Confronting the challenges facing CCPs

The mandatory clearing space is developing quickly in the post-crises environment. Alex Harborne looks at the space in more detail.

The post-trade space continues to evolve after the 2009 G20 meeting in Pittsburgh. One policy mandated following that landmark summit was the migration of a significant portion of over-the-counter (OTC) derivatives into clearing in central counterparty clearing houses (CCPs). This change was codified into law in the United States through the Dodd-Frank Act and the European Market Infrastructure Regulation (EMIR) in the European Union (EU). The changeover is not without its many challenges.

The financial crisis of 2007 to 2009, in which OTC instruments, and specifically credit default swaps (CDSs), played a significant role, has forced regulators to push the more standardised variants of these once opaque instruments onto transparent trading venues and then on to clearing in CCPs to curtail settlement risk. Having been impressed by the good results of LCH.Clearnet and others in winding down the positions following the Lehman Brothers' default using just one third of the initial margin held, the G20 has been pushing the use of CCPs to clear standardised OTC contracts.

Instruments deemed too complex and bespoke will continue to be traded bilaterally and will remain un-cleared, albeit with higher margining costs. A remaining risk to market stability lies with what one might call semi-standardised OTC contracts - instruments that are neither sufficiently "plain vanilla" to be traded on a derivatives platform and/or cleared through a CCP - or truly bespoke.

The challenge is compounded as banks, courtesy of Basel III capital requirements, are under immense cost pressures to get these contracts off their balance sheets. What might this mean, and how might the banks respond to this altered cost environment for what is clearly a lucrative business? How will they do this? The fear is that they might put significant pressure on a CCP to clear the instrument in question, whatever the difficulties in determining its valuation. A problem here is that the clearing environment is being modified by the uneasy mixing of exchange-listed and traded derivatives with the OTC variety.

Another issue is that CCPs are competing with each other to an extent that did not exist pre-2007. This might risk upsetting the integrity of centralised clearing if these market infrastructures start a race to the bottom on the initial and variation margins that clearing members are expected to post, or if they accept OTC transactions outside of their traditional risk parameters. Regulators have made it abundantly clear that such behaviour will not be tolerated, but one wonders how they would monitor this.

CCPs can fail. The Paris-based Caisse de Liquidation des Affaires en Marchandises (CLAM) collapsed in 1974 when traders were unable to meet margin calls. The Kuala Lumpur Commodity Clearing House in Malaysia failed following defaults by six brokers trading palm oil contracts on the Kuala Lumpur Stock Exchange. The Hong Kong Futures Exchange had to be rescued by the government in 1987 when it too ran into trouble. The sheer volume of swaps now passing through CCPs today versus 1974 and 1987 is of a different order of magnitude altogether. As a result of changes in business, IT, and regulation, CCPs are in effect much more systemically critical than they were 30, 20, or even 10 years ago. Preventative, reactive, and responsive measures to mitigate and handle a CCP default must be at the forefront of central bankers’ and capital markets regulators’ agendas.

The implication of an outright CCP failure is hard to fathom, as opposed to the failure of a clearing member or two. A CCP failure might be caused by the default of a large clearing member, though there is considerable testing for such an eventuality. Large clearing banks do tend to be members of multiple clearing houses crossing jurisdictions, which could potentially lead to contagion. Logically, sufficient margin and the default fund would go a long way towards protecting the mutual, or at least attenuating a great deal of this risk. One potential problem would be a sudden shortage of liquidity. This is an issue that needs to be addressed by global regulators. Another factor that could lead to a CCP’s failure would be if it found itself saddled with complex, high-risk OTC instruments that had not been correctly valued and which it was unable to settle.

A number of papers have been published by financial institutions on how to mitigate the risk of a CCP failure, though these seem rather vocal at speaking about and to the CCP rather than behaving as a member of a collective endeavour with any sense of load-sharing.

PIMCO, the California-based asset manager, wrote a white paper advocating a minimum contribution from CCPs equivalent to 5 percent, $20 million or the third largest clearing member contribution. A white paper by J.P. Morgan in September 2014 went further and suggested CCPs contribute more than 10 percent of member contributions or the largest single clearing member contribution in order to shore up their risk management. That same J.P. Morgan study urged CCPs and clearing members to top-up a re-capitalisation fund, which could be accessed if the CCP uses all of the capital available in its risk waterfall. This would enable the CCP to keep operating during extreme market stress.

CCPs counter that EMIR already requires them to place 25 percent of their own capital resources before those of non-defaulting members within the default waterfall. It is essential that CCPs routinely perform stress tests to ascertain their risk positions relative to evolving market conditions, their risk appetite and limits, and how they maintain operations during a 'black swan' market event.

This leads to what would happen in the event of a CCP failure. The Committee for Payments and Market Infrastructures (CPMI) and the International Organisation of Securities Commissions (IOSCO) published a report in October 2014 – "Recovery of Financial Market Infrastructures (FMIs)"– laying down guidance on how systemically important FMIs should have a "comprehensive and effective recovery plan," as stipulated under the CPMI-IOSCO Principals for FMIs. The report identifies recovery tools that fall into five categories. They are:

  • Tools to allocate uncovered losses caused by a participant default
  • Tools to address uncovered liquidity shortfalls
  • Tools to replenish financial resources
  • Tools for a CCP to re-establish a matched book
  • Tools to allocate losses not related to a participant default.

The guidelines do not go into specifics; that is best left up to the CCPs to work out and it is something they are considering urgently, particularly given the imminence of centralised clearing in Europe as mandated under EMIR from 2015. A failure to work towards those guidelines outlined by CPMI-IOSCO could expose CCPs to undue risk, and in a worst case scenario – default.

CCPs, like stock exchanges, banks, regulators, and other financial entities are all cogs within the same machine. In the last five years, CCPs have become a larger cog and it is essential that all of the component parts work together to ensure the machine continues to function.

pdfDownload the PDF.

Alex Harborne

Contact Alex Harborne at or telephone him on +44 (0) 20 8600 2300.

Tags: CCPsCCPcentral counterparty clearingEMIRDodd FrankRegulationClearingCPMI-IOSCO