End of the Waterfall

The Buy-Side Speaks Out on CCP Risk

As regulators draft new standards for strengthening clearinghouse protections against a catastrophic default, customers are setting out their list of demands.

OVER THE PAST several months there has been extensive discussion within the derivatives industry about what would happen, and what should happen, if a catastrophic loss overwhelmed a  clearinghouse’s financial resources and drove it to the brink of failure.

While such an event is highly unlikely, regulators have asked clearinghouses to prepare recovery plans to ensure that they can maintain continuity in their clearing services even in extreme scenarios. Regulators want these plans to describe in detail the rules and procedures for allocating losses and covering liquidity shortfalls, and the steps they would take to replenish their loss-absorbing resources.

As Benoit Coeure, a member of the executive board of the European Central Bank, explained in November, even though clearinghouses are now subject to a number of “fairly strict and conservative” regulatory requirements, that is not enough. Central banks and regulators learned from the 2008 financial crisis that it is necessary to go beyond “normal” risk management, he said. Even if all of the new requirements are properly implemented, “the unthinkable may still happen” and for that reason clearinghouses must anticipate what would happen when their normal defenses have failed.

Joining the Debate

Discussions about clearinghouse financial resources are by no means a new topic in the derivatives industry. There is a long history of dialogue between the clearing members, who contribute most of those financial resources, and the clearinghouses themselves about the optimal balance of financial resources and risk management arrangements.

But times have changed, and the customer side of the business has become much more vocal on clearing issues. With most over-the-counter derivatives now subject to mandatory clearing in the U.S. and similar obligations coming soon in Europe, large asset managers have more collateral in clearinghouses than ever before and they want to be sure that their money is safe.

In the last 12 months, a small number of leading asset managers—notably BlackRock and Pimco—have taken a seat at the table in the discussions about clearinghouse recovery and have brought their own set of priorities into focus. In addition, at least two trade associations representing hedge funds and mutual funds have voiced their concerns in position papers and letters to regulators.

Overall, buy-side firms have been very supportive of central clearing for over-the-counter derivatives. They cite advantages such as increased transparency, the mitigation of counterparty risks and improved access to markets. They also recognize that the odds of a clearinghouse failure are extremely low. After all, none of the major clearinghouses were forced to use any of their loss-absorbing resources during the financial crisis, despite the default of Lehman Brothers. And since the crisis, regulators have put in place higher financial safeguards, including the “cover 2” requirements based on the potential for the two largest clearing members to fail simultaneously.

The buy-side firms note, however, that central clearing concentrates risks into a handful of clearinghouses and the amount of risk at stake is much higher than before. That makes it all the more important to plan ahead in case one of these clearinghouses suffers a catastrophic loss. As the saying goes, past performance is no guarantee of future results.

Their main concerns fall into six categories:

• Adequacy of financial resources;
• Transparency into default management procedures and financial health;
• Protection of customer margin;
• Variation margin haircutting;
• Participation in auctions; and
• Government support.

1. More Skin in the Game

One of the concerns raised by asset managers is whether clearinghouses have enough of their own money in the default waterfalls.

Pimco was one of the first to sound the alarm. In a white paper issued in October, the California-based asset manager said clearinghouses should increase the amount of their own capital in the guaranty fund. Pimco argued that this is not just to make sure that there are enough resources in the waterfall to protect against loss. More importantly, it gives the clearinghouse an incentive to protect those resources by diligently managing its risks.

“The more capital contributed to the guarantee fund from clearing members, the more incentivized member firms are to ensure that they are managing risk correctly,” Pimco said. “Similarly, the more contributed capital that the CCP is required to post to the guarantee fund, the more the CCP is inclined to ensure that the margin buffers from clearing members are sufficient and that  clearing members’ risk management processes are sufficiently robust.”

Pimco recommended that clearinghouses should boost their contributions to default funds and suggested three ways to set a minimum amount. “We believe that a contribution floor that is the highest of 5% of the guarantee fund, US$20 million or the size of the third-largest clearing member contribution would be an appropriate amount that would sufficiently increase CCPs’ skin in the game while also balancing business and efficiency concerns.”

