The Financial Stability Board (FSB) and its chairman, Mark Carney, last month reiterated their intention to prioritize central counterparty (CCP) resilience, recovery and resolution for the remainder of 2016. They are absolutely right to focus on this issue. Several clearing houses have become systemically important as a result of global clearing mandates, and it’s vital this infrastructure is as secure as possible – which means establishing a credible and robust recovery and resolution framework.
This isn’t a new topic, of course. Considerable thought has gone into this at both the regulatory and industry level over the past few years – and ISDA has published several papers on the issue (here’s our most recent). But the thinking is continually evolving, particularly on the issue of resolution. An important recent consideration has been when and how recovery becomes resolution – in other words, at what point should resolution authorities step in, and what tools will be available to them?
It’s a crucially important issue. At ISDA, we recognize there may be situations where a resolution authority has to intervene before CCP-led recovery efforts have fully run their course. That might include circumstances where it is felt the recovery measures set out in the CCP rule book would further increase systemic risk or lead to contagion. But, if resolution authorities elect to enter a CCP into resolution, we believe it is important to abide by certain conditions to maximize certainty and predictability and maintain market confidence.
In particular, we recommend that resolution authorities, should they intervene, follow the rules and the tools defined in the CCP rule book. ISDA has already set out a proposed recovery framework, which includes a variety of loss-allocation and position-allocation tools and the sequence of their use, aimed at providing maximum predictability of outcomes. We recommend this framework be adopted in CCP rule books, approved by regulators and followed by resolution authorities. By following this transparent rule book, a resolution authority would provide comfort to market participants and minimize market disruption, as well as ensure the concept of ‘no credit worse off’ – a central element of the ISDA recovery framework – is applied.
Careful thought should also be given to the point of entry. ISDA believes recovery should be CCP-led as far as possible, but if that is not possible, the indicators for a resolution authority intervention should be defined upfront. Clarity over the entry point would, again, help provide certainty about the process.
It’s important, though, that these triggers aren’t automatically applied. For instance, it’s possible one of the conditions for intervention might be failure by the CCP to achieve a matched book. However, it’s also possible the problem is limited to a small subset of illiquid products. In that case, it might be preferable for the CCP to implement position-allocation tools for that subset, such as partial tear-up, rather than trigger resolution of the entire CCP.
There’s another important element to all of this. Whether through recovery or resolution, clearing participants should be compensated for any losses incurred through loss-allocation or position-allocation tools, over and above the CCP’s funded and unfunded default resources. This emulates the outcome that would be achieved if clearing participants were to go through an insolvency process.
All of this comes back to CCP resiliency. Ensuring CCPs are strong to begin with minimizes the prospect of a recovery or resolution action. That’s why the measures outlined in our paper on CCP resilience – transparency, stress testing, appropriate skin in the game, monitoring of concentration risk and scrutiny of suitability of products for clearing – are vital.
In making these proposals, ISDA is continuing in its long-standing role of ensuring legal and contractual certainty for industry participants, and in helping to build reliable and transparent procedures to deal with periods of market stress. Both the FSB and European regulatory authorities are due to publish further proposals on CCP soundness in the coming months, and ISDA will continue to engage with its membership, the wider industry and all relevant regulatory institutions to ensure the best solution on this issue.