Loss assignment plans crucial for CCPs, says BOE

A Bank of England paper released today has warned that Central Counterparties need clear and detailed loss assignment procedures in place in case of default.

In certain cases, the default waterfall put in place by a CCP will be exhausted. “Without a mechanism to allocate losses which exceed these resources, the CCP would then become insolvent,” says the report, written by David Elliot, an analyst in the BOE’s Financial Stability department.

“The failure of a CCP could be very disruptive. In the absence of an appropriate resolution regime, the CCP would have to stop trading and enter liquidation. Clearing members would not receive payments due from the CCP and might not be able to access their margin and any remaining default fund contributions for some time,” the paper continues.

“CCPs are in principle able to address these concerns by writing loss-allocation rules which allocate among surviving clearing members any losses which exceed the default fund, thereby preserving the CCP’s solvency and potentially allowing it to continue to operate.”

Given the potentially catastrophic consequences of a defaulting CCP (see Hong Kong 1987 for one example) it is conceivable that surviving clearing members would step in and make up the shortfall required to keep the CCP solvent. This, however, cannot be relied upon by CCPs and could take some time.

Loss allocation rules at CCPs will need to ensure that the CCP can return to a matched book. The BOE paper proposes four clear ways in which this can be achieved: calling on additional financial resources from clearing members, variation margin haircutting, initial margin haircutting and termination of open contracts.

You can view the full paper here: http://www.bankofengland.co.uk/publications/Documents/fsr/fs_paper20.pdf

Tags: Bank of EnglandCCP