Benoît Coeuré: Central counterparty recovery and resolution
Keynote speech by Mr Benoît Coeuré, Member of the Executive Board of the European
Central Bank, at Exchange of Ideas #2 "Central clearing - guarantee of stability or new moral
hazard?", organised by Eurex Clearing, London, 24 November 2014.
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Summary
The mandatory use of central clearing is a relatively new regulatory tool for mitigating
systemic risk in the OTC derivatives space. It has brought the central counterparties (CCPs)
to the forefront of financial market regulation. It is therefore crucial for CCPs to have
comprehensive and effective recovery plans, relying on a wide range of recovery tools, to
continue providing their critical services also in a very severe crisis without requiring the use
of resolution powers by authorities. Obviously the stability of CCPs primarily depends on the
establishment and implementation of robust risk management framework. But CCPs are also
in a unique position to set up efficient and comprehensive recovery plans as they can base
them on contractual arrangements with members. But CCPs need to have appropriate
procedures for managing conflicts of interest between stakeholders - it is vital to involve all
those who would bear losses in the design of the recovery plan. And on the regulatory side,
we need to make sure our approach is cautious and non-prescriptive at this stage. I am
confident that CCPs, authorities and stakeholders will work together constructively to meet
the ambitious objectives set out in the recent CPMI-IOSCO report.
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Ladies and Gentlemen,
Today, I want to share some thoughts with you on the recovery and resolution of central
counterparties (CCPs).
The mandatory use of central clearing as a regulatory tool for mitigating systemic risk in the
OTC derivatives space is a rather new feature in the history of financial market regulation. It
has brought CCPs to the forefront of financial markets and financial market regulation hence
it is crucial for CCPs to have comprehensive and effective recovery plans.
When we talk about "recovery" in relation to CCPs, we refer to the ability of a CCP to recover
from a threat to its viability and financial strength so that it can continue to provide its critical
services without requiring the use of resolution powers by authorities. Resolution, on the
other hand refers to the orderly winding-down of an FMI, and would take place only if
recovery fails or is not desirable.
Last month, the Committee on Payments and Market Infrastructures (CPMI) and the
International Organization of Securities Commissions (IOSCO), published a report on
"Recovery of financial market infrastructures". Also last month, the Financial Stability Board
published a report on the Key Attributes of Effective Resolution Regimes for Financial
Institutions, which includes an annex dedicated to resolution regimes for FMIs. Together,
these two reports are important milestones in strengthening the resilience of FMIs, and of the
financial system more broadly.
Today, I will focus on the importance of CCP recovery and resolution, and the challenges
faced by CCPs in designing appropriate recovery tools. I will also describe the specific role
played by authorities during recovery situations, and mention the work that still needs to be
done in the field of CCP recovery.
Recovery as a part of CCP risk management
Before I explain why it is important for CCPs to have recovery and resolution tools, I would
like to make it clear that these tools should only be seen as a way to complement regular risk
management. In fact, recovery is the last step of a CCP's risk management.
The regulatory requirements relating to the safety and efficiency of Financial Market
Infrastructures defined under the CPMI-IOSCO Principles for Financial Market Infrastructures
(PFMIs) (and national laws) are already fairly strict and conservative. Their aim, inter alia, is
to ensure that recovery procedures will not need to be activated. In other words, if a CCP
respects the requirements for risk management set out in the PFMIs (and national
regulations) - which I should add that overseers and regulators are closely monitoring - this
should, in principle, be enough to preserve the CCP and its functioning.
To ensure the PFMIs are properly and comprehensively applied, CPMI and IOSCO have set
up an implementation monitoring procedure covering 28 jurisdictions. Two reports on the
timeliness of the implementation have already been published and another work-stream will
start shortly to assess whether jurisdictions have adopted legislation or policies to implement
the PFMI (Level 1). The first assessments of the consistency and completeness of the
Principles' implementation (Level 2) for CCPs and TRs in the EU, Japan and US will be
released in early 2015. Further L2 assessments will start at the end of the first quarter next
year. In parallel, we have just initiated in all 28 jurisdictions an assessment of the
implementation and application of authorities' Responsibilities, with reports scheduled for
autumn 2015. Moreover, preparatory work is now starting for a Level 3 assessment. It is
anticipated that an assessment of the consistency of the outcomes of the application of the
PFMIs to CCPs will start in autumn 2015. All these measures demonstrate that the regulatory
community is extremely serious - and transparent - about the proper and equal
implementation of the PFMI.
However, even if the safety rules under the PFMI are properly implemented, the unthinkable
may still happen. Central banks and regulators have learned from the recent financial crisis
that focussing only on "normal" risk management is not enough. In the event of a default of a
major clearing member, a CCP might not be able to allocate all the losses and liquidity
shortfalls that may occur. Therefore, each CCP needs to have a recovery plan for allocating
any residual losses and liquidity shortfalls so that it can ensure continuity of its clearing
services even when normal defences have failed. Without a robust recovery plan, the CCP
might have to be resolved.
