Benoît Coeuré: Ensuring an adequate loss-absorbing capacity of central
counterparties
Special invited lecture by Mr Benoît Coeuré, Member of the Executive Board of the European
Central Bank, at the Federal Reserve Bank of Chicago 2015 Symposium on Central
Clearing, Chicago, 10 April 2015.
* * *
Ladies and gentlemen1
This Symposium organised by the Federal Reserve Bank of Chicago is a major event for
discussions on key themes regarding central clearing, and it is a privilege for me to deliver
this lecture in front of such a distinguished audience.
I would like to make some comments on a topic which has been steadily going up the central
clearing agenda, namely the need to increase the loss-absorbing capacity of central
counterparties (CCPs) beyond their current levels.
Because of their growing systemic importance, CCPs need to be exceptionally robust, and
that means being able to cope with even extreme losses. And to achieve this, it may well be
necessary to increase their existing loss-absorbing capacity. But what is less clear at the
moment is whether this can be done by having CCPs observe the existing, tough
international standards, which have been introduced only relatively recently. Or whether
there is a need for new requirements that are more demanding or more specific. And if so,
how can we best do that in a way that preserves the benefits of central clearing, provides the
right incentives to CCPs and to their clearing members, and strengthens the financial system
as a whole?
These questions go to the heart of the current work by the two international standard-setting
bodies most directly involved, the Committee on Payments and Market Infrastructures
(CPMI) and the International Organization of Securities Commissions (IOSCO), as well as by
the Basel Committee for Banking Supervision (BCBS) and the Financial Stability Board
(FSB). Today I will cover some of the issues authorities are tackling.
The global regulatory agenda implemented since the crisis has made CCPs
considerably safer.
As a result of the G20's commitment to introduce clearing obligations, CCPs have become
"super-systemically important", and ensuring their safety is thus critical. Over the past few
years, the global regulators (CPMI-IOSCO, FSB and BCBS) have offered guidance in many
areas to increase the resilience of CCPs and their participants. Let me give you four
examples:
First, rigorous risk-management standards via the Principles for financial market
infrastructures: the PFMI were adopted by CPMI-IOSCO in 2012, implementing ambitious
standards covering every aspect of a CCP's risk management framework. These Principles
are significantly tougher than those they replace and their consistent implementation across
jurisdictions is currently being monitored.2
Second, guidance on CCP recovery and resolution: in 2014, as a supplement to the PFMI,
CPMI-IOSCO published comprehensive guidance on financial market infrastructure (FMI)
recovery.3 It considered the types of tools that CCPs and other FMIs can use to deal with
severe financial problems that could threaten their existence. In addition, the FSB adopted a
framework on FMI resolution.4
Third, specific treatment of banks' exposures to CCPs: the BCBS has revised its previous
Basel II capital framework, which applied a zero capital charge to banks' exposures to CCPs,
in order to better capture the risks stemming from the financial system's increasing reliance
on CCPs. One of the main features of this revised framework is the preferential treatment
given to exposures to qualifying CCPs, i.e. CCPs supervised in a manner consistent with the
PFMI.
Finally, enhancing the understanding of CCP risks via increased transparency: in order to
ensure CCPs are providing participants with the necessary information to evaluate the risks
linked to clearing, CPMI and IOSCO have published two disclosure frameworks. The
Disclosure Framework and Assessment Methodology,5 released in December 2012, and The
Public Quantitative Disclosure Framework6 for CCPs, released in February 2015, which
require CCPs to disclose information on topics such as the size of their credit risk, liquidity
risk, collateral, margins, business risk, custody and investment risks. Let me add that public
disclosure requirements are particularly important for indirect members who, unlike direct
members, do not play a direct role in the CCP's risk governance.
Should authorities be doing more to address potential weaknesses in CCP risk
management?