BlackRock made a similar point in an April letter to the Commodity Futures Trading Commission. The asset manager noted that clearinghouses have evolved from member-owned utilities to commercially owned for-profit institutions, yet they continue to put most of the risk on their members.

“Given the evolution in the structure of a CCP, we believe that the CCP should be required to contribute more than a minimal amount,” BlackRock said. In addition, this amount should be “risk-based” rather than a fixed number. The company suggested measuring the amount as a percentage of the guaranty fund or as the equivalent of the largest clearing member contribution, and estimated that either approach would work out to 8% to 12% of the guaranty fund.

To be sure, this is not the only idea put forward by the buy-side to boost clearinghouse resources.  For example, BlackRock also has suggested that clearing members should commit more resources. As the company explained in its April letter to the CFTC, clearinghouses typically have the ability to call on clearing members to contribute additional funds above and beyond their contributions to the guaranty fund. BlackRock raised the concern that these assessment powers may be difficult to exercise during times of severe market distress and recommended funding these amounts in advance.

The company acknowledged, however, that this would increase costs for clearing members, which would very likely get passed through to their customers. The company therefore called for careful consideration of the “trade-off” between requiring more resources and retaining as many clearing members as possible.

2. More Transparency

Asset managers also have urged clearinghouses to be more transparent about their risk management practices and in particular their procedures for working through the default of a clearing member. Equally important, they have stressed the importance of having transparency into the financial health of a clearinghouse throughout a recovery situation, including regular updates on how it is implementing its recovery tools.

This was one of the main issues raised by the Alternative Investment Management Association in a position paper it issued last October. AIMA, a London-based trade association for the hedge fund industry, said that level of transparency is essential for preserving customer confidence in a clearinghouse. 

“Transparency is a key factor in maximizing voluntary participation by clients for as long as possible during a period of financial distress and encouraging a swift return of those clients that ceased participating upon signs of the CCP’s  recovery,” AIMA wrote in its paper. “We, therefore, strongly recommend that regular detailed and reliable information be given to CCP participants as to the financial health of the CCP to which they are exposed in order for the recovery initiatives to be given the greatest chance of proving successful.”

3. Protect Customer Margin

This has been a hot topic for the buy-side ever since the regulators first began discussing the idea of extending recovery and resolution planning to financial market  infrastructures several years ago. Virtually every buy-side institution that has weighed into this debate has vehemently opposed using any portion of the collateral of a non defaulting customer to absorb losses at a clearinghouse, except in the most extreme situations (see the next section). They argue that this would contradict the goal of promoting greater use of central clearing, increase  the risk of contagion and undermine the quality of risk management at clearinghouses.

“CCPs already have an artificially dominant position in the market due to the roll-out of mandatory central clearing of OTC derivatives,” AIMA said in its position paper. "Allowing CCPs to preserve themselves through haircuts of client margin would further erode market discipline on CCP management by creating a 'heads I win, tails you lose' scenario," the London-based association said.

“Clearing members are uniquely positioned to assess central counterparty risk and recommend improvements in risk management. Our goal is to ensure that the risks of central clearing are both transparent and effectively managed.”
Walt Lukken
President and CEO of FIA Global

The Investment Company Institute, a group that represents the U.S. mutual fund industry, also has spoken out on this issue. As far back as 2013, when regulators begun discussing international standards for recovery and resolution of financial market infrastructures, ICI cautioned against relying on margin posted by customers to absorb losses from a default. Such a move would impose the costs of recovery on entities that did not contribute to the losses and would run counter to the regulatory goal of promoting central clearing, ICI warned.

ICI reiterated these views in an April letter to the CFTC and urged the agency to consider these views as it develops standards for clearinghouse recovery  plans. ICI emphasized that regulated funds are generally not members of clearinghouses and therefore are not in a position to monitor a clearinghouse’s risk management or manage the risk of loss  in a default scenario. Using margin of non-defaulting customers as a recovery tool “would impose unfairly the costs of recovery” on entities that did not contribute to the losses or the default and do  not have the ability to manage the risks of the clearinghouse, ICI said.

