CPMI-IOSCO: Framework for Supervisory Stress-Testing of CCPs

In April, the global banking and capital markets authorities together announced a mid-course correction to their work transforming central counterparty clearing of OTC derivatives contracts. In their search in 2009 for the answer to the ‘OTC counterparty risk problem’ that had so brutally hit the world’s financial system and economy, the authorities grasped at a notion then circulating in central banking circles: if clearing houses had proven themselves able to manage the risk of on-exchange transactions during the market turmoil of 2008 and the failure of Lehman Brothers, then they ought to be called upon to do the same for the off-exchange business that had gone off the rails.

Thomas Murray’s research focus has always been on client risks in post-trade clearing and custody services and market infrastructure operations. Given the marked changes in CCP risk profiles announced by the authorities, the firm spent two years preparing a detailed monitoring programme of the world’s 30 most significant infrastructures, which was launched for clients in September 2013. The importance of CCP risk monitoring has not decreased since, and given the authorities’ latest step in tightening the oversight via more stringent risk management testing, it would appear that caution about the success of this multi-year regulatory policy experiment remains the watchword.

What prompted the authorities to act now?

In the years following the Global Financial Crisis, CCPs have become increasingly global, interconnected and critical segments of the financial system. The rise and pace of central clearing has accelerated. The increased use of central clearing of derivatives was intended to enhance financial stability by simplifying the network of counterparty exposures between financial institutions, and reducing the aggregate size of these exposures through multilateral netting by a CCP. In achieving this objective, however, CCPs have become more interconnected with their participants and other financial institutions on which they rely for key services, such as liquidity providers and custodians. Risk has also become more concentrated in a few large CCPs and a shrinking number of clearing members. The continued growth in central clearing, and the resulting networks, have further heightened the need for CCPs to have effective governance arrangements and risk controls to achieve the risk reduction benefits of central clearing – as is their corporate mission. Specifically, if CCPs are not properly managed, they can transmit financial shocks, such as liquidity dislocations and credit losses, across domestic and international financial markets.

This progressive transformation has led to ongoing efforts made at both the domestic and international levels to strengthen individual clearing house financial resilience, and to ensure that they support financial stability in the markets in which they operate. In 2012, CPMI (then CPSS) and IOSCO published the Principles for Financial Market Infrastructures (‘PFMIs’), which strengthened and harmonised the three pre-existing sets of international standards for these institutions. Among other things, the PFMIs set expectations that CCPs would maintain a higher level of financial resources to address credit and liquidity risks. CPMI and IOSCO have been promoting full, timely, and consistent implementation of the Principles and the corresponding responsibilities set out for the market authorities through their implementation monitoring programme.

In April 2015, the G20 Finance Ministers and Central Bank Governors asked the Financial Stability Board to work with the CPMI, IOSCO and the Basel Committee to develop and report back on a workplan for identifying and addressing any remaining gaps and potential financial stability risks relating to CCPs that are systemic across multiple jurisdictions, and for helping to enhance their resolution in case of a fatal flaw.

As part of the CCP workplan, the two bodies were asked to evaluate the existing stress-testing policies and practices of CCPs, and consider the need for, and develop as appropriate, a framework for consistent and comparable stress tests of the adequacy of CCPs’ financial resources (including capital) and liquidity arrangements, which could involve supervisory stress tests.

The framework announced on 10th April 2018 presents the results of this work, with more granular guidance on certain Principles and Key Considerations in the PFMIs regarding CCPs’ financial risk management, including their own internal stress-testing frameworks and margining practices. To complement this guidance, CPMI-IOSCO developed this framework to support the design and execution of supervisory stress tests that would help authorities better understand the macro-prudential risks that could materialise if multiple CCPs were to face a common stress event.

What might Thomas Murray suggest?

Since the Pittsburgh Declaration more than eight years ago, the firm has very publicly and repeatedly expressed its concerns that CCPs were not the right place to solve the OTC counterparty risk dilemma. The risks entailed in the two very different categories of derivatives were never meant to be mixed in a common position book. It was understood that the authorities were not going to withdraw their proposal; the policy work done by the firm was meant to heighten awareness amongst market participants and their authorities that, in its view, the mistake made needed to be corrected one way or another.

Today, Thomas Murray sees the corrective measures continuing to be made by the authorities as rather like a shoehorn to force a foot into a shoe that does not fit. Whilst shoes can stretch, when not the right form they are more likely to cause problems, but at least the ‘cobblers’ of IOSCO and CPMI are shaping and stitching together measures to modify the shape of the policy shoe.

The Framework

CPMI-IOSCO are calling for exercises designed and executed by capital markets authorities, with or without the direct participation of the CCPs themselves. These tests can be designed to achieve different objectives. For example, one test might evaluate a CCP’s ability to react to a very specific problem on its own; another might involve multiple, inter-related CCPs in order to evaluate macro-level impacts on the financial system. The authorities are looking to understand the potential credit risk changes of this sort of event, as well as what might happen to liquidity risk. These tests are not meant to supersede those that the CCPs are themselves expected to conduct.

The authorities note the question they have on the inter-dependencies that may have grown amongst CCPs these past 7-8 years as their environment has been modified. The effects of the tests are supposed to be measured, too, on other entities, such as participants, liquidity providers, and custodians. The results are to be reviewed by groups of central bankers, capital markets authorities, and macro-prudential supervisors. Certainly, these test results may lead to modifications in risk management decisions by many different parties whose workings are intertwined.

The tests are also meant to estimate valuable information on the potential impact of shocks, such as market price impacts due to the liquidation of similar or common assets held across multiple CCPs that are managing one or more defaults at the same time. Although extremely relevant for financial stability, CPMI-IOSCO acknowledge the complexity of arranging tests that will lead to clear results – but it posits the question in the context of announcing this framework.

The framework stipulates that the authorities must address these components for the writing of all tests:

  1. Purpose and exercise specifications
  2. Governance of the test
  3. Developing stress scenarios
  4. Data collection and protection
  5. Aggregating results and developing analytical metrics
  6. Use of results and disclosure

Where the CPMI-IOSCO stress test framework goes from here

Thomas Murray analysts will continue to monitor the evolving regulatory requirements for running CCPs as the derivatives markets themselves grow and change. The firm’s central counterparty risk assessments provide an extensive alert system for CCP managers and their clients.

Also beginning in April 2018, the firm will be looking for the progressive amelioration of trade repository data, which when cleaned up will finally provide considerable information on outstanding derivative positions.


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.

Tags: CPMI-IOSCOStress-TestingCCPOTC DerivativesCentral Counterpartypost-tradeRisk MonitoringderivativesCounterparty RiskCPMIIOSCOcentral clearinggovernancePFMIsG20Financial Stability BoardBasel Committee