As I just mentioned, the regulatory standards have been significantly strengthened since the
financial crisis. However, catastrophic losses beyond those already covered by the regulatory
requirements could still occur. Given the critical role of CCPs in financial markets, regulators
need to think the unthinkable. Indeed, stress events concerning CCPs are - thankfully - rare:
the most recent example of a CCP failure was the collapse of the Hong Kong Futures
Exchange clearing house in 1987. A more recent - albeit less dramatic - stress event was
the uncertainty caused by the default of a clearing member at KRX, the South Korean CCP,
which caused it to tap its mutualised default fund, and revealed that clearing members were
not always aware of their potential liabilities towards the CCP. When such events occur, they
have the potential to shut down the markets they serve. With the emergence of
supersystemic CCPs serving global derivatives markets, a CCP failure could be a catastrophic
event of global proportions.
In September 2014, the gross notional outstanding amount of centrally cleared positions was
estimated at USD 169 trillion for OTC interest rate derivatives, and at USD 14 trillion for
credit derivatives.7 The sheer magnitude of these figures (around ten times the GDP of the
United States or European Union) gives us an idea of the severity of the potential
consequences from a stress event at a major global CCP.
Authorities see the distinct benefits of central clearing and wish to set proper market
incentives for participants to move away from bilateral trading and into the centrally cleared
world. Mandatory central clearing allows risks to be pooled, monitored and properly
managed. However, pushing more complex products towards mandatory central clearing
makes risk management more challenging, and therefore may increase the risks to which
CCPs and clearing members are exposed. Authorities may need to assess whether overly
complex products should really be submitted to central clearing, so as to ensure CCPs can
continue pooling risks in a safe and efficient way.
In recent months, concerns have been expressed regarding the adequacy and consistency
of the level of risk management across the CCP landscape. At this stage, it is too early to say
whether current regulations are insufficient. New requirements may well prove necessary but
the impact and coverage of the existing regulatory framework should first be
comprehensively assessed.
Authorities have started exploring and analysing potential issues with the granularity and
consistency of global standards, and will continue to do so in the coming months. For
instance, CPMI-IOSCO has put in place a substantial implementation monitoring programme
of the PFMI across jurisdictions:8 the monitoring work so far has shown that many
jurisdictions have made good progress in adopting the PFMI in their domestic regulatory
frameworks. A more detailed analysis of whether the content and the outcome of
implementing legislation, regulations and policies are complete and consistent is currently
under way.
Furthermore, the granularity of margin practices is being reviewed, and CPMI-IOSCO is now
assessing - in cooperation with the industry - the consistency of CCP stress testing
practices.9 Consistency does not need to be achieved by imposing standardised models on
all CCPs - a "one size fits all" approach may not be appropriate, and regulators may be more
effective by relying instead on minimum standards, which all CCPs would be required to
apply to their models. The outcome of these exercises will be of crucial importance in
identifying and calibrating the need for further regulatory action.
Staying clear of pitfalls and misconceptions.
If gaps were to be identified in CCP risk management standards, requiring the adoption of
new global requirements, we would need to make sure the debate is being framed in an
appropriate manner.
First of all, there may be no single best solution for addressing concerns related to CCP
safety. Optimal solutions may vary according to the business model of the CCP (including its
ownership structure), according to the CCP's risk profile (including the types of products
cleared - i.e. cash products or derivatives), and according to the size and concentration of
exposures within clearing members (including the extent of indirect clearing). Regulators may
wish to keep a certain degree of flexibility when they make their final recommendations.
We also need to be cautious when drawing analogies between CCPs and banks. CCPs have
in fact a fundamentally different business model and liability structure. CCPs are not
leveraged and they do not actively take risk: barring the default of a member or an
operational incident, their net risk exposure at any point in time is always equal to zero.
Another major difference is the limited extent to which CCPs are expected to cover their
exposures via their own funds, as the concept of "bail-in" is directly built into their risk
management. Indeed, coverage is achieved to a very large extent via pre-funded resources
provided by the clearing members themselves. Bail-in is a new concept for banks, but not for
CCPs. In addition, CCPs can rely on contractual arrangements to allocate losses among
their members. The statutory tools implemented by banking supervisors for ensuring the
resilience of banks may therefore not be appropriate for CCPs, and we should be cautious
about any comparisons we make. They could be misleading.
Furthermore, taxpayers should obviously not be liable for any losses incurred by CCPs.
