Of rats and men: would member compensation imperil CCPs?

CCPs and members split over whether compensation after default losses is moral hazard or fair

In an attempt to check Hanoi’s flourishing rat population, French colonial authorities in Vietnam once offered locals a bounty for each rat tail they presented to municipal authorities. It didn’t go as planned, though. Rather than killing the rodents, entrepreneurial locals built farms for them, cutting their tails off, but keeping their stock alive to breed more bounties, which led to many, many more rats.

This bit of Grand Guignol is recalled today as the Great Hanoi Rat Massacre of 1902. French colonial authorities probably didn’t know about moral hazard; the idea that rewarding a party for taking risk when they will be unscathed by any consequences can go seriously awry.

But central counterparties (CCPs) today do know. They warn that proposals from European authorities on how to distribute losses in a member’s default could give other members an incentive to bypass the early steps that might contain a problem, in the knowledge they will be rewarded once the situation has turned far more serious.

“The compensation provisions have created some controversy, because we see that changing the incentive structure of the CCP,” says Rafael Plata, secretary general of the European Association of Clearing Houses in Brussels. “It disincentivises clearing members to participate in the earlier stages so we don’t reach the latter stages of resolution.”

Clearing members, however, say they deserve to be compensated for shouldering the losses of a defaulting member and steadying a teetering clearing house.

“We feel it is wrong for members to be required to keep putting more and more money into the CCP, effectively cleaning up the balance sheet of the CCP. Once you get past a certain point of losses, funded and unfunded default fund, further costs should be compensated out of future earnings,” says Bill Stenning, managing director of clearing, regulatory and strategic affairs at Société Générale in London.

The clearing houses have at least some reason to worry, as do clearing members. In September 2018, Nasdaq Commodities took an €114 million bath after power trader Einar Aas defaulted. Nasdaq held an auction to sell off Aas’s portfolio, but invited only four clearing members in an attempt to keep things quiet and avoid moving the market. Bidders, however, were not interested in the full portfolio, and the failure of the auction ended up torching almost two-thirds of Nasdaq’s default fund – with members picking up the slack.

Bill Stenning

The debate matters, because compensation issue is currently under review by lawmakers. In November 2019, the Council of the European Union finally produced a draft of the Central Counterparty Recovery and Resolution Regulation, and it is now negotiating a final version with the European Commission and the European Parliament, each of which has their own draft version.

The Council and EC versions are broadly similar, with a few differences. Both would give resolution authorities the option of paying clearing members compensation if they assumed losses in excess of those outlined in the clearing house’s operating rules. The Council’s proposed regulation would also give resolution authorities the power to exact a “resolution cash call”.

A Council spokesperson clarified that their rule is intended to award compensation across all types of losses, not just a clearing member’s default. The EC’s text is similarly worded but states only that compensation can be paid where members take losses “that deviate from” the clearing house’s operating rules. The EC did not reply to requests for clarification on whether this would include all types of losses.

In contrast, the European Parliament’s version would only allow compensation for losses not generated by a default or ‘non-default losses’ (NDLs).

The key challenge in all of this is: how do the resolution authorities think of compensation?

Risk expert at a clearing house

In theory, the proposed regulation is more likely to lead to clearing members receiving compensation for NDLs than for default losses; there is no ceiling on this type of compensation. In defaults, the clearing house’s rules outline a set amount of losses that clearing members would assume through loss-allocation tools; amounts for which the members would not be compensated. If losses exceed that level, however, the Council and EC texts could put compensation on the agenda.

Despite the apparent largesse of the Council and EC drafts, neither actually guarantees compensation; they only open the door for it. Whether it is granted is left up to resolution authorities; a group of arbiters to be appointed by regulators in the country where the clearing house is domiciled.

As no resolution authorities will be named until the regulation is finalised, it is hard to know how sympathetic they would be to one side or the other.

“The key challenge in all of this is: how do the resolution authorities think of compensation?” asks a risk expert at a clearing house.

