Following on BlackRock’s April 2014 white paper on CCP default procedures, PIMCO has produced one of their own. We review what these firms are saying, how they differ, and assess how realistic some of their requirements and requests really are.
Both PIMCO and BlackRock advocate that CCPs have greater exposure to their own risk by putting up cash to the default fund. BlackRock says “the default waterfall needs to be strengthened by increasing the CCP’s risk-based contribution to the guaranty fund”. PIMCO says “CCPs should be required to have a substantial minimum amount of “skin in the game”. We can agree with this for CCPs run by commercial organizations such as Eurex Clearing or LCH.Clearnet – they manage risk for the entire industry, and theoretically would be even more conservative if they could lose their own money too. But what about the Options Clearing Corp or DTCC that are industry utilities? Should all CCPs be commercial? Should all be utilities with guarantees? We think that a uniform rule for CCPs is going to have to look at this question first. We are reminded of a paper we wrote up recently, “Nationalize the Clearinghouses” from August 2014. Further, if CCPs have to put up their own money, there’s only one place that money would really come from: clearing fees. It’s not like the cash is just sitting there on a CCPs balance sheet just waiting to be put into the default fund. Our view: good idea, but lots and lots of work to figure out who, how it works, etc.
Both PIMCO and BlackRock are advocating market-based solutions to CCP resolution and recovery. No one is saying that central banks should bail out CCPs as the last resort. This is a notable point and one that would support the idea of CCPs as private entities rather than as utilities. But at the same time, we can only think of one type of entity in the current market environment that would be able to buy and hold assets in distress until a future date when they could be sold off safely (TARP II, anyone?).
PIMCO and BlackRock sort of disagree on whether regulators should focus on recovery or resolution of a CCP. PIMCO advocates recovery: “In our view, the recovery of CCPs is a better solution than the resolution of CCPs as recovery allows the markets to continue to function in a more continuous manner. However, the recovery of CCPs should not be guaranteed, just like banks are not guaranteed recovery in the event of a default.” BlackRock takes something of the other side: “We do not believe that maintaining the continuity of services by any one CCP is critical to avoiding the next financial crisis. In fact, we are concerned that this approach will accelerate participants’ actions to close positions if a CCP is at risk of failing.” In the what-if scenario of a failing CCP, this can be looked as a version of the Prisoner’s Dilemma. What’s the better strategy for maintaining a solid balance sheet when looking at a potential CCP crash given a certain set of regulations? Regulators will set the tone and the market will take corrective action. Its up to regulators to ensure that the market goes where it ought to. So far, the regulatory focus is on recovery, as per last week’s CPMI/IOSCO report, “Recovery of financial market infrastructures“.
The papers hold some other good stuff too. BlackRock advocates that “transparency of CCP risk management practices should be increased, including the margin setting decisions of their risk committee, the results of stress tests, and the totality of resources available for loss absorbency in the event of default, so as to provide market participants sufficient information to permit independent analysis as to the risk of clearing with a particular CCP. Risk management practices should be harmonized across all CCPs.” Yeah, lots of luck, but its a great idea.
PIMCO wants that “client assets should be afforded the same protections under the futures model as under the cleared OTC model.” That’s probably more realistic.
All in all, both these papers are a good read. Some of the wish-list may be unobtainable but other points are both relevant and important in the context of where these two large buy-side firms are willing to entrust their business.
A link to PIMCO’s October 2014 article is here.
A link to BlackRock’s April 2014 paper is here.