Banks and buy side firms have been calling for an increase to the slice of the risk waterfall stumped up by CCPs. They reckon this would make CCPs more resilient, and avoid tapping into mutualized resources in the event of a massive default. But some experts are saying that increasing CCPs’ share of “skin in the game” (SITG) won’t achieve risk objectives and will result in costlier clearing house fees.
The purpose of SITG is to avoid moral hazard. If CCPs have something to lose, they won’t make risky decisions. But it seems like some of the calls for increasing SITG are more about introducing additional loss absorbing capital, which is not really what the layer is set up for. One expert* said that if clearing members are partially subsidized by CCP capital, it could actually result in riskier behaviour: “If you are too high, then you start completely changing the nature of that layer, and start creating moral hazard.”
Under EMIR (European Market Infrastructure Regulation), CCPs are required to hold the equivalent of 25% of their regulatory capital as a component of the default waterfall (SITG). So, if a CCPs regulatory capital is €100 million, then it would be required to hold €25 million as a separate sum, as a portion of the member default waterfall. In the event that all of the defaulting company’s initial margin and default contributions were used, SITG would be the next line of defense.
CCPs manage risk that clearing members introduce, which is why SITG is calibrated on regulatory capital or the risk the CCP is responsible for (operational, investment liquidity, etc). So, even if there was an increase to that layer, it wouldn’t add up to meaningful loss absorbing capacity. Meanwhile, the result of increasing SITG, and its cost, could leave CCPs with the option of either exiting clearing completely or raising clearing fees to recover at least the cost of capital requested by its shareholders.
Most likely the CCP would increase its fees. A recent report from LCH.Clearnet pointed out that: “It is ironic that when financial market participants are arguing for a CCP to increase the SITG, they are in effect advocating for an increase in clearing fees.”
In other words, there’s a vicious circle in which clearing members are calling for increasing SITG, risking an increase to clearing fees, in order to create a layer that would not make the resolution of a default better anyway, a source said.
Moreover, SITG is no panacea for moral hazard, said another source: “Commercial incentives of having to keep customers should be sufficient to make sure that the CCP is not sloppy. If it has to go to loss sharing and it appears that the CCP ended up in the situation because it was sloppy, clients are going to go elsewhere.”
“The last thing you want with competition is a race to the bottom. Clearing members and clients don’t want the cheapest margin necessarily, they have more complex and sophisticated ways of assessing their CCPs. I mean, if you jump from a plane, you don’t want the cheapest parachute,” a source said.
Then, there’s a social aspect to the debate. Namely, that a CCP’s shareholders benefit in the good years, but if the CCP gets into trouble and does not properly manage risk does it make sense that customers have to bear the cost? “Where a CCP is hugely profitable, it should really set aside more, a reserve fund that goes into SITG,” the source said, adding that a CCP with a constrained profit model, or owned by users, shouldn’t be included in such an assessment.
LCH.Clearnet handles the ‘alignment’ between clearing members, CCP management and shareholders by linking management compensation directly to usage of the SITG layer. There is a direct financial impact to executive management if SITG is breached, for example. In the defaults LCH has managed, all have been resolved using only the defaulting member’s initial margin and have not gone into any other parts of the waterfall.
The future of this debate is set to go international. The Financial Stability Board has set up a working group and committee for recovery and resolution plans, and the topic of harmonizing regulations across borders is moving forward in earnest. One source said that it seems like there is momentum for progress in 2016, after a period of feeling stalled. Now, regulators appear willing to think about the indirect links between market players and how that feeds into resilience. Things should get more interesting in the second quarter, with probably a bit more ambition on making a global framework, the source said.
But in some ways the debate hasn’t moved on enough. One source said that during discussions, the issue could be distilled into two words: Who Pays? And the conclusions after that discussion: Not Me.
For more on CCPs and SITG, see the Finadium research report “CCP Recovery and Resolution Plans: Players, Regulations and Ideas,” February 2015.
*The sources cited in this article have asked to remain off the record.