Loaded or fair?

When a clearing member defaults, the house initiates a ‘waterfall’ – a series of steps that begin with an auction of the defaulter’s portfolio and using the default fund contribution of the defaulting member. The CCP recovery and resolution regulation requires clearing houses to then pony up a quarter of their regulatory capital, known as ‘skin in the game’, before moving on to tap the default fund contributions of non-defaulting members and making a further cash call on them, known as a default fund assessment. Thereafter, clearing houses may begin haircutting variation margin gains for non-defaulting members.

Clearing houses say that if resolution authorities were to compensate members, they would be tampering with the waterfall.

Generally, there only needs to be one single member who has an interest in the portfolio of the defaulter to bid and to close out the position

Bill Stenning, Société Générale

“It would be a serious challenge for them to suggest they are willing to compensate for whatever happens,” says the risk expert at a clearing house. “We get extreme member scrutiny and if mutualisation is diminished, then it is going to dampen the enthusiasm for high-risk standards. If they indicate they are not interested at all in providing compensation then the participants will, of course, be incentivised to ensure there are no problems.”

Clearing members, however, dispute that compensation would dissuade them from participating in those early stages. They point out that, in a default, members would still lose a lot of money if an auction failed and they would not be compensated.

“I don’t see why a clearing member would think it is a good strategy to not bid properly in the auction just to get some compensation at the end of the waterfall,” says Ulrich Karl, head of clearing services at the International Swaps and Derivatives Association in London. “The CCPs would ask for default fund replenishment, have to use the default fund assessments, and the clearing member would have to take losses from tools like variation margin gains haircutting. It doesn’t add up as a useful defensive strategy.”

Default funds at least look flush. For example, based on regulatory disclosures from the third quarter, Eurex Clearing’s entire default fund totalled €4.3 billion and LCH’s for interest rate swaps was £6 billion.

Stenning of Société Générale says only one member would need to have an interest in the defaulter’s portfolio for the auction to succeed, so he doubts compensation would lead to failed auctions.

“Generally, there only needs to be one single member who has an interest in the portfolio of the defaulter to bid and to close out the position, so there should always be some bidders, except in the most extreme of market disruptions,” says Stenning. “I don’t see how compensation would lead to everyone – every single member – independently reaching the conclusion to bid so low as to utilise the full funded and unfunded resources of the CCP only to receive compensation for the excess out of future earnings.”

Poker face

Resolution authorities, given the broad discretion they get in the Council and EC drafts, might choose to play their cards close to their chest on the subject of compensation to keep clearing members guessing and presumably more involved in trying to contain a default early on.  

“If you have got a CCP that had a very robust waterfall and it is clear that the challenge was that participants simply didn’t come to the auctions or they weren’t interested in participating, you are less likely to see any interest from resolution authorities in providing compensation for that,” says the risk expert at the clearing house.

Rafael Plata

But clearing members are thinking ahead – to how they would be compensated. They have been lobbying for compensation from the clearing house’s future profits, instead of equity. This arrangement would give the members first dibs on the CCP’s cash, ahead of shareholders.

“Clearing members have been pushing for compensation for losses from the use of recovery or resolution tools in both default and non-default loss events in the form of claims on future income of the CCP,” says Karl of Isda. “The idea is that the CCP wouldn’t have any future income had the clearing members not taken losses in the form of variation margin gains haircutting.”

The Council text allows resolution authorities to grant either claims on the future profits or a stake in the clearing house. In the EC’s version, however, clearing members would get only stock.

Yet another factor that could influence a resolution authority is how eye-popping the compensation might get.

Plata of the European Association of Clearing Houses says there is a risk that taxpayers could end up footing the bill if a small clearing house faced losses that were many multiples of its earnings. Given the public’s disgust with bailing out the financial sphere, governments may lean towards limiting compensation to clearing members to make very sure there is no silver lining for them in a messy default.

And if there’s no default?