Losses should be entirely borne by the CCPs themselves and their participants, in an
appropriate and proportional manner, and in line with prudent incentives. In particular, the
involvement of indirect participants should be carefully considered: their contribution to the
loss allocation process should take into account the fact that they have no contractual
agreements with the CCP, and, unlike direct members, have no part in the CCP's risk
governance process (and therefore have no say in the CCP's risk management).
Lastly, the issue of compensating clearing members for losses incurred during a recovery or
resolution process remains comparatively unexplored and deserves careful attention.10
Let me now turn to the various tools that authorities could use to address potential
shortcomings in CCP risk management and loss-absorption capacities. These options have
very different implications, namely in terms of sharing the funding needs between CCPs and
participants, and in terms of providing the right incentives to CCPs' stakeholders.
Increasing the level of pre-funded resources held by CCPs to cover default losses
beyond the current standards.
One possible conclusion from the current review of the international implementation of
regulatory requirements, and the analysis and assessments being carried out in parallel,
could be that standards regarding margins and stress testing are sufficiently stringent, but
are not implemented consistently across CCPs and jurisdictions.
Authorities could also conclude that the standards themselves are not sufficiently strict and
that there is a need for CCPs to bolster the arrangements that may be used in a pre-recovery
stage. This might require CCPs to cover their exposures beyond the "cover 2" standard
currently set by the PFMI for systemically important CCPs.
Bear in mind that prudent margins and an adequately sized default fund are the very
foundations of a CCP's risk management. If CCPs appropriately cover credit and market
risks via their initial margins, and adequately stress test their exposures under extreme
conditions, there will be only a residual chance that they will not be able to cover default
losses.11 We should remember that cover 2 is already a very stringent criterion, which has
never been observed in a real crisis. However, as I stated earlier, the unthinkable may
happen.
The next question is how this increase in resources should be funded. Recently, there have
been some calls to increase the contributions made by CCPs themselves to the total amount
of financial resources posted - the so-called "skin in the game". In the European Union,
CCPs already have to contribute 25% of their required regulatory capital to the default
waterfall, which would be used before tapping the mutualised default fund. Should we go
further, and demand a larger contribution from CCPs?
Such a step would raise many challenges. "Skin in the game" should primarily serve to
provide incentives for the CCP's management and shareholders to ensure their risk
management framework is sufficiently prudent, and limits excessive risk taking by clearing
members. It should not be seen as a significant financial resource to cover a CCP's
exposures: indeed, the purpose of CCPs is to mutualise counterparty risk, not to remove it
from clearing members altogether and bear it themselves. CCPs are risk poolers, not
insurance providers.
In fact, a substantial increase of "skin in the game" could provide clearing members with a
false sense of security, by reducing their potential contribution to the loss-allocation
process.12 This could lead them to be less vigilant in monitoring risks, which may have severe
consequences for the safety of CCPs. Furthermore, in order to represent any meaningful part
of the default waterfall, "skin in the game" would need to increase dramatically, thus
completely changing the size of CCP balance sheets and their business models. This could
even defeat the purpose of mandatory central clearing by pushing CCPs to dramatically
increase the cost of clearing, or to compromise on their risk management in order to retain
profitability.
In sum, it seems reasonable that an increase in prefunded resources, should it become
necessary, should be mainly borne by clearing members.
Strengthening CCP recovery capabilities via specific recovery tools.
An alternative conclusion to our current discussions could be that cover 2 is an appropriate
standard for ensuring CCP resilience in a pre-recovery phase, but that more reassurances
are needed to ensure CCPs can adequately cope with a recovery situation if they face tail
losses.
Let me stress that, here too, it is too early to state whether and, if so, what additional
guidance regarding recovery capacities will be needed. However, let us think about the ways
in which authorities could improve CCP recovery tools if the need did arise.13
In a recovery situation, a significant amount of additional funding could come from ex post
cash calls on non-defaulting clearing members, also referred to as "default fund top-ups" or
"emergency assessments". This could provide CCPs with ample resources to avoid a
complete depletion of their capital, and would share the funding burden across the whole
clearing membership. Such assessments are usually allocated according to each member's
contribution to the CCP's default fund. This way of allocating assessments, provided it is
transparent, gives members a degree of predictability about what will happen. Nevertheless,
they could expose surviving clearing members to sudden and very large liquidity demands
which they would have to source in the market, and could thus have strong contagion
effects14 - even pushing members to close out their contracts and leave the CCP, rather than
face the spiralling costs of remaining a member. For these reasons, such tools may prove
problematic for bank supervisors.
