Recently the question has come up about which are less risky in today’s financial environment: bilateral counterparties or CCPs. Both have their own pros and cons, and it is well known (to the industry, if not to regulators) that CCPs do not minimize or eliminate risk, they just spread it around differently. We are finding that there is a piece missing to the question, which is, “what is the risk now that banks and CCPs may be deemed Significant Financial Counterparties (SIFIs) and have implicit or explicit government guarantees?”
As part of both Dodd-Frank and the Financial Stability Board’s documents, banks worldwide can now be deemed SIFIs, be required to publish a living will and be subject to government takeover in case of actual or imminent failure. In the US, this process is called the Orderly Liquidation Authority and would be run by the FDIC subject to the US Treasury’s approval. The FSB has their own G-SIFI list (we hear that the Bank of China was mighty pleased to be included). Banks could fight the takeover but we suspect that none would if things were that bad. Europe has a version of the Orderly Liquidation Authority in discussion but financial turmoils have prevented further discussion. In the meanwhile, governments rush to bail out their heroes with no overriding plan. We looked at Orderly Liquidation Authorities in some depth for a report issued by BNY Mellon in early 2012, “Securities Lending, Crisis Management and the Orderly Liquidation Authority.”
Meanwhile, CCPs have their own orderly liquidation program. In a July 2012 report, IOSCO/CPSS has brought up the idea that CCPs should have their own resolution authority. We expect that this will happen shortly on a global basis if it hasn’t happened already domestically. As we noted in a write up on IOSCO/CPSS’s consultation paper, “IOSCO/CPSS is requesting market comments on how a resolution authority for a failed CCP would recover funds. Should losses be allocated based on holdings or haircutting of margins? The document recognizes that nothing is perfect: ‘Enforcing contractual obligations to replenish default funds would potentially result in losses being distributed in a different manner to margin-haircutting solutions. Enforcing outstanding cash call obligations might be difficult to implement rapidly with respect to clearing members and more so if extended to indirect participants. Cash calls could also have a destabilising effect, particularly with respect to indirect participants, who often do not have access to credit markets or other sources of liquidity.’ Further, what would the margin haircut approach be on underlying clients?”
Also in July, the US Financial Stability Oversight Council issued its list of Financial Market Utilities that are systematically important under Dodd-Frank. All of the big US CCPs are on the list. Effectively, this means that these CCPs are now under the government’s eye, have to write resolution plans (living wills) and to some degree now have an implicit government guarantee.
Looking at both banks and CCPs, which is less risky in the face of a default may come down to the specific details of each group’s resolution plans. Banks taken over by the government would have their derivatives (including securities loans and repo) split up by well-collateralized (for the good bank) and under-collateralized (for the bad bank) transactions by counterparty. A CCP might be able to selectively tear up certain contracts to keep things in order. The mechanics are tricky in both cases and there is no guarantee that counterparties would be made whole in case of a default, but it seems to us that governments are becoming or have become the backstop for all major financial counterparties. This should remove one part of the question on which is safer in the event of a selective default. We’ll leave the next logical question, “what happens if more than one default happens at one time…?” for another day.