CCP recovery is therefore a crucial issue. One could even argue that continued provision of
services is more important for CCPs than for other financial institutions. This is because
CCPs, as for FMIs in general, are different to other financial institutions from a number of
perspectives:
1. The use of a CCP is mandatory for certain products. So the relevant clearing
services must be preserved under any and all circumstances.
2. CCPs are systemic risk managers at the core of the financial system. Their smooth
operation is a necessary condition for many other types of financial services.
3. In most cases, CCPs have only very few - if any - substitutes or alternative
providers.
4. The size and composition of CCP balance sheets is different - for instance, their
balance sheets rarely include subordinated debt instruments. This makes bail in as
a recovery or resolution tool difficult.
Designing recovery tools
Although setting up recovery plans will be a challenge for CCPs, they are in a unique and
perhaps better situation to do so than other financial institutions such as banks. Banks also
need such recovery arrangements. A key difference between banks and CCPs is that a
CCP's recovery plan can be based on contractual agreements with its members. Unlike
banks' protected depositors, they can be assumed to understand and manage their risk
exposures. CCPs must have rules and procedures that allocate losses and liquidity shortfalls
that are not covered by prefunded resources. From that perspective, CCPs are in a unique
position in drawing on additional resources from members if and when needed.
Simply having a recovery plan is not enough: CCPs also need to think about the optimal
design and number of recovery tools.
As stated in the CPMI report I mentioned earlier, recovery tools should be comprehensive,
effective, controllable, create appropriate incentives for risk management, and minimise
negative impact.
The challenge is that no individual tool can equally meet all of these criteria because of
trade-offs. For example, uncapped cash calls are comprehensive, but may create
disincentives for central clearing. Variation margin haircutting can be effective, as it reduces
pay-outs rather than requiring additional pay ins, but its systemic effects can be uncertain
due to the way losses are allocated. Initial margin haircutting may also be considered as
comprehensive, but on the other hand, it could increase the potential for contagion risk.
The CPMI-IOSCO report on the recovery of FMIs offers a thorough description and analysis
of the various pros and cons of different recovery tools, as well as the trade-offs that exist
between them. It is probably not possible at this point to identify a single specific recovery
plan that is optimal and superior to any other plan. CCPs have a range of options to choose
from. It will be important not to rule out, a priori, the use of some of these tools. Rather, it
might be advisable for CCPs to have many different tools potentially available. This way, they
will be able to choose the appropriate tools in a specific recovery situation.
One of the main challenges in drawing up recovery plans will be addressing the potential
conflicts of interest between stakeholders.
Indeed, different loss allocation tools will have different effects on the distribution of losses.
For example, rules on variation margin haircutting might be designed in a way that losses are
passed on to clients, while cash calls might only have an effect on direct clearing members.
Similarly, participants might not be willing to contribute to sharing losses which arise as a
result of management failures.
It is therefore vital to involve those who would bear losses or liquidity shortfalls in the
formation of the recovery plan. Mechanisms should be foreseen for involving all relevant
stakeholders in the CCP's decision-making process: this could mean establishing procedures
whereby the CCP board formally consults direct participants, indirect participants and/or
linked CCPs, as relevant, or having such relevant entities directly represented on the board,
on the risk committee, or on other relevant committees. As opinions among stakeholders are
likely to differ, the CCP should have clear processes for identifying the diversity of
stakeholders' views, and for managing any conflicts of interest between them.
In the field of recovery of FMIs, we are entering new territory. Therefore, authorities have so
far taken a cautious approach to developing standards and regulation. The recently
published CPMI-IOSCO report on the recovery of FMIs is not intended to create additional
standards for CCPs or authorities beyond those set out in the PFMIs. Rather, the regulatory
approach is non-prescriptive, and is aimed at providing guidance that should help FMIs to
choose the appropriate mix of recovery tools. Over time, we may very well see the
development of more prescriptive rules and regulations. A more prescriptive approach will in
my view become inevitable if the current approach fails to prevent a race to the bottom
between CCPs or across jurisdictions. The ongoing CPMI-IOSCO implementation monitoring
process will be crucial to identify gaps and draw the lessons as needed.
Authorities are also aware of the need to ensure consistency between regulations affecting
FMIs and those affecting banks. On one hand, FMI overseers and banking supervisors need
to work closely together to ensure CCP recovery tools are consistent and not rendered
ineffective by regulations affecting banks, or by the intervention of supervisors. On the other
hand, overseers and supervisors need to make sure CCP recovery tools do not threaten the
stability and soundness of financial institutions, and do not contradict the objectives of
banking regulations. In this regard, CPMI and IOSCO have been working closely with the
BCBS to ensure rules regarding FMI recovery and resolution are fully consistent with the
preservation of the stability of participants. At the ECB, while respecting the separation
between bank supervision and CCP oversight, we will strive to ensure consistent approaches
and a common understanding of risks.