Another tool which is frequently mentioned in discussions on CCP recovery is variation
margin gains haircutting (VMGH). In my view, this tool may have a certain advantage over ex
post cash calls, in the sense that it would alleviate the need for members to raise extra
liquidity to meet their obligations: the CCP would simply perform a write-down of its outgoing
payment obligations to clearing members with "in the money" positions. To the extent that
this tool would hit members which are not liquidity- constrained, it is more reliable and the
systemic impact could be less. So although it could lead to unequal loss allocation among
clearing members and create ex ante uncertainty on the burden sharing of the cost of
default,15 it could also mitigate pro-cyclicality concerns to a certain extent.
Another series of measures to be considered by authorities are the voluntary or forced
allocation of open positions among clearing members. These measures would help CCPs
reestablish a matched book following a participant default. In my view, if authorities choose to
promote these tools, we should take care to encourage voluntary measures to the extent
possible. Indeed, forced allocations could lead to effects which are difficult to control, for
example by requiring participants to take on positions which are not closely related to their
clearing activities, and for which they cannot adequately measure risks, particularly in volatile
market conditions. A last-resort option could be a partial or complete tear-up of open
positions, but this could cause significant disruption to the products and markets where
contracts are terminated, and therefore should be avoided to the extent practicable.
A solution which seems to be supported by parts of the industry would be to dedicate an
additional tranche of the CCP's capital for recovery needs. While increases could be
discussed, I believe it may not be advisable - for the reasons already outlined above - to
place the entire burden of extra loss-absorption on CCPs.
For the sake of completeness, I would also like to mention alternative recovery tools such as
the proposal by a consortium of insurers to provide coverage for extreme tail losses, or the
idea that CCPs should issue bail-in-able debt instruments. Such solutions deserve
consideration as they can enhance market discipline, but they require further analysis before
being truly considered as viable options by authorities. For example, it is unclear whether
there would be a deep enough market for CCP bail-in-able debt, given the tail nature of the
risk being priced, and the risk that demand will be exhausted once the total loss-absorbing
capacity proposal for banks is calibrated and implemented.
You will note that I have not made any mention of emergency liquidity provision to CCPs by
central banks. A fundamental principle is that it is up to the CCP to maintain adequate and
robust liquidity arrangements, both in normal and crisis times. If a clearing house believed
that it could easily and readily access central bank liquidity, this would weaken its incentives
to make the necessary arrangements. Of course, there can be cases where all the necessary
arrangements have been made but the CCP is facing losses beyond what was predicted and
needs temporary liquidity support while remaining solvent. In that case, this option will be
available and there should be no technical obstacles to using it. But there can be no
commitment from the central bank to provide liquidity, and that's a basic principle of central
banks in general, not only for CCPs but for banks as well.16
In sum, while some of these tools appear more appropriate than others, all of them imply
drawbacks, and authorities will need to proceed cautiously if they favour one over another.
CPMI-IOSCO is currently reviewing existing CCP recovery mechanisms, including loss
allocation tools, and will consider developing more granular standards for CCP recovery
planning if that is needed.
However, even enhanced recovery tools may not be enough to prevent the CCP from being
resolved, first of all because it is impossible to estimate ex ante the size of potential
uncovered exposures, secondly because under certain circumstances it might be preferable
to resolve a CCP - especially if the market has lost confidence in this CCP as a going
concern.
Effective CCP resolution as an ultimate tool.
Lastly, we need to assess whether more assurances are needed so that a CCP can be
effectively resolved and can re-launch its viable operations, and whether the measures
discussed before are either ineffective or out of line with market preferences.
