On Aug. 16, three high-level groups of regulators issued a coordinated package of reports aimed at strengthening the safety and resiliency of derivatives clearinghouses worldwide. The reports review current risk management practices and recovery planning, identify several areas where current practices need strengthening, and seek feedback on proposed guidelines for the implementation of global standards for clearinghouse resilience, recovery and resolution.
The issuance of these reports is part of a broader agenda to strengthen the global clearing system while also mandating greater use of central clearing for derivatives. Comments on the proposed guidelines are due by mid-October, and the guidelines are scheduled to be finalized next year.
The following special report summarizes the main points of three key documents released on Aug. 16 that relate to clearinghouse resiliency, recovery and resolution. The special report also summarizes several other initiatives identified in an overall planning document also issued on Aug. 16. These initiatives include data collection exercises focusing on "interdependencies" among clearinghouse participants as well as the economic incentives for clearing.
The full text of these documents are available at the links below. FIA plans to analyze these documents in the coming weeks and consider the implications for member firms before responding to the regulators.
1) Assessment of Current Financial Risk Management Practices and Recovery Planning
The Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) conducted an assessment of financial risk management practices and recovery planning at a sample group of 10 central counterparties in nine jurisdictions. The assessment focused on the implementation of certain parts of the Principles for Financial Market Infrastructures, a set of global standards issued in April 2012. The assessment's conclusions served as the basis for a consultation paper identifying areas where improvements are needed.
The 10 CCPs in the sample group were: ASX Clear (Futures), BM&FBovespa Clearinghouse, Clearing Corporation of India, CME Clearing, Eurex Clearing, ICE Clear Credit, JSCC, LCH.Clearnet Ltd., LCH.Clearnet SA, and Singapore Exchange Derivatives Clearing.
The analysis was grouped into six topics:
- Governance of risk management
- Credit risk management
- Margin practices
- Liquidity risk management
- Collateral policy and investments
- Default management and recovery planning
The report found that CCPs have made "important and meaningful progress" in implementing arrangements consistent with the standards, but identified "gaps and shortcomings" in several areas and called for "prompt action" by CCPs to address these issues. Three gaps and shortcomings were identified as "serious issues of concern" that need to be addressed by the end of 2016. These three areas are:
- Rules and procedures for recovery planning
- Policies and procedures to ensure the required level of financial resources on an ongoing basis
- The inclusion of liquidity-specific scenarios in stress testing frameworks
2) Proposed Guidance on Risk Management and Recovery Planning
CPMI-IOSCO published a consultative report that proposes more granular guidance on certain aspects of the PFMI standards. The regulators explained that this guidance is needed because of the increasing importance of clearinghouses to the financial system, and because of the "gaps and inconsistencies" identified in their assessment of current practices.
"CCPs have become increasingly critical components of the financial system in recent years, due in part to the introduction of mandatory central clearing for standardized over-the-counter derivatives in some jurisdictions," the report said. "It is imperative that each CCP is sufficiently resilient to withstand clearing member failures and other stress events to a very high probability. Furthermore, CCPs must have recovery plans that enable them to allocate credit losses and liquidity shortfalls fully and replenish financial and liquidity resources in a timely manner."
The proposed guidance covers five "key aspects" of a CCP’s financial risk management framework. These five aspects are:
- Governance and disclosure relating to a CCP’s risk management framework
- Credit and liquidity stress testing
- Coverage of credit and liquidity resource requirements
- CCPs’ contribution of their own financial resources to losses
The report also proposed guidance related to the development of recovery plans. The proposed guidance builds on existing guidance issued in October 2014, and is aimed at addressing several areas where the regulators said CCPs need to further develop their recovery plans.
Specifically, the report reiterated that a CCP’s recovery plan should include tools that comprehensively and effectively address, among other things, 1) the allocation of losses not caused by participant default, 2) the allocation of uncovered credit losses and liquidity shortfalls following participant defaults, 3) the speed of replenishment of depleted financial resources, and 4) the re-establishment of a matched book following a participant default. The report also reiterated that a CCP should test and review its recovery plan.
