On 8th May 2018, CPMI-IOSCO released anonymised updates on the three critical risk areas where central clearing houses are scrambling to meet the business and regulatory demands as set forth in the 2014 Principles for Financial Market Infrastructures (‘PFMIs’). These three are recovery, coverage of financial resources, and liquidity stress testing.
To meet the demands of overseeing the changing risk profile of CCPs, competent authorities have set up multinational teams composed of central bankers and capital markets regulators, which continue to examine and monitor clearing houses relative to the standards outlined in the PFMIs. The 24 Principles set out the baseline standards for market infrastructures, and when taken together they do provide a comprehensive overview of these businesses. The report released last month is an update to work done two years before at the so-called Level (‘L3’). These peer reviews examine consistency in the outcomes of implementation of the Principles by FMIs, and also the implementation of the Responsibilities by national authorities.
For those who follow this segment, a striking point in this summary report is the dropping of the term ‘resolution,’ which had invariably gone together with ‘recovery’ as a business and regulatory goal within the PFMIs. It would be extraordinarily hard and disruptive to liquidate a central market actor like a CCP without wreaking havoc on positions, and so it would appear that the authorities are putting literally all efforts into getting clearing houses back to a balanced book. That is eminently sensible, as Thomas Murray advised in an earlier public consultation run by the Financial Stability Board.
Thomas Murray and the PFMIs
The main thrust of Thomas Murray’s work is independent, third-party detailed vetting of post-trade infrastructures and custody banks on behalf of their clients. Concerning CCPs, clients asked Thomas Murray to extend its expertise to the previously calm realm of central clearing when the risk profile changed suddenly and drastically post-2009, at the behest of G20 governments. Thomas Murray was involved in advising the drafting of the Principles for the FMIs, given its expertise; and for clearing houses, the PFMI structure was largely adapted to fit in the firm’s questionnaires, which were themselves somewhat more extensive.
Thomas Murray has also advised multiple CSDs and CCPs on how to do their own monitoring of their performance relative to this benchmark, with detailed remedies suggested when operations fall short of the goal.
CPMI-IOSCO Summary from May 2018
Overall, the Level 3 report judged that participating CCPs have made progress in implementing arrangements that, collectively, help advance the public policy objectives of the PFMIs.
In particular areas, however, some CCPs have not implemented practices that are fully consistent with specific standards. These were first identified in the August 2016 L3 assessment and, based upon the results of this assessment, remain outstanding in a number of specific instances both for certain derivatives CCPs that participated in the August 2016 L3 assessment (and were urged to remediate such issues by the end of 2016), as well as for some of the additional nine CCPs that were evaluated for the first time under this expanded L3 assessment.
As CPMI-IOSCO reported, the failures of these CCPs to implement practices consistent with specific standards of the PFMI constitute, in certain instances, issues of concern that are serious and warrant immediate attention. With the Principles drafted very publicly by 2011, approved in 2012 and in effect in 2014, the authorities' frustration is commensurate with the long warning period given: no one could have missed the objectives and deadlines.
In keeping with their respective responsibilities for regulation, supervision, and oversight, authorities are expected to ensure that the PFMIs are applied consistently in their respective jurisdictions and implemented by individual CCPs, as noted in Responsibility D of the PFMIs. As is their duty, CPMI and IOSCO have shared the concerns identified in this assessment with the relevant authorities for each particular CCP. Of note for Thomas Murray clients, while the report focuses on the sample of 19 CCPs that were assessed, other CCPs, as well as their supervisors, regulators and overseers, should also consider any issues of concern identified in this follow-up report, if and where relevant, and take prompt action to address them.
The guidance on resilience and the revised Recovery Report published by the CPMI and IOSCO in July 2017 should be taken into account by the relevant CCPs in making the appropriate enhancements to their practices.
The central areas in the report were:
All of the 10 CCPs that were surveyed in the initial L3 assessment have reported changes in their recovery plans in the last 18 months. In particular, the two CCPs that were identified in the previous report as not having any recovery plans in place have made progress, but were still in the process of putting in place rules and arrangements to implement the plans as of the effective date of this review.
Most of the remaining CCPs made changes to their recovery plans, mainly to their rules and procedures to allocate uncovered credit losses, to re-establish a matched book, to address uncovered liquidity shortfalls, and to replenish financial resources following a particular default. CCPs that were not part of the initial L3 assessment have also made changes to their recovery plans, mainly to their rules and procedures to address uncovered credit losses and to re-establish a matched book. Taken together, this enhances safety and efficiency in payment, clearing, settlement and recording arrangements and, more broadly, limiting systemic risk and fostering transparency and financial stability.
