BIS-IOSCO Report Calls for Clearing Houses to Set Out Recovery Plan

The report, first issued for consultation in August 2013, states that all systemically important financial market infrastructures—with a special focus on CCPs—should have a comprehensive and effective recovery plan as required by the CPSS-IOSCO Principles for Financial Market Infrastructures (PFMI), and lists a number of tools institutions could leverage when deemed to be at risk.

"A CCP should have additional tools in place that allow it to re-establish a matched book," the report says. "These tools may include collecting resources from its participants by means of cash calls and raising additional equity capital."

For CCPs, which are more likely to be exposed to credit and liquidity risk from a participant default, recovery tools can help in addressing and allocating uncovered credit losses that would cause the failure of an institution. Cash calls, variation margin haircutting, or initial margin could be used to help leverage the risk exposure of the CCP. To re-establish a matched book following participant default, CCPs are advised to force allocation of contracts and to resort contract termination.

CCP as SIFI
Last month, a study led by JP Morgan Chase laid out a framework to allow for CCP resolution and recapitalization in the event of a CCP failure or crisis scenario, exposing CCPs as "one of the most systemically important of any systemically important financial institution."

According to the study, a standard, disclosed stress test framework should be mandated by regulators and used to size the total loss-absorbing resources.

"CCPs should be recapitalized rather than liquidated upon failure, to continue systemically important activities. To ensure a CCP has appropriate available resources, the default funding waterfall should eliminate unfunded assessments on non-defaulting clearing members, but be extended to include dedicated recapitalization resources," the study says. "These resources should be funded from the contributions of CCPs as well as their clearing members. The size of the funding resources-including the recap fund-will be defined by regulatory-driven, transparent and rigorous stress tests, with scenarios and results that are fully disclosed to participants."

Delivering on Promise
For Diana Chan, CEO of EuroCCP, the work being done around CCP recovery is a very positive element. "There is this recognition by regulators that accidents do happen," she says. "The unpredictable could happen even with the best minimum safety standards as implemented by the European Market Infrastructure Regulation (EMIR), and there will be some events that could cause a CCP to default."

She insists this is also a bold move towards greater transparency and predictability, both of which are required to ensure market stability.

"In the event of a really catastrophic scenario that causes the CCP to burn through his whole default waterfall, we would then have a plan, a resolution and recovery plan to ensure the market stability is not disturbed. Everything will be predictable in that there are clear procedures to follow," she explains.

As well as promoting greater market confidence in CCPs by increasing the predictability of any given scenario, regulations around recovery and resolution in systemically important institutions can help reap the promised benefit of the new centrally-cleared market paradigm.

The BIS and IOSCO report was published ahead of the upcoming meeting of the Group of 20 (G20) in Brisbane, Australia in November. The G20 has been instrumental in raising discussion around and reinforcing institutions deemed after the crisis as 'too big to fail'.

The European Commission is also expected to introduce draft legislation on CCP recovery and resolution at the beginning of 2015.

The Bottom Line:

• CCPs are viewed as "one of the most systemically important of any systemically important financial institution" and industry bodies , such as the BIS and Iosco, have called for clearing houses to be given the tools needed to recover from losses and liquidity shortfalls.

• Cash calls, variation margin haircutting, or initial margin could be used to help leverage the risk exposure of the CCP. To re-establish a matched book following participant default, CCPs are advised to force allocation of contracts and to resort contract termination.

• Recovery plans will help in promoting greater market confidence through predictability and help reap the promised benefit of the new centrally-cleared market paradigm.