Buy-side support for FSB on CCP resolution

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US buy-side trade body the Investment Companies Institute (ICI) says it supports the Financial Stability Board’s (FSB’s) guidance on central counterparty (CCP) resolution.

CCPs became fundamental to derivatives trading after the 2008 global financial crisis (GFC); in 2009 at the Pittsburgh meeting of the G20, it was agreed that derivatives trades should be centrally cleared, along with other measures. CCP’s provide this clearing, by effectively becoming a counterparty to each firm in the bilateral trade, with enough capital stored in the CCP to weather the default of one of those firms. As a result they should prevent a default from knocking on to other firms and having a systemic effect. However, recently concerns have been raised that CCP funds are not sufficient to protect them from default and as a result may not provide the necessary level of protection.

The FSB consultation on how to provide resolution in the event of a CCP failure proposed that authorities should:
• Identify hypothetical default and non-default loss scenarios (and a combination of them) that may lead to a resolution of a CCP;
• Conduct a qualitative and quantitative evaluation of existing resources and tools available in the resolution of the CCP;
• Assess potential resolution costs;
• Compare existing resources and tools to resolution costs and identify any gaps; and
• Evaluate the availability, costs and benefits of potential means of addressing any identified gaps.

In its letter responding to consultation on the guidance, the ICI noted the approach could “reduce uncertainty in the event of a CCP’s failure and assure market participants that they will receive fair treatment from resolution authorities.”

“We support the FSB’s proposed five-step process for assessing the adequacy of financial resources and tools available to support the resolution of a CCP,” the ICI wrote. “As we have set out previously, in developing its final guidance on the five-step process, the FSB should seek to strike a balance between providing certainty regarding the resolution process and allowing resolution authorities sufficient flexibility to respond to unanticipated circumstances.”

It also made several recommendations for changes to the FSB’s proposed guidance, with a view to enabling regulated funds, as customers of CCPs, fair treatment during a CCP’s resolution:
• Transparency: at a minimum, the FSB should encourage authorities to communicate to clearing participants – clearing members (CMs) and customers – the tools and strategies they plan to use to resolve a failed CCP;
• Certainty and consistency: the FSB should establish that a CCP enters resolution at the point when it has depleted its own recovery resources, the resources of CMs that are committed to the CCP’s recovery and, if applicable, credit facilities or capital injections that may be provided by a parent entity;
• Fair Treatment: the FSB should support the use of resolution strategies that rely on the resources of the entities ultimately responsible for the failure of the CCP’s risk management function – the CCP itself, CMs and equity holders – rather than seizing resources from non-defaulting customers (NDCs) who are users of the CCP that play no meaningful role in, or control over, CCP risk management and have not contributed to the CCP’s distress; and
• Aligned incentives: the FSB should not support the use of resolution tools such as variation margin gains haircutting and contract tear ups, which may discourage voluntary clearing, create moral hazard by incentivising CCPs and their CMs to take excessive risks, or destabilise markets by incentivising CMs and CCP customers to liquidate trades in anticipation of adverse outcomes in times of stress.

The ICI argued that these recommendations, will provide greater certainty to market participants; improve market confidence; and support the achievement of global post-crisis political commitments, including encouraging greater clearing of OTC derivatives.

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