IOSCO/CPSS consultation: what happens when a CCP fails?

A new consultation report published today by the International Organization of Securities Commissions (IOSCO) and the Committee on Payments and Settlement Systems (CPSS) looks at what happens when financial market infrastructures (FMI) fail. Our particular interest is the section on what IOSCO/CPSS think is supposed to happen when a CCP fails. Citations from the report and our comments follow.

CCPs are classified as an FMI that takes credit risk, as opposed to FMIs that act as agent and take on no credit risk themselves. A core assumption to the consultation paper is that CCPs operate with robust risk waterfalls. We note that the interest in Legally Segregated/Operationally Commingled (LSOC) may disrupt this assumption over time if it grows in popularity. But for now, regulators are relying first on the risk waterfall.

The consultation document is counting on the contractual mutualization of risk as what would save a CCP, and that this mutualization would need to occur ex ante of any CCP failure. “This ability to mutualise loss allocation across the FMI’s participants via rules and contractual agreements is not generally the case for other financial institutions and offers a valuable protection against failure.”

If a CCP cannot re-establish a matched book following a member default, IOSCO/CPSS are suggesting that CCPs be allowed to tear-up contracts in order to keep itself solvent. “CCP’s rules to permit for the termination of any unmatched contracts that could not be sold in auction, with cash settlement of them based on a valuation of the gains/losses (known as “tear-up”) to allow for the CCP to remain solvent…. Having this option as a backstop may incentivise active bidding in an auction.” Certainly this would be a severe move for market participants. IOSCO/CPSS envision a selective tear-up as opposed to a complete tear-up of all positions.

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?

Equity holders would be affected by a resolution authority taking over a CCP: “Once in resolution, further loss allocation amongst creditors should follow the ranking in insolvency, as the only available alternative course would be liquidation. Equity will therefore typically be written down ahead of debt holders absorbing further losses by creditors.”

Other commentary follows what we have seen before from Dodd-Frank and the Financial Stability Board about Orderly Liquidation Authorities including possible stays of early termination rights. “The exercise of early termination rights by a large number of participants triggered by the commencement of resolution measures could place a huge further strain on the financial and operational resources of the FMI and could prevent it from continuing critical operations and services. In the case of a CCP, there is also an increased risk that if some of the participants exercise early termination rights, the CCP may no longer have a ‘matched book’.”

The IOSCO/CPSS Consultation Paper is here.

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