CCP debate needs to go beyond skin in the game

Discussion needs to move on to how to keep markets functioning in a default situation, argues QIC's Nick Horn


So far the debate on clearing house sustainability has focussed narrowly on how much 'skin in the game' participants must have in order to absorb the impact of the default of one or more clearing members. However, to capture the true risk posed, this discussion must broaden to how these same participants are incentivised to maintain commitment to a clearing house through times of stress. If debate continues solely on how much more capital either a clearing member (CM) or central counterparty (CCP) needs, the end result will be an expensive and inefficient design, with few end-users.

The International Swaps and Derivatives Association recently published a white paper, 'CCP default management, recovery and continuity: A proposed recovery framework', offering a basis for any clearing house to formulate a default management plan (DMP) to absorb a member failure. Isda's advice on default management can be summarised in three points:

i) the measures that a CCP should have at hand to achieve recovery;

ii) the need for an explicit process that describes how and when these measures may be used; and

iii) clear guidance on what conditions must be prevalent in order to conclude that resolution is the best course of action.

Of the two options available, Isda states a clear preference for recovery over resolution – and this is logical. A pro-resolution mind-set would, at the first sign of market stress, have participants considering how they might deal with a Lehman-style default rather than looking to manage the ongoing testing conditions.

Likewise, Isda's emphasis on transparency on these issues is encouraging. This is important for the integrity of both the CCP and the market it serves. With no assurance or citable reference for debate, such as retrospective legal action, on how the interests of solvent market-users are upheld, you cannot expect participants to trade on in good faith.

For buy-side players with a fiduciary responsibility for their clients' assets this uncertainty will likely see them take swift action in a crisis: perception of stress will quickly become reality. These are the same arguments that underlie some of the buy side's negative feedback on Isda's 2014 Resolution Stay Protocol.

Transparency and assurance on process, especially in an untested marketplace, are a must for building a resilient system.

Isda has understandably simplified real-world considerations in order to stimulate debate. However, it is crucial to keep participants' incentives in mind when assessing its guidance or we risk debating the rules of a game nobody will play.

Additionally a failure to assure end-users that their trade is not at the permanent mercy of the capital adequacy of a small number of clearing providers, with a pro-cyclical disincentive to serve markets, presents a risk in itself.

End-users engage in derivative contracts for commercial reasons and it makes sense to discuss how economic incentives can be used to increase the probability of an effective recovery effort, as driven by the quality of the DMP.

Isda's guidance makes clear the importance of the DMP. The effectiveness of the default plan determines the market's perception of a clearing house's integrity (both before and during stress scenarios), the size of any potential risks and the actual likelihood of avoiding a resolution scenario. Resolution may be the right outcome in any given event, but the market's belief that it is not an inevitable conclusion is crucial to managing this process.

Default position

A number of points therefore need to be considered when designing an effective DMP under Isda's guidance – the principal one is how do you improve the likelihood of a viable auction of a defaulted member portfolio?

This is the primary tool for managing default risk: a matched book with committed CMs returns the clearing house to a stable condition so this should receive the most attention, but the question remains are clearing members incentivised to bid on orphaned portfolios in all situations?

Incentives are typically in place to support competitive tender (for example, the lowest bidder wears non-margined default losses first), but how would a member view this if the commercial viability, not solvency, of a clearing house was undermined?

For example, in an environment where a (non-suffering) clearing house is available to trade the same products and many clients are simply switching to this alternative CCP, are we sure that current design prevents the auction failing in entirety? If there aren't appropriate incentives for CMs to take on more risk during times when the market needs their support, the first line of defence from recovery is severely compromised.

To expand on the issue of rehousing trades, how does the market ensure that all demand for orphaned positions is absorbed? The bidding on orphaned positions occurs exclusively between CM entities, all of which are capital-constrained and potentially holding directional portfolios. The ironic outcome could be a recovery process that impedes the survival of a market or trading venue through a disregard for the internal appetite to absorb the risk that is producing stress.

All entities should be interested, on a commercial basis, in working on this aspect.
Even if it is possible to port a trade away from a defaulting CM this process comes with its own problems.

Say, for example, a backup CM does adopt your trades; does your new provider have the capital and appetite to do so in that environment? What is their view of the commercial value of this proposition? What if your chosen alternative is also experiencing problems? It is hard to be confident that someone will answer that call when you make it. Moreover, just how many end-user participants will be big enough to remain relevant to enough providers through the good times to compensate for the bad?

The alternative is to pay handsomely for an emergency line of credit that is unenforceable. These problems clearly become magnified if your trades are bid on by a CM your organisation has minimal or no prior relationship with. Anyone who has gone through the process of employing a clearing provider knows this is a lengthy process. Assuming there are a meaningful number of positions that need a home, this means workable terms must be agreed between unfamiliar parties within 48 hours.

Pret a porting

There are two things currently missing from discussions on making portability an explicit process. Firstly, industry needs agreed documentation which combines the precision of CM service terms with negotiable latitude on key commercial/operational aspects, for utilisation when time is short.

Secondly, clearing house membership terms must have conditions that increase the likelihood of existing direct member and client relationships being honoured. Under forced porting, the current legal framework lacks robustness just when you need it. Regulators may need to be called on to mandate action but these are projects for Isda and CCPs to work on respectively.

Once the issue of portfolio transfer has been resolved the issue becomes one of how do you ensure continuity of trading in the event of a CM member default? Isda rightly points out that "forced allocation of contracts (adding unwanted and unmanageable positions at a time of stress) could expose non-defaulting CMs to greater risks than forms of contract termination". However, there are many reasons why tearing up problematic contracts should not be a course of action taken casually.

Tearing up a trade has broader impacts than simply resolving a contract ahead of its due date. Take the inflation swap market: were it to experience a dislocation, many billions of dollars of awkward and long-dated inflation swaps would be looking to find a home.

Much of this exposure supports long-dated liability management structures for pension schemes and insurance companies. While these players might not realise a cash loss from contract termination, their portfolios are now exposed to the primary risk they were tasked with managing in the first place. Rehedging could be prohibitively expensive, if it is even possible. A result like this has wider repercussions to society.

More needs to be done in order to assure trade continuation. Without more confidence that your clearing house and its members care about continuity of trade, we may find that end-users panic at the first sign of instability. The answer is not to force risk on to CMs, as Isda points out. However, discussion should be had as to what could be done, such as including explicit funds within the DMP to support the auction of problematic risk.

Isda's guidance on how to utilise default funds to best effect is a welcome distraction to arguments over who should provide those funds and how much they should commit. However, the principles of transparency and open expression on any CCP's resolution should be expanded to help the broader market understand the obligations agreed between a clearing house and its members.

This aids market participants in forming an opinion on whether a CCP operates to manage risk only, or if there is a clear sign that benefits extend into providing assurance that a market remains functional. It should be expected that productive feedback on CCP governance will follow this clarity.

Given enough thought it is possible to largely improve the alignment of the incentives of regulators, CMs, CCPs and end-users.

Nick Horn is senior investment risk analyst at QIC in Brisbane.

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