Managing a recovery situation
The main responsibility for designing, setting up and implementing recovery plans is with the
CCPs themselves, in close co-operation with their members and other stakeholders who
could potentially be affected. However, this does not discharge authorities from their own
responsibilities, including in particular the review and assessment of CCP recovery plans, as
well as the oversight of their implementation.
It is very difficult to predict the conditions that would require a recovery plan to be activated.
There are many unknowns and uncertainties. It cannot be ruled out that a given crisis would
be different from anything that has been experienced so far. So it is not clear if the recovery
plan will work as intended. Some discretion is therefore needed both for the CCPs
themselves and perhaps more importantly for the authorities, which cannot take a "hands off"
approach during a crisis situation.
Authorities have a particular responsibility to do what is systemically needed in a crisis, and
are better-placed to do this than CCPs given their broader perspective. For instance,
authorities could be faced with a situation where the application of resolution procedures is
preferable to the activation of a recovery plan. This means, of course, that much will depend
on the willingness of authorities to do the right thing in the moment of crisis.
The recovery of CCPs is absolutely vital and hence it is of utmost importance that CCPs set
up comprehensive and efficient recovery plans. However, there could still be a need to
resolve a CCP if its recovery plan is not enough to address the particular crisis situation it is
going through.
First of all, the attempt to recover may simply fail: ex-ante recovery plans may prove
inadequate ex-post. Recovery plans have, fortunately, not yet needed to be implemented in
real life, so it remains to be seen how they work in practice.
Most importantly, however, recovery is not a purpose in itself, but a means to preserve
financial stability. From that perspective, resolution could be preferable over recovery if the
application of a recovery plan is deemed to lead to undesirable results. For example, loss
allocation tools could end up over-exposing certain groups of participants, such as buy side
institutions or individual banks, depending on the scenario involved. Moreover, resolution
may also become necessary if participants do not want to use the CCP any longer, and
prefer instead to wind it down.
Designing effective resolution plans for CCPs is therefore also a key issue. The FSB's report
on Key Attributes of Effective Resolution Regimes for Financial Institutions is an important
milestone in this regard.
Further steps
The last point I wish to make today is to acknowledge that important work still needs to be
done in the field of CCP recovery. The work on recovery has not come to an end with the
publication of the CPMI-IOSCO report. Some further steps will be needed.
First of all, we need to make sure that the CPMI-IOSCO guidance on recovery is effectively
and consistently implemented internationally. The CPMI-IOSCO report leaves a wide range
of options for CCPs to meet the requirements put forward. We need to make sure that their
implementation does not give rise to regulatory arbitrage and competitive distortions. In this
regard, I mentioned earlier that CPMI and IOSCO are currently carrying out an
implementation monitoring exercise for the PFMI: monitoring the implementation of the
guidance on recovery and resolution will also be a priority.
We also need to better understand the systemic implications of pushing risk back to
participants through allocation of uncovered losses and liquidity shortfalls. How will stress be
transmitted through the system once a CCP's pre-funded resources have been exhausted?
An understanding of interdependencies, such as common participation, is particularly
important. We also need to make sure we consider scenarios in which multiple CCPs enter
recovery simultaneously. For instance, some clearing participants may be unable to fulfil all
their obligations if multiple CCPs simultaneously ask for emergency cash calls and
replenishments.
In this context, more thinking on CCP crisis scenarios could give us a somewhat clearer idea
of the specific problems CCPs might have to face in a recovery situation, including the
potential size of losses and liquidity shortfalls. To that end, deeper analysis of reverse stress
testing to cover hypothetical portfolios and market conditions which go beyond 'extreme but
plausible' would also be helpful. This is why CPMI-IOSCO have identified stress testing as a
policy priority, and will soon launch a work stream to develop potential guidance regarding
best practices and methodologies. The objective would be to ensure that all CCPs apply
reliable and comparably robust stress testing frameworks.
Conclusion
Despite the work that still needs to be done to ensure the full effectiveness of CCP recovery
and resolution, it is important to understand that CCPs are truly beneficial for the
preservation of financial stability. Since the financial crisis, the systemic importance of CCPs
has greatly increased, and there may be concerns within the market about their safety and
soundness. Some of these concerns are legitimate, and regulators are taking them serious
and aim at addressing them. However, it should be recalled that the alternative to central
clearing is far more risky: the non-cleared world, which existed before the crisis, was
dangerously opaque, did not allow for pooling of risks, and was inefficient in terms of
collateral mobilisation. Risk management frameworks of CCPs shall be designed to provide
the right incentives to all stakeholders to manage theirs risks and positions prudently.
Regulators are fully aware of the need to ensure the robustness of CCPs, and are
determined to apply international standards such as the PFMI and the guidance on recovery
and resolution in a consistent and rigorous way, consistent with bank supervision and leaving
no room for regulatory arbitrage.
I am confident that CCPs, authorities and stakeholders will work together constructively to
meet the ambitious objectives set out in the CPMI-IOSCO report.
Thank you very much for your attention.