JPMorgan Chase & Co. Office of Regulatory Affairs issued a paper proposing steps required to establish a credible securities and derivatives clearinghouse (“CCP”) resolution framework to manage the event of a CCP failure.
According to the paper, the “issue of resolution” has become increasingly important given that the use of CCPs in the United States is now mandatory, and there is a larger volume of transactions going through these institutions. Additionally, many CCPs have migrated from being utilities owned by members to private for-profit institutions, introducing a possible conflict between a CCP’s role as a market utility and its commercial objectives to increase revenues and market share.
The paper listed two questions about CCP resolution that must be answered: (i) do CCPs have sufficient financial safeguards to minimize the threat of “too big to fail”? and (ii) if a CCP should fail, how can that failure be managed to limit market contagion, avoid pro-cyclicality and ensure the continuity of financial market functions?
The paper recommended solutions to consider regarding a CCP resolution framework:
- a standard, disclosed stress test framework mandated by regulators and used to size “Total Loss Absorbing Resources;”
- the CCP’s entire Total Loss Absorbing Resources should be fully pre-funded;
- CCPs should be recapitalized rather than liquidated upon failure, to continue systemically important activities;
- CCPs should have “Recapitalization Resources” to allow opening on the business day following failure with a fully funded Guarantee Fund;
- CCPs should contribute to the Guarantee Fund and Recapitalization Resources the greater of 10% of the Guarantee Fund or the largest single clearing member contribution; and
- beyond this minimum, CCPs should retain flexibility as to how such resources are tranched and allocated.
According to the paper, the proposed approach will “promote greater market confidence in CCPs, providing the last step to achieving the promise of the newly centrally-cleared market paradigm driven by global legislation and regulations.”
Lofchie Comment: The important questions, as framed in the JPMorgan paper, underscore the core problem with central clearing. Simply put, CCPs are not the great cure to systemic risk. CCPs are the ultimate too-big-to-fail SIFIs. By the government essentially mandating that tremendous volumes of transactions flow through CCPs, failure of a major CCP would not only have the potential to cause significant credit risks, it would also create major operational problems. Once all trading in a particular asset flows through a (failed) CCP, it is not clear that the market would be able to quickly develop a means to trade around the failed CCP in the relevant product (which would be a matter of some urgency as all market participants would have had their trades in the relevant product terminated or at least threatened).
In a report issued last week, IOSCO described the difficulty of CCPs maintaining appropriate levels of capital as a “fine balancing act” that would be made more difficult by the “competitive pressures” to which CCPs are subject. That description, issued by an association of global financial regulators, does not reflect confidence in CCPs. Indeed, it raises the very significant question of whether concentrating credit and operational risk through CCPs is superior to a system in which risk is more dispersed.
As the IOSCO report observes, it is the global financial regulators that have been behind the push for the use of central clearing. This puts them in a difficult position in assessing whether central clearing is a good idea, or, even if it might be a good idea in part (i.e. whether there are limits on the types of transactions or counterparties to which central clearing is appropriate.) Other risks of central clearing highlighted by the IOSCO report include: “the inherent pro-cyclicality of margin calls [that CCPs are going to drain liquidity from the financial markets at a time when such a drain will be most damaging]; and the widespread use of similar risk management models [the CCPs effectively force the entire market to adopt the same view of risk]; the varying levels of capitalization of CCPs to withstand the failure of clearing members [given that the market is forced to clear through CCPs, market participants can not choose to step away from a poorly capitalized CCP], risk related to the investment policies of CCPs, the acceptance of collateral of varying quality and the structure of default waterfalls.”
Perhaps a non-governmental body would be best positioned to lead a public discussion of these risks.