The European Securities and Markets Authority (ESMA) has released a consultation paper on CCP interoperability. While the goal of allowing free choice in CCPs makes fine sense, the details of holding collateral and what happens in the case of default raise serious issues about risk management.
The ESMA paper covered five topics on interoperability:
1) Legal risk – this is the biggest hurdle and offers multiple ways for CCPs to say no to interoperability. Items like “That the CCP has assessed the potential for cross-border legal issues to arise as a result of its participation in the interoperable arrangement, in particular with regard to its default procedures and the enforceability of collateral arrangements” will be almost impossible to resolve unless both CCPs are operating under the same legal jurisdiction, otherwise bankruptcy laws could be a permanent obstacle to any resolution of a default.
2) Open and fair access – say a CCP gets into an interoperability agreement, how does it get out? While a legal exit may look good on paper (“That the documentation governing the interoperability arrangement does not unduly restrict the termination of the interoperability arrangement where one of the interoperating CCPs considers it necessary to terminate it on duly justified risk grounds”), making this happen in practice requires substantial advance thinking.
3) Identification, monitoring and management of risks – the minefields and work required to make this section a reality are too numerous to go into. Our favorites include “That the CCP has comprehensive information on the operations of the interoperating CCPs, including the potential reliance on third parties as critical service providers, enabling the CCP to perform effective periodic assessments of the risks associated with the interoperability arrangement” and “That the CCP has put in place risk management tools, such as margin or default fund policies, to address any weakening of the CCP’s overall risk management framework due to the interoperability arrangement.” In one reading of these clauses, a CCP would need to have funds to cover not only its own risk waterfall but also parts of the risk waterfall of its interoperable CCPs. That would mean knowing the details of each other’s risk and capital as well as all calculations and procedures. This won’t go over well.
4) Deposit of collateral – we just wrote an entire report on this one topic. How CCPs take collateral and what kinds of accounts it is held in are sure to be central issues in operability. A collateral highway or liquidity hub moving assets from a central CSD to multiple CCPs is one thing; two CCPs cooperating is quite another.
5) Cooperation – CCPs, which are borderline cooperative but also competitive, would need to take an open book policy with each other. “This includes sharing information throughout the process and sharing their respective risk assessment reports before they are finalised and submitted….” Hmm.
While regulators are keen on interoperability, CCPs themselves are doubtful this can occur in the near future. As we noted in our November 2012 report (CCPs and the Business of Collateral Management), “CCPs do not expect that the promise of global interoperability will come to fruition anytime soon. They are firm believers that regulators must first come to agreement on global bankruptcy laws and that may never happen. If regulations get sorted out, then the next large challenge to surmount will be risk management practices and legal agreements between the CCPs themselves. As CCPs are already reluctant to enter into this type of agreement with other CCPs in domestic markets, it would take a regulatory mandate to effect change. Given the ongoing struggles in implementing Basel III, CCPs expect that it will take many years before regulators finally look critically in their direction on a global basis.”
The ESMA proposal provides multiple avenues for CCPs to just say no to interoperability agreements. While there may be some slow movements forward, we do not expect CCP interoperability, especially on the collateral side, to become a reality for a long time to come.
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On counterparty risk between one CCP and another, a bespoke risk management framework together with margining approach would be required – considerable work and collateral would be involved. A key question would be whether CCPs would be members one of another or if not how that would affect such risk and collateral arrangements. The tail risk being managed is of the other CCP defaulting (either through commercial default or by one of the other CCP’s members defaulting and taking it down). This means that a lot of layers of protection in the other CCP have to be burned through including the CCPs own capital (newly strengthened in the EU). In addition, the portfolio being risk managed is a single net portfolio across all trades where one party clears in one CCP and the other party clears in the other – regardless of who the original parties are. This also ought to furnish a degree of portfolio netting. For both reasons this ought to mean that the risk and margin funding costs are relatively small.
In addition, there ought to be considerable benefits in enabling trades between parties each of which prefers to clear in a different CCP – including the general simplification and promotion of trading liquidity which will become an increasing desire from market participants as liquidity fragments over time through the creation of multiple SEFs and multiple CCPs. For example there would be little / no for differential CCP trade pricing between interoperating CCPs.
Another issue is default management for i.e. the default of a CCP as a scenario to operationally and legally prepare for. Since CCPs are still working on creating smooth portability management in the event of clearing member default this may be challenging.
My expectation however of the main hurdles to overcome are a. the instinct of CCPs to compete rather than cooperate with one another and b. the fact that both CCPs and market participants are already overloaded with taking on board new regulations and associated market changes. Perhaps only regulation (e.g. EU open access / interoperability initiatives) can overcome a. any time soon given b. If it does however I would suggest that the above challenges are surmountable and the benefits considerable if a sensible pace of change is set (say a couple of years).