One scenario that both clearing houses and members agree on is that compensation should be paid when losses have nothing to do with a defaulting member, and are squarely the clearing house’s fault. 

“I would think, to the degree that the ecosystem had suffered as a consequence of this and if there are any private funds that could be dispersed to members for losses, that resolution authorities would be very willing to do so,” says the clearing house risk expert.

But there are times when clearing members might be at least marginally responsible for NDLs and this could influence compensation. For instance, clearing members have no say over a CCP’s efforts to prevent fraud or cyber attacks, so being compensated for any such losses might make sense. But the members could have a hand in drawing up the clearing house’s policy on investing their cash margin contributions, possibly leading the CCP into riskier investments. Compensation in this case might not be warranted.

The European Market Infrastructure Regulation is strict on what clearing houses can invest in, fencing them into high-quality assets. Ironically, because of these limitations, some clearing houses park their cash in the repo market, which can open them to losses. The value of the collateral could tank, for instance, if a repo counterparty or bond issuer defaulted. This is part of the reason why clearing houses are keen to be able to access central bank deposit accounts.

One type of loss that CCPs might be held tangentially to blame for would be the bankruptcy of a custodial bank that happened to be holding non-cash collateral for a clearing member. Clearing houses would bear at least some responsibility as they must approve a member’s custodians.

The European Parliament’s draft text allows compensation only for NDLs, and even that would be limited to situations where no resolution authority had stepped in to save the clearing house.

“The Parliament had a more straightforward explanation of when compensation can be used and what it can be used for,” says the risk expert at the clearing house. “What the Parliament essentially narrowed it down to is: if it is the CCP’s fault, if it is an NDL and if it is mutualised, then they have to compensate for that.”

Given the Council text removes initial margin from the write-down procedure tool, CCPs can still possibly write down the default fund for a non-default loss

Ulrich Karl, Isda

Karl of Isda says compensation could shield clearing members from excessive NDLs. Currently, there is no set minimum of NDLs that clearing houses have to cover before they start sharing losses with members. Parliament is the only one of the three bodies to have set a minimum amount of skin in the game that clearing houses have to assume for NDLs – at 75% of regulatory capital. Clearing members say it’s too low, especially given how scantily capitalised clearing houses are.

“Compensation in non-default events slightly mitigates the lack of CCPs’ own capital that would have to be used before clearing members take losses,” says Karl. “CCPs are really thinly capitalised, and if there is a catastrophic non-default loss it might wipe out their equity. And then the next tool in the toolbox of the resolution authority would either be to use the cash call or to use the write-down tool.”

Unlike the European Parliament, neither the Council nor the EC set any minimum amount of NDLs that clearing houses would have to swallow. The Council’s version, however, would require the EC to submit a report five years after the regulation finally took effect, which assesses whether resolution authorities can draw on enough money to cover the NDLs. If that were not the case, the EC would have to write new legislation with new rules.

Karl says the threat of member compensation for NDLs might also lessen the possibility of dipping into default funds to cover them. All three drafts of the rules exempt a list of unsecured liabilities from being written down by resolution authorities and the Council added initial margin to them in its draft. Clearing members saw this as banning any haircuts to their initial margin. That would leave only one place to turn: the default fund. Karl notes that by not explicitly excluding the default fund, resolution authorities might worm their way into default money to plug non-default losses.

“Given the Council text removes initial margin from the write-down procedure tool, CCPs can still possibly write down the default fund for a non-default loss,” says Karl. “That could at least be mitigated by compensation, but, ideally, we don’t want the CCP to be able to use the default fund in a non-default event.”

In the end, market participants will not know whether the authorities will allow compensation – and what impact it will have on the loss waterfall – until a clearing house suffers severe distress that necessitates a regulatory intervention. Everyone hopes this is an extreme tail-risk event.  

In Hanoi, the denouement came much faster. Officials knew something was up when healthy – but tailless – rats were observed cavorting about town. Just a few months in, the bounty was abandoned.