Much like recovery frameworks, CCP resolution frameworks are currently being designed
and implemented across jurisdictions. The FSB is reviewing CCP resolution regimes and
resolution planning arrangements. Based on this review, it may develop minimum standards
for CCP resolution planning, strategies and tools without resorting to a government bailout,
and without resulting in contagion to other parts of the financial system. Meanwhile, the
European Commission is preparing specific EU legislation.
If, after an in-depth assessment, authorities come to the conclusion that an additional source
of financial resources is needed, what form should these extra funds take?
Let me first reiterate that any bailout of CCPs with public money should be categorically
excluded. Resolution plans should fully allocate losses to CCPs and their participants.
Having clarified this point, I can potentially see four main ways of increasing resolution
capacity:
The first would be to increase the amount of regulatory capital held by CCPs, and explicitly
ring-fence a share of this capital as a means to recapitalise a new entity in a resolution
scenario. In the EU, CCPs are required to hold sufficient own resources to cover operating
costs over a six-month period - this requirement could be strengthened, not only in order to
cover for a potential wind-down, but also to meet the funding costs of a new entity. For the
reasons described above, I believe there would be important drawbacks in relying only on
CCPs to increase their regulatory capital. CCPs should provide a proportional contribution to
the resolution process, but should not bear all the costs.
A second policy option could be to make use of initial margin haircutting as a means to fund
the resolution process and establish a new CCP. While this would provide CCPs with
significant resources, mutualised across the entire clearing membership, and could provide a
base for re-launching a viable CCP with some degree of certainty over the sharing of losses,
it would also imply a significant change in the way clearing members understand their
liabilities towards the CCP - indeed, in certain jurisdictions, initial margin currently has to be
bankruptcy-remote. It would be difficult to predict the potential pro-cyclical effects resulting
from this tool, as well as the effects on incentives for members to take part in central
clearing. As a result, this tool should be carefully considered for resolution scenarios, and
should perhaps be ruled out of the recovery toolkit altogether.
A third option would be to set up a cross-CCP resolution fund, much like the Federal Deposit
Insurance Corporation or the Single Resolution Mechanism recently established for banks in
Europe. This fund would be financed by risk-based contributions from CCPs and clearing
members, but could also be financed by other stakeholders who may benefit (directly and
indirectly) from the risk-management services provided by CCPs. While this idea is
conceptually appealing, it may be very demanding to implement. Such a resolution fund
would need to be established on a cross-jurisdictional basis, which implies significant
coordination challenges, and it would have to be phased in over a large number of years. I
frankly don't see the political momentum for such a solution.
A fourth option would be for each CCP to establish its own dedicated recapitalisation fund,
funded mainly by clearing members, with a proportional contribution from the CCP itself. The
recourse to this recapitalisation fund would certainly create many challenges. The resolution
authority must be able to identify certain clearing services which are still viable, and these
must be insulated from the losses affecting the non-viable clearing services. However, if we
are to go in the direction of new requirements for CCP resolution, I believe this could be a
promising avenue to explore.
Should additional pre-funded capital or liquidity resources be needed for cases of resolution,
this will have to be shared in a fair way among all relevant stakeholders. Global coordination
and consistency is therefore important in order to ensure a level playing field.
Looking beyond the debate on CCP loss-absorbing resources, we should keep in mind that
there are other key questions regarding resolution.
Indeed, the success of a resolution process will not only depend on whether the CCP has
adequate resources, but also on whether it is actually resolvable (for instance, whether its
viable activities can be separated from its non-viable ones and transferred to another CCP).
This will depend to a large extent on the operation and design of the CCP being resolved -
e.g. whether its viable clearing activities are insulated from losses from the non-viable ones
through separated default management silos. It will also depend on whether or not positions
from the CCP which undergo resolution can be successfully transferred to another entity in a
safe and timely manner, via an interoperability link or some other means. Further analysis
will probably be required regarding the means to facilitate the porting of positions in a
resolution scenario, in order to guarantee substitutability across CCPs.
Another issue to consider is the extent to which resolution authorities should be able to
impose a temporary stay on early termination rights for CCP participants, which may be
normally triggered upon the entry of the CCP into resolution.17 This topic will surely feature
prominently in the discussions on the implementation of CCP resolution regimes.
