all but confirmed it would act as the lender of last resort to a CCP in trouble. Nonetheless, it is believed this is not going to be unconditional lending and liquidity would not be extended to a CCP that was unlikely to remain solvent. It is speculated that central bank lending will only be extended to CCPs should a CCP face a liquidity shock as opposed to a massive hole in its default fund, for example.
At present, ICE appears to be the exception rather than the rule. The CME Group has explicitly refused to put its own capital into default funds arguing its existing stress testing is sufficient already. CME highlights its stress testing incorporates a multitude of financial crises simultaneously including the 2008 financial crisis, the 1987 stock market crash and the spectacular demise of the hedge fund Long Term Capital Management (LTCM). CME also argues that putting more of its own capital into default funds could facilitate greater moral hazard insofar as banks might start transacting in riskier OTC products without posting additional capital.
Whether or not CCPs introduce more skin in the game remains to be seen. Given the regulators’ interest in the matter, it could yet become a possibility.