CPMI and IOSCO reiterate the importance of developing comprehensive and effective recovery plans, consistent with standards in the PFMIs, and informed by associated guidance in the revised Recovery Report. To that end, if a CCP has not fully implemented a comprehensive and effective recovery plan, this is a serious issue of concern that should be addressed with the highest priority. Additionally, certain elements of CCPs’ recovery plans were highlighted as serious issues of concern in the initial L3 assessment.
Many of these elements remain in place as of the effective date of this report, namely:
- Some CCPs employ only one capped tool to address uncovered credit losses. Reliance on this tool alone may be insufficient for a CCP to comprehensively allocate uncovered losses. Other tools may be necessary to achieve the outcome expected in Principle 4.
- Some CCPs do not have mandatory rule-based recovery tools to re-establish a matched book, and it is unclear whether reliance by these CCPs on voluntary, market-based tools alone would effectively restore a matched book. These CCPs should have a range of tools available that are sufficient to ensure that the CCP can re-establish a matched book in recovery.
Although all CCPs have now identified at least one tool for addressing liquidity shortfalls, certain tools identified in this assessment do not appear consistent with the standards in the PFMI. A small number of CCPs lacked rules and procedures that indicate processes to replenish any financial resources employed during a participant default in a manner that allows the CCP to continue to operate in a safe and sound manner. These CCPs should give the highest priority to addressing these remaining serious issues of concern, because the lack of such tools or equivalent measures may undermine a CCP’s ability to meet the standards in the PFMIs.
Coverage of financial resources
Some of the CCPs surveyed in the initial L3 assessment reported that they have taken steps in the last 18 months to strengthen their arrangements for maintaining sufficient financial resources to meet their coverage target. These steps include introducing or lowering early action thresholds to either inform decision-makers or call for additional resources from clearing members when the CCP experiences a narrowing of the gap between stress losses and prefunded resource levels. For the CCPs that were not part of the initial L3 assessment, some reported steps to improve practices for maintaining sufficient financial resources to meet their coverage target.
Although all CCPs have procedures designed to maintain sufficient financial resources, some CCPs nonetheless reported one or more breaches during the review period. The monitors also identified procedures that do not achieve outcomes consistent with the PFMIs. While automatic and discretionary responses to a breach in coverage are both appropriate as long as they allow for the prompt and full remediation of a breach in coverage, practices that lead to insufficient or protracted responses could cause a CCP to fall short of achieving outcomes consistent with the standards in the PFMIs. This particular shortcoming is in the process of being resolved as of the issuance of this report.
Liquidity stress testing
While CCPs reported enhancements to several areas of liquidity risk management, limited progress has been made by the participating CCPs over the last 18 months in developing liquidity-specific scenarios in their stress testing framework. Specifically, some participating CCPs do not include in their liquidity stress tests a sufficiently wide range of scenarios that take into account the material liquidity risk posed by the non-performance of entities other than participants (such as settlement banks, nostro agents, custodian banks, liquidity providers, and linked FMIs). The PFMIs provide that an FMI should maintain sufficient liquid resources in a wide range of potential stress scenarios. The fact that, following the publication of the initial L3 report, some CCPs continue to lack sufficient liquidity-specific scenarios is a serious issue of concern that should be addressed by the relevant CCPs, also with the highest priority.
Since launching its CCP risk assessment programme in September 2013, Thomas Murray has gathered very extensive data and qualitative information on 29 CCPs, a broader collection of information than that covered by CPMI-IOSCO because it suits other purposes. The firm’s CCP reports have been repeatedly cited in the annual IOSCO market risk assessments.
As the segment has evolved over the course of this decade, the assessments came to include the appropriate elements in the PFMIs as they came into force, including the quantitative disclosure elements required of CCPs only as from 2015. The authorities’ continued, very public monitoring demonstrates that sufficient concerns remain such that it is helpful for infrastructure clients to read Thomas Murray’s independent assessments on the clearing houses, and beneficial for the clearing houses to continue to engage with the firm for assistance in preparing their PFMI reports.
The author, Thomas Krantz, is Senior Advisor, Capital markets, in the firm of Thomas Murray; and served as Secretary General of the World Federation of Exchanges (2000-2012). The views expressed are his own, and not necessarily those of the firm.