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A blog on financial markets and their regulation
In July 2012, the CPSS (Committee on Payment and Settlement Systems of the Bank for International Settlement) and the IOSCO (International Organization of Securities Commissions) put out of consultation a report on resolution of CCPs (Recovery and resolution of financial market infrastructures: Consultative report).
Buried deep inside the report is a proposal that would permit orderly failure of even systemically important CCPs. The idea is that the CCP could simply tear up some of its settlement guarantees and wash its hands off positions that it is unable to honour. The CPSS-IOSCO document says:
… contracts could be given a final value based on the price at which the most recent variation margin payment obligations from and to participants had been calculated. To the extent that defaulting participants with out-of-the-money positions had been unable to pay variation margin to the CCP, the CCP’s obligations and variation margin payments to all in-the-money participants could be haircut pro rata to the size of their variation margin claims. This would have the effect of allocating in full the losses that had been suffered, and limiting exposure to future losses by eliminating unmatched positions or the possibility of further obligations arising on these unmatched positions. All other contracts – probably the vast majority of the contracts cleared – could remain in force. (para 3.13)
The idea seems to be that if huge price swings and defaults in some particular segment of the CCP’s activities inflicts life threatening losses on the CCP, then the resolution mechanism steps in, cuts this segment loose and allows this segment to die. The remaining segments of the CCP can continue to function unimpeded.
Another way of looking at this is that all settlement guarantees provided by the CCP are loss limited by deep out of the money options that kick in when the CCP enters resolution. If I buy a future at 500, I would normally expect the CCP to honour this contract however much the asset price rises in value. Selective tear up means that if the asset price shoots up to say 5,000 and so many sellers default that the default losses overwhelm the capital of the CCP, it (the CCP or the resolution authority) may simply haircut me and forcibly close out my position at 4,000. It is as if along with buying the future at 500, I also sold a call to the CCP at 4,000.
The big difference is that ex ante, I do not know the strike price of this call. If I had a choice of executing my buy trade at different exchanges (with different CCPs), I would clearly choose the CCP with highest expected strike price for the call that it would wrest from me in resolution. That gives me an incentive to choose the CCP that risk manages this contract well – high margins, aggressive intra-day margin calls, and intense scrutiny of concentrated positions. Volumes in each asset class would drift to the exchange or CCP that imposes strict risk management in that asset class. Instead of a race to the bottom, there would be a risk to the top. Exchanges and CCPs would try to compete on the basis of the most exacting margin requirements. Healthy competition among CCPs would be possible.
Absent any segregation of business segments, a large CCP which clears many different products has a huge incumbency advantage. It can enter a new product segment with low margins and grab market share. People would still trade there relying on the total resources of the CCP (across all segments) even if they know that on a standalone basis, this segment of the CCP is not a reliable guarantor of trades because of the inadequate margins. In effect, the established segments of the CCP would subsidize the new segment and allow it to drive new entrants out business. The threat of selective tear up by a resolution authority has the potential to limit such cross subsidies and make the market for CCP services more contestable and competitive.
Incidentally, the use of haircuts to provide partial insulation of different segments of a CCP from losses in other segments is nothing new. For example, LCH.Clearnet runs a Swap Clear service for Interest Rate Swaps which is structured in such a manner that other segments of LCH are partially insulated from losses in this segment. LCH.Clearnet default fund rules (especially SwapClear Default Fund Supplement rules S8-S11) provide for haircuts if the resources available in the Swap Clear segment are inadequate to meet the obligation of the CCP. My memory is that when the Swap Clear service was first started, the old members of LCH were worried about the potential large losses in this segment being allocated to them, and this separation of segments was worked out to allay their concerns.
The advantage of building selective tear-up into the resolution process is that this allows a carve-out of segments to happen ex post after life threatening losses have materialized. This makes a resolution (without bailout) of a CCP more credible, palatable and feasible. While the large global CCPs came out of the 2008 crisis unscathed, I fear that the next crisis will not be so kind to them. I consider it highly likely that within the next decade a prominent CCP in a G7 country would need to be resolved.