4. Variation Margin Haircutting—Only After All Else Has Failed

There is one area, however, where some asset managers are willing to make an exception to the general position that customer margin should be sacrosanct. In an extreme situation, when all the resources in the default waterfall have been used and the clearinghouse has exhausted all of its options for replenishing its resources, imposing haircuts on variation margin might be the only way to keep the clearinghouse going. In effect, this would mean withholding funds that would be paid out to customers with gains on their positions while continuing to collect in full from customers with losses. 

Kristen Walters, global chief operating officer for risk and quantitative analytics at BlackRock, explained this view at a public meeting at the CFTC in April. BlackRock strongly opposes using variation margin haircutting as a tool for clearinghouse recovery, she said, but could see a justification for using it in a truly extreme situation, where a clearinghouse has gone  beyond recovery and has been forced to wind down its operations. Even then, it should only be used once or twice and within a short window of time, or else it would fatally  damage customer support for that clearinghouse.

“The only instance that we can see variation margin haircutting being used would be in a situation where the CCP has gone through the entire fully funded default waterfall, an orderly liquidation or resolution has been instituted, and in the context of potentially replacing management, using the existing operations, and recapitalizing the failed CCP,” Walters said.

At the same meeting, Tracey Jordal, a senior counsel at Pimco, added that variation margin haircutting should be viewed as a “doomsday tool” only used as an extreme last resort. Jordal also warned that customers need to know in advance how many times it might be used or else they would be reluctant to continue using that clearinghouse.

One reason why the buy-side is so wary about using this tool is the potential negative effects on their investment portfolios. Sam Priyadarshi, head of fixed income trading at Vanguard, explained that variation margin haircutting would be particularly disruptive to customers who are relying on their cleared derivatives to offset losses elsewhere in their portfolios. Speaking at the FIA’s Annual ​International Futures Industry Conference in Boca Raton, Fla. in March, he observed that variation margin haircutting would cause customers to lose part of the gain on their hedges.

Given the likelihood that a clearinghouse would only resort to using such a tool during a period of market stress, customers very likely would be counting on their hedges to offset their risks at a particularly critical moment. “Variation gains haircutting should be absolutely the last resort,” Priyadarshi said. “In fact, I would advocate that there should an additional CCP capital tranche before variation margin hair­cutting is called upon.”

5. Broader Participation in Auctions

In the event of a default and a determination that an auction is necessary to neutralize a CCP’s market risk, buy­side firms say that clearinghouses should open their auctions to customers as well as members. Expanding participation beyond the clearing member community during a time of default could lead to better prices for the positions sold through the auction and cover more of the losses, they say.

“AIMA recommends that in order to maximize participation in CCP auctions of the unmatched positions of defaulted clearing members, thus the likelihood that these unmatched positions obtain new counterparties, CCP auctions should be open to both buy­side and sellside participants,” the association said in its position paper.

6. Provide Emergency Support—At a Price

Another option in an extreme scenario is for a clearinghouse to receive emergency financial support from the government. AIMA addressed this issue in its position paper, saying it recognized that governments should have the “prerogative” to provide funding to a CCP on the brink of failure if sustaining its operations is determined to be in the public interest. AIMA noted that under the Bank Recovery and Resolution Directive which took effect in January, governments in Europe have this prerogative with respect to banks that have failed,and commented that the cost of this support may be less than the potential cost of a clearinghouse’s failure.

AIMA warned, however, that it may not be desirable or even possible to preserve the functioning of a CCP or return it to viability during the kind of severe market conditions that would cause a clearinghouse’s failure. In addition, relying on government support should not simply be used to restore a clearinghouse to financial health as that would distort normal market forces.

Instead, any provision of government support should reflect the fact that the CCP “has failed as a business,” AIMA said, adding that the government should receive full ownership of the clearinghouse and operate it as a state­owned enterprise, with the goal of eventually selling its stake and returning the clearinghouse to private ownership.

“In return for public funding of a CCP in resolution, whatever the amount, AIMA proposes that the relevant government acquires a 100% ownership stake in that CCP, such that it becomes a stateowned enterprise,” the association said. “We suggest that the government could then seek to recover its financial support through the future revenues of the CCP and its eventual divestment to alternative private sector buyers.”