A new research report from the Bank of England has modeled out how CCP financial resources can affect their stability in times of stress. The conclusions have some important policy implications that could create new risk waterfall policies for CCPs and potentially change how banks account for Default Fund and Initial Margin collateral.
In “Central counterparties and their financial resources — a numerical approach,” the authors evaluate how CCPs can best protect themselves and their members by determining the right mix of initial and variation margin, and by utilizing more intensively the various aspects of the risk waterfall.
“Until recently, banking supervisors applied a zero risk weight to collateral lodged with CCPs in all forms. Henceforth, the Basel rules on risk weights applied to banks’ exposures to CCPs require that IM lodged at major CCPs will be subject to a risk weight of 2%, equating to a 0.16% capital charge, while a non-zero risk weight will apply to DF contributions. As such, regulation may alter CCPs’ incentives in setting the balance of collateral between IM and DF because of the different costs they impose on clearing members.”
Here are some of the main conclusions:
“Our results suggest that CCPs may choose to rely more on [Default Fund] (survivors-pay) than [Initial Margin] (defaulter-pays) resources for markets in which asset price volatility is higher than those in which prices are less volatile.” As a policy implication, volatility can be linked to the size of the Default Fund for CCP members with the expectation that this fund might be used more than for asset classes with lower volatility.
“Our model produces a strong tendency to procyclicality in resource requirements.” This is a given but still notable from a Central Bank research paper. A need for CCPs to consider procyclicality is captured in EMIR and could become standard worldwide.
“Our simulations show that the CCP’s optimal choices are influenced by the cost of collateralisation and by the capital requirements faced by its members. So in our model, as the cost of collateral increases, CCPs choose to rely increasingly on [Default Fund].” This in turn plays back to the conversation on how secure those Default Funds are and whether CCPs are the next Too Big To Fail institutions.
“It is the existence of financial incentives such as [regulatory capital requirements] that make a compelling case for regulators to consider minimum requirements on CCPs with regard to the level and allocation of their default resources, while giving CCPs enough discretion to manage the risks they face appropriately.”
We aren’t entirely sure if this paper is a justification for EMIR or a set up for additional regulation, but the model the authors present is notable in its analysis. We think that policy makers will refer back to this report in the future when working out rules related to CCP financial stability, collateral and capital charges.