No easy fix for CCP investment loss issue, banks fear

UK-based CCPs have to pass investment losses to members and BoE says it would be logical for returns to be shared as well. But market participants say that will not win CCP shareholder support

Bank of England artwork
The Bank of England

Proposals designed to ease clearing member concerns about their exposure to clearing house investment losses are unworkable, according to market participants.

Recent rule changes at UK-based central counterparties (CCPs) LCH.Clearnet and Ice Clear Europe – a result of new UK laws – require clearing members to bear the brunt of investment losses once the capital a clearing house has allocated to these losses has been depleted. At LCH.Clearnet, this buffer amounts to €15 million.

CCPs invest received collateral in low-risk assets, but could suffer losses if the issuer of an instrument defaults, or if the counterparty to a repurchase or reverse repurchase agreement defaults. Clearing members say the risk they have been told to assume is too great, and two main solutions have been suggested – either they share in CCP investment gains as well as covering losses, or CCPs increase their buffers.

The Bank of England (BoE) sees the sense in the first of these ideas: "There is some logic to a structure where both the returns and the risks go to the clearing members. We have no problem with that and we also believe there should be a high level of disclosure from the CCPs to their members and their shareholders on what their investment portfolio looks like and how the funds are being invested," says Graham Young, a senior manager in the BoE's market infrastructure division.

Industry groups are also pushing this approach. The Futures Industry Association (FIA) argues that if banks are forced to bear the losses of a CCP's investment strategy, they should also be able to participate in the upside.

There is some logic to a structure where both the returns and the risks go to the clearing members. We have no problem with that

"In essence, if LCH is required to allocate losses to LCH members, it should also pass through gains to LCH members. LCH members must have complete transparency and governance over the investment policy that applies to investment of LCH member collateral," said the FIA in an April 11 letter to LCH.Clearnet.

But despite the idea having powerful backers, market participants say it is unlikely a CCP's shareholders will accept investment income being redirected to clearing members.

"It's hard to think of a workable solution whereby gains are returned and equity holders are kept happy. The London Stock Exchange is the largest shareholder of LCH, and it may feel it has put enough money into the shareholding and may not want to see other players take part of the profits," says one London-based consultant.

Clearing members have also urged CCPs to allocate more capital to the investment loss buffer to make it less likely that losses spill over to members. They argue this aligns the interests of a clearing house with those of its members, as the latter currently do not have a say in how a CCP manages its investment portfolio.

Banks have rounded on LCH.Clearnet in particular – its buffer is one-sixth the size of the $90 million available at Ice Clear Europe – and a number of clearing members have called for the CCP to put more of its own capital at risk.

"We appreciate that this loss would initially be swallowed by the CCP's own capital, but if its amount of capital is too thin, then who will cover the remaining losses? And in the case of LCH.Clearnet, €15 million is insignificant," says one London-based clearing specialist at a UK bank.

In an emailed statement, a spokesperson for the CCP says: "LCH.Clearnet continues to consult with its members on collateral and liquidity management."

The LSE failed to respond to requests for comment by press time.

The BoE's Young says CCPs should contribute part of their capital to meet investment losses, and that it should be in line with the amount they have to hold against investment risk under the European Market Infrastructure Regulation. However, he notes that UK law limits the amount they can put up. It states losses must be allocated in a way that ensures a CCP's day-to-day business is not threatened.

"There is an implicit maximum CCPs can set, otherwise their solvency could be at risk. However, between this minimum and maximum level, it's up to the CCPs to decide how much capital they want to contribute to cover the first-loss piece," says Young.

Even if a CCP agreed to commit more capital, it would either need to be put up by existing shareholders – which is not likely to be popular – or by new investors, potentially diluting shareholder returns. The head of derivatives clearing at one international bank in London says he expects both options to be unworkable.

The relevant portions of the UK Financial Services and Markets Act 2000 came into force on May 1, including broad new provisions relating to the recovery and resolution of CCPs. The rules require UK-based clearing houses to plan for the allocation of default losses, as well as non-default losses that "threaten the central counterparty's solvency". There is no guidance on how to determine what counts as a solvency-threatening loss.

LCH.Clearnet detailed its rule changes in a filing with the Commodity Futures Trading Commission last month. According to the amendment, should the clearing house incur an investment loss, it would absorb the first €15 million using its own capital. Any losses above the €15 million threshold would be allocated to its clearing members according to their average margin weight.

Similarly, Ice Clear Europe amended its rule book to state that it would take the first $90 million of losses should it suffer investment losses, with anything above that shared among clearing members. The amendment adds that Ice Clear Europe's $90 million commitment will also be used to cover other non-default losses – those arising from operational issues, for example.

The UK is the only jurisdiction known to have introduced rules for CCP recovery and resolution, but the European Union is working on proposals that could be published before the end of this year.

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