In sum, debates regarding the appropriate level of CCP resources should not prevent us
from addressing other crucial issues linked to resolvability.
Keeping the systemic perspective in sight
I have repeatedly made the point that increasing the level of financial resources available to
CCPs requires careful consideration, in view of the potential costs for all relevant
stakeholders. I believe it may also be necessary to examine the effects of any additional
CCP requirements on the financial system as a whole.
First and foremost, it will be important to ensure that incentives for central clearing are not
negatively affected. Efforts by authorities to strengthen the robustness of the financial system
would be compromised if additional funding costs were to push participants away from CCPs
and back into the bilateral world. It will therefore be crucial to ensure consistency between
new rules affecting CCP loss absorption and the collateral regime for bilateral trades, and the
capital regime for banks' exposures to CCPs.
More generally, in recent months, market participants have expressed concerns that, due to
the significant amount of new regulation being discussed and implemented worldwide, it is
sometimes hard to get a full picture of the regulatory architecture currently being set up. I
therefore believe it is important for authorities to continue to work together, as they have
done since the crisis, and to assess the combined effects of global regulation on the market
and on incentives to mitigate risks. An example of this type of cooperation is the work carried
out by the OTC Derivatives Assessment Team, which brings together representatives of
several regulatory committees, and which published a report in 2014 examining the
incentives for central clearing in the current regulatory landscape.18
Part of this work will involve looking at how regulations applied to CCPs interact with those
applied to other entities in the financial system, namely banks. Thanks to the work being
carried out by CPMI-IOSCO on stress testing and margins, we are beginning to get a better
picture of how risks are being managed across the whole CCP landscape. In my view, an
important step for the future will be to put together CCP stress testing and the stress testing
carried out by big global banks (one way of doing this could be to define common stress
scenarios, and see how the entire system performs). Authorities, CCPs and market
participants need to assess the extent to which banks will be able to absorb losses passed
on to them by a CCP, and how a recovery or resolution process will affect the banking
system.19
In this respect, authorities will need to pay particular attention to pro-cyclicality. As already
mentioned, many of the proposed instruments to increase CCP loss absorption will have a
significant cost for clearing members. We need to be aware that, very often, these costs will
arise during a stressed market situation, when clearing members may already be facing
significant liquidity pressure. Authorities responsible for CCPs and those responsible for
banks should try and work towards a common understanding on pro-cyclicality, in order to
ensure consistency in their regulatory actions.
Lastly, I believe we also need to move towards a more systemic view of the interconnections
between CCPs and clearing members, namely via the channel of indirect participation. The
PFMI already require CCPs to identify, monitor and manage material risks arising from tiered
participation arrangements. Here too, the CCP authorities and banking authorities should join
forces and get a broader picture of this issue, making use of the available data and
developing network analyses.20 CPMI-IOSCO together with the BCBS and FSB will soon
launch joint analytical work in this field.
Conclusion
I have made the case that the global regulatory agenda implemented since the crisis has
made CCPs considerably safer. If these requirements are applied consistently, significant
improvements to CCP loss-absorbing capacities may not be required. CPMI and IOSCO are
currently reviewing CCP risk-management practices on a global scale and will identify any
areas where greater consistency or granularity is needed.
If the need did arise for further loss-absorption capacities, we will have to make sure any new
requirements provide the right incentives for CCPs and their members, offer authorities a
certain degree of flexibility and do not create disincentives for central clearing. Whether we
choose to bolster the tools for CCP resilience, CCP recovery or CCP resolution, we will need
to be aware of potential trade-offs in the way losses are allocated, and remember that there
may be no ideal approach. I have provided an overview of the pros and cons of these various
approaches.
It will be crucial not to lose sight of the systemic view when discussing CCP loss absorption,
and to pay close attention to the interconnections between CCP exposures and bank
exposures, and to the impact of CCP risk-management on pro-cyclicality in the global
financial system.
I look forward to learning from our discussions today and I hope they will shed new light on
some of the trade-offs I have identified.
Thank you for your attention.