Financial Stability Paper 37: Got to be certain: The legal framework for CCP default management processes
Jo Braithwaite and David Murphy
Central clearing offers numerous benefits to financial stability including multilateral netting of cleared exposures and the centralisation of default management. These benefits explain the pivotal role of central counterparties (‘CCPs’) in the post-crisis derivatives market reforms. However they lead to a key financial stability question: will CCPs be able to manage a large member default effectively?
There are various aspects to this question, and we concentrate on one of the least studied: the legal certainty of CCP default management practices. This aspect is important because the prospect of legal challenge to a CCP could be destabilizing, and the legal framework within which CCPs operate is a complex and, in some areas, newly constructed one.
We evaluate the diverse legal rules governing CCP default management by investigating the extent to which they provide adequate legal certainty. The paper discusses the processes of clearing and collateral posting in detail, establishing the nature of the rights which CCPs rely upon when managing defaulting members. We then consider the relationship between CCP default management processes and insolvency law, as defaulting members are sometimes (but not always) insolvent. This leads to an evaluation of the legal issues arising along a typical default timeline of default declaration; returning to a matched book; and use of the defaulter’s collateral.
Our findings are that English and EU law provide legal certainty for many aspects of CCPs’ default management processes, but some challenges remain. One set arise through the piecemeal nature of the legislative framework, while others turn on the importance of CCPs’ contractual drafting being as robust as possible. The paper concludes with recommendations on both legislative and drafting issues.
Financial Stability Paper 37: Got to be certain: The legal framework for CCP default management processesJo Braithwaite and David Murphy
Central clearing offers numerous benefits to financial stability including multilateral netting of cleared exposures and the centralisation of default management. These benefits explain the pivotal role of central counterparties (‘CCPs’) in the post-crisis derivatives market reforms. However they lead to a key financial stability question: will CCPs be able to manage a large member default effectively?
There are various aspects to this question, and we concentrate on one of the least studied: the legal certainty of CCP default management practices. This aspect is important because the prospect of legal challenge to a CCP could be destabilizing, and the legal framework within which CCPs operate is a complex and, in some areas, newly constructed one.
We evaluate the diverse legal rules governing CCP default management by investigating the extent to which they provide adequate legal certainty. The paper discusses the processes of clearing and collateral posting in detail, establishing the nature of the rights which CCPs rely upon when managing defaulting members. We then consider the relationship between CCP default management processes and insolvency law, as defaulting members are sometimes (but not always) insolvent. This leads to an evaluation of the legal issues arising along a typical default timeline of default declaration; returning to a matched book; and use of the defaulter’s collateral.
Our findings are that English and EU law provide legal certainty for many aspects of CCPs’ default management processes, but some challenges remain. One set arise through the piecemeal nature of the legislative framework, while others turn on the importance of CCPs’ contractual drafting being as robust as possible. The paper concludes with recommendations on both legislative and drafting issues.
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Interesting related article in the WSJ today on DTC discussing the ability to get support from key players in repo market in case of a default by a major member. This follows a reported attempt last year to get committed lines of credit from members of to $50 billion that received a cold reception particularly from smaller members. What is needed is a change in the way the default ladder is structured. The members instead of being at the bottom of the ladder should really be at the top in a liquidation. Instead of being the last to share in the possible losses after the unwind of a defaulted member the members should be first to be assigned the positions of a defaulted member. In this way, they are actively involved in the unwind and protect the very positions that are a part of the holdings they also have. This would possibly prevent a firesafe risk that is so much a concern for the Fed. The assignment would be proportional to the members use of the CCP. After 30 years of service this CCP should be looking at fixing their structure instead of looking for funding from various related and un-related parties.
Interesting related article in the WSJ today on DTC discussing the ability to get support from key players in repo market in case of a default by a major member. This follows a reported attempt last year to get committed lines of credit from members of to $50 billion that received a cold reception particularly from smaller members. What is needed is a change in the way the default ladder is structured. The members instead of being at the bottom of the ladder should really be at the top in a liquidation. Instead of being the last to share in the possible losses after the unwind of a defaulted member the members should be first to be assigned the positions of a defaulted member. In this way, they are actively involved in the unwind and protect the very positions that are a part of the holdings they also have. This would possibly prevent a firesafe risk that is so much a concern for the Fed. The assignment would be proportional to the members use of the CCP. After 30 years of service this CCP should be looking at fixing their structure instead of looking for funding from various related and un-related parties.