Comments on the consultative report are due by Oct. 18. A final report on the guidance is targeted for the first half of 2017.
3) Essential Aspects of Resolution Planning
The Financial Stability Board (FSB) issued a "discussion note" that identifies a set of questions and considerations that are regarded as core to the development of effective resolution strategies and plans for CCPs.
The FSB explained that although it has already developed guidance for managing the failure of a financial institution, more specific guidance on CCP resolution is needed to ensure that any CCP can be resolved without resort to a government bailout and without resulting in contagion to other parts of the financial system.
The FSB said it will publish proposed guidance on CCP resolution in early 2017, with the aim of finalizing the guidance by July 2017. The guidance will inform resolution authorities, such as the Federal Deposit Insurance Corporation in the U.S., as they develop strategies and plans for resolving CCPs that cannot recover from a default or other losses.
“CCPs form a central part of the post-crisis reforms of OTC derivatives markets to help reduce risk in the financial system. But we must also ensure that CCPs are themselves robust and this includes appropriate resolution regimes,” Elke König, Chair of the FSB Resolution Steering Group and Chair of the European Single Resolution Board, said in a press release announcing the release of the discussion note. “There has already been much industry comment on CCP resolution, and we welcome further public comment in response to this discussion note.”
The note seeks comment on 11 aspects of CCP resolution:
- Objectives of CCP resolution
- Resolution strategies
- Timing of entry into resolution
- Adequacy of financial resources in resolution
- Tools to return to a matched book
- Allocation of losses in resolution
- Non-default losses
- Application of the “no creditor worse off” safeguard
- Treatment of CCP equity in resolution
- Cross-border cooperation
- Cross-border effectiveness of resolution actions
Comments on the discussion note are due by Oct. 17.
4) Other Elements of the CCP Workplan
The FSB also released a progress report on the “CCP Workplan” developed by international regulators to coordinate their efforts to enhance CCP resilience, recovery and resolution. The progress report summarizes several other initiatives now under way or coming soon, including an analysis of clearing incentives, a follow-up review of financial risk management practices, a framework for supervisory stress testing, and an analysis of “interdependencies” within the clearing system.
Clearing Incentives: A "derivatives assessment team" working under the Basel Committee, CPMI, IOSCO and the FSB will assess the incentives to centrally clear OTC derivatives resulting from the various standards for capital and margin requirements developed by standard-setting bodies. In particular, the team will focus on the impact of regulatory initiatives such as the impact of the Basel III leverage ratio, margin requirements for non-cleared derivatives, and capital requirements for bank exposures to CCPs. This work is expected to commence in the first quarter of 2017 and a report will be prepared by the end of 2017. This assessment will not affect, however, the leverage ratio consultation issued by the Basel Committee earlier this year, which asked for feedback on the impact of the leverage ratio on client clearing and clearing member business models. According to the workplan, the Basel Committee will finalize its revisions to the leverage ratio’s “design and calibration” by the end of 2016.
Risk Management Review: In the first half of 2017, CPMI and IOSCO plan to conduct a "follow-up targeted review" of CCPs’ progress in addressing the three most serious issues of concern identified in the assessment of current financial risk management practices. The regulators said this follow-up review is expected to cover "a wider range of CCPs and product classes" than the current assessment.
Stress Testing: CPMI–IOSCO have started work on a framework for stress testing of CCPs by supervisors and plan to issue a draft framework in the first half of 2017. This will complement the guidance now under development for stress testing that the CCPs conduct themselves.
Interdependencies: CPMI-IOSCO has launched a data collection exercise that aims to identify and quantify interdependencies between CCPs and their direct members, indirect members, investment counterparties, liquidity providers, and other financial institutions. The data collection exercise will cover approximately 20 CCPs, and will be complemented by information from 28 globally active banks on their top 10 CCP exposures. The findings will be published in early 2017.
Contact Jackie Mesa for further information.