CCP in Focus - Skin-in-the-Game – How much skin should a CCP put in, if a CCP puts in Skin?

The following terms are used:

  • "Skin-in-the-Game" – This is a European Union (EU) requirement for a Central Counterparty Clearing House (CCP) to place 25% of its total minimum capital ahead of non-defaulting clearing members within the default waterfall. CCPs in Europe must maintain minimum capital requirements that are either a minimum EUR7.5m or, in aggregate, sufficient to ensure an orderly winding down (at a minimum six months of operating costs) and to provide adequate protection to the CCP against credit, counterparty, market, operational, legal and business risk. [1] Skin-in-the-Game represents an additional 25% on top of the total minimum capital.
  • "Hypothetical Capital (Kccp)" – Kccp is a hypothetical capital requirement for a CCP, set by the Basel Committee on Banking Supervision (BCBS), for the purpose of determining the capitalisation of the clearing member's default fund contributions. It does not represent the actual capital requirements for a CCP. (BCBS 227)

In the event of a clearing member default, placing a CCP's capital resources ahead of non-defaulting clearing member's collateral can be seen as a prudent and conservative policy. It should help align the interest of the shareholders of the CCPs and clearing members and provides an extra layer of protection in the common pool of financial resources. This extra layer of capital is called Skin-in-the-Game. As well as it being stated within the European Market Infrastructure Regulation (EMIR), it also indirectly referenced by the BCBS in its document BCBS 227 (DFccp); however, that text does not place any requirements on the amount a CCP should contribute.

The purpose of this article is to analyse the differences between CCPs that contribute Skin-in-the-Game and CCPs that have decided not to. The Options Clearing Corporation (OCC) and the Korean Exchange (KRX) do not place their capital resources ahead of non-defaulting clearing members, according to their default waterfalls, which set out the agreed order of liability. The remaining 27 CCPs that Thomas Murray Data Services analysed do, including the one we choose to cite here, NASDAQ OMX Clearing because their figures are publically available. The amount a CCP places ahead of its non-defaulting clearing members makes a big difference to clearing members capital exposures to CCPs. Working through the calculations (see appendix), an estimate for the average capital a clearing member would have to hold for exposures to NASDAQ OMX Clearing would be USD16,000, whereas with OCC it would be USD3m.

Why the huge difference? There are two drivers. Firstly, for OCC, its hypothetical requirements (Kccp), which is not related to Skin-in-the-Game, is very high. Secondly, OCC does not place resources ahead of its non-defaulting clearing members.

The calculation of the aggregate capital requirement (K*CM) is dependent on whether or not a CCP places resources ahead of non-defaulting clearing members. As NASDAQ OMX Clearing has Skin-in-the-Game that is greater than the hypothetical capital (KCCP), it can use equation 3 from BCBS 227, which is simply a capital factor (c1) multiplied by the default fund contributions from surviving clearing members (DF'CM). OCC, on the other hand, without a capital commitment, must use equation 2. This equation penalises clearing members. The less a CCP contributes Skin-in-the-Game when compared to its hypothetical capital, the more that the hypothetical capital is multiplied by a 100% capital factor (c2). This leads to clearing members holding more capital against their exposure.

For OCC to be able to use equation 3, it must place Skin-in-the-Game of an amount that is greater than or equal to KCCP, which in this case would be just under USD40m. OCC has total equity, as of December 2013, of just over USD25m. Maybe it is indeed time for OCC to reduce its clearing members' rebates? [2]

Mechanically, as a result of not contributing Skin-in-the-Game, non-defaulting clearing members at both OCC and KRX are higher up in the waterfall, meaning there is a higher risk of their resources being utilised should a clearing member default. This recently occurred in Korea with KRX. HanMag Securities (equity capital of USD20m), a derivatives broker, caused USD45m in losses after it submitted a series of incorrect trades at KRX. The result was that for the first time in collective memory, non-defaulting clearing members were asked to top up their contributions.

Is there an opposite case for the fair mutualisation of risk? What happens if there is too much Skin-in-the-Game? ASX Clear (Futures) recently received a credit rating from Standard & Poor's (S&P). Within the report, S&P stated that ASX Clear (Futures) contributes paid-in financial resources that are more than twice that of the clearing participants, which in its opinion reduced effective risk mutualisation. The clearing members might feel less of a need to stay sharp on risk management. Can there be too much Skin-in-the-Game? Possibly.

As Skin-in-the-Game increases, the clearing members' capital exposure reduces, up to a point. This is to encourage CCPs not to take excessive risks with, among other things, their investment policy. By a CCP placing more capital higher up in the default waterfall, non-defaulting members are less likely to be affected by losses caused by another clearing member. This is essentially what a CCP is set up to do; however, there exists a fine balance between requiring a CCP to place capital ahead of non-defaulting clearing members whilst still incentivising clearing members to carry out effective risk management standards.

The International Swaps and Derivatives Association (ISDA), in a response to the European Banking Authority (EBA) consultation paper, stated that having a 50% Skin-in-the-Game requirement may not strike the right balance between protecting non-defaulting members and ensuring that they have incentives to bid competitively in an auction of a defaulting clearing member's portfolio at a time when resources need to be replenished.

This is partly negated by the fact that CCPs have changed, or are in the process of changing, their rulebooks to incentivise participation in the auctioning of a defaulting clearing member's positions. SGX recently held a consultation, whilst ICE Clear Europe and Eurex Clearing AG already implement these rules within their rulebooks.

As mentioned previously, EMIR dictates that a CCP should have minimum Skin-in-the-Game of 25% of its minimum capital. With some CCPs, for example OCC, this would amount to very little when compared to contributions made to the default fund. It would also result in OCC not meeting the conditions to use equation 3 under. OCC, in order to equal or exceed Kccp, would have to effectively put in many multiples of Skin-in-the-Game.

In theory, by requiring a CCP to place its capital ahead of its non-defaulting clearing members in the event of a default, the infrastructure may benefit from more resources being available in aggregate. This is because if a CCP was not mandated to place resources ahead of non-defaulting clearing members, it may not even hold this amount as equity reserves, thus reducing the total amount of resources available in the default waterfall.

For some years now, Skin-in-the-Game has become global best practise, with the vast majority of CCPs placing some capital ahead of non-defaulting clearing members. As monopolies in their respective markets, OCC and KRX do not have to compete with other CCPs to attract clearing members wanting access to their service, and as such there is no incentive to use equation 3. Yes, Skin-in-the-Game may be best market practice; and, yes, it does add to the reliability and robustness of a CCP. But short of mandating the use internationally, CCPs such as KRX and OCC are free to do as they please with clients ultimately paying for the difference.

Annex 1

Annex 1 shows the Basel III summary statistics that enable a clearing member to calculate their capital exposure to the CCP. NASDAQ OMX Clearing and the OCC were chosen because their information is available in the public domain. The assumption made was that the average capital a CM (Kcm) must hold is equal to the aggregate default fund contributions from surviving clearing members (DF'CM) divided by the number of clearing members (n). An interesting point is that if OCC places enough Skin-in-the-Game to equal its Kccp, then they can utilise equation 3. In aggregate clearing members would have to hold capital to cover exposures of approximately USD30m, a considerable capital saving for clearing members.

[1] European Market Infrastructure Regulation (EMIR), Article 16

[2] FT – OCC Considers Reducing Rebate -

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Tags: CCP in FocusEMIRCCP