On November 28th, 2016, the European Commission (EC) has published a proposal for a framework for the recovery and resolution of central counterparties and amending Regulations (EU) No 1095/2010, (EU) No 648/2012, and (EU) 2015/2365l¹. This regulation is based on the work at the international level of the Financial Stability Board (“FSB”), the Basel Committee, Committee on Payments and infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO). FSB published in August 2016 a discussion note on “Essential Aspects of CCP Resolution Planning” and jointly with the Basel Committee, CPMI and IOSCO, a progress report on the work plan to enhance the resilience, recovery planning and resolvability of CCPs².

On November 28th, 2016, the European Commission (EC) has published a proposal for a framework for the recovery and resolution of central counterparties and amending Regulations (EU) No 1095/2010, (EU) No 648/2012, and (EU) 2015/2365l¹. This regulation is based on the work at the international level of the Financial Stability Board (“FSB”), the Basel Committee, Committee on Payments and infrastructures (CPMI) and International Organization of Securities Commissions (IOSCO). FSB published in August 2016 a discussion note on “Essential Aspects of CCP Resolution Planning” and jointly with the Basel Committee, CPMI and IOSCO, a progress report on the work plan to enhance the resilience, recovery planning and resolvability of CCPs².

The EC’s proposal uses the by now well accepted mechanics known from the Bank Recovery and Resolution Directive (BRRD) as basis and adopts the recovery and resolution framework to the specific features of CCPs’ business models and risk profile, which is very much different from banks.

Unfortunately the regulation as proposed does not foresee any level two regulation or Regulatory Technical Standards (“RTS”). Thereby the regulation will not be flexible to adapt to the future evolution of international consensus on CCP regulation, i.e. recommendations by the Financial Stability Board (“FSB”) on recovery and resolution of CCPs, which are impending, or changes in EMIR.

The regulation proposes national Resolution Authorities, where each Member State shall designate one or more Resolution Authorities that are empowered to use the resolution tools and exercise the resolution powers as set out in this Regulation. Resolution Authorities could be national central banks, competent ministries, public administrative authorities or other authorities entrusted with public administrative powers.

The Resolution Authority then will establish, manage and chair a Resolution College to carry out the resolution tasks and ensure cooperation and coordination with third-country Resolution Authorities. The Resolution College includes all relevant regulators for the CCP and its key Clearing members, comparable, but not limited to, the colleges overseeing CCPs under EMIR. Key constituents are:

• the Resolution Authority of the CCP;
• the competent authority of the CCP;
• the competent authorities and the Resolution Authorities of the clearing members;
• the competent authorities
• the members of the ESCB
• relevant national central banks
• the competent authority of the parent undertaking
• the competent ministry, where the Resolution Authority referred to in point (a) is not the competent ministry;
• ESMA;
• the European Banking Authority (EBA).

Thereby the proposed regulation misses out on the opportunity to implement a single CCP supervisor and Resolution Authority, which would be in a position to pool expertise and data and replace the current patchwork of CCP oversight. Today the regulation follows the national supervision approach as set out by EMIR, creating colleges around national regulators to supervise CCPs. In an extreme stress scenario, where one or multiple CCPs are in danger of failing, a centralised approach would however provide maximum efficiency, as decisions have to be taken holistically considering multiple CCPs, Clearing Members, etc. at the same time. The CCP regulation chosen in 2012 under EMIR lead to a patchwork solution for CCP supervision³, where Central Banks (e.g. De Nederlandsche Bank (DNB), Banca d’Italia, Bank of England, …), National Banking Regulators (e.g. Bundesanstalt für Finanzdienstleistungsaufsicht (Bafin), Autorité de Contrôle Prudentiel et de Résolution (ACPR), Finansinspektionen, …) or Exchange Supervisors (Comisión Nacional del Mercado de Valores (CNMV), Comissão do Mercado de Valores Mobiliários (CMVM), Komisja Nadzoru Finansowego (KNF), ..) were tasked with overseeing CCPs in different countries. The current patchwork character of CCP regulation has been reaffirmed by the EMSA Peer Review under EMIR 21 “Supervisory activities on CCPs’ Margin and Collateral requirements” published on December 22nd, 2016, where ESMA clearly states, that there is need to enhance supervisory convergence between national supervisors⁴. The report – in its limited scope – already identified a number of areas where supervisory approaches differ between national supervisors and includes recommendations to improve consistency in supervisory practices. Around each national regulator, colleges – with a high overlap of participants for the key CCPs – have been created that would need to work in parallel in the case of the potential failing of multiple CCPs. With the evolution of the last years, in 2017 where the listed and OTC Derivatives markets come more and more together in CCPs a new centralised approach should have be considered.

Resolution Authorities, when taking resolution actions, can use a range of resolution tools individually or in any combination:

1. Position and loss allocation tools;
2. Write-down and conversion tool;
3. Sale of (CCP) business tool;
4. (Transfer to) Bridge CCP tool;
5. Any other resolution tool consistent with Articles 21 (Resolution objectives) and 23 (General principles regarding resolution).

Reading and commenting on the proposal should be of interest to clearing members of CCPs and their clients, since it might massively impact also none-defaulting clearing members and their clients. As part of its powers, the Resolution Authority can reduce the value of any gains payable by the CCP to non-defaulting clearing members (Variation Margin Gains Haircutting) and issue a resolution cash call, requiring non-defaulting clearing members to make an additional contribution in cash to the CCP up to an amount equivalent to their original contribution to the CCP’s default fund. The resolution cash call can come after and in addition to any calls for new contributions by the non-defaulting clearing participants already exercised under its rules by the CCP itself in order to replenish default funds used up due to a default of a counterparty. If a non-defaulting clearing member does not pay the required amount(s), the Resolution Authority may require the CCP to place that clearing member in default and use the clearing member’s initial margin and default fund contribution in accordance with EMIR to cover losses.

In addition, the Resolution Authority can use a loss and position allocation tool, i.e. it may terminate certain or all contracts (a) of the clearing member in default, (b) the contracts of the affected clearing service or asset class or (c) the contracts of the CCP in resolution. The focus of the position management tool is used to rematch the book of the CCP or bridge CCP. The loss allocation tool can be used for a number of purposes, including to cover the losses of the CCP, to restore the ability of the CCP to meet payment obligations and to recapitalise the CCP and replenish its pre-funded financial resources to an extent sufficient to restore its ability to comply with the conditions for authorisation and to continue to carry out its critical functions.

It seems that the recovery and resolution tools will impact even client positions, which are held indirectly in client accounts and are segregated. Through EMIR the option to especially protect assets of indirect clearing participants has been created with the introduction of client asset segregation and portability. The proposed legislation might make it possible to override normal property rights and allocate loss to specific stakeholders as well as to withhold the payment of gains from the CCP, also impacting client and segregated client accounts.

 Clearing members will have to adapt their clearing services agreements with clients, to reflect the required changes in the CCP rule books as part of the CCP’s preparation for the potential implementation of recovery and resolution plans as well as the potential use of the powers by a Resolution Authority which might affect contracts entered into by the clearing member on a client’s behalf. In addition, clearing members will have to communicate the new, potential liabilities to their clients, i.e. the potential losses or costs arising from the exercise of recovery tools by the CCP or the Resolution Authority.

The proposal obviously is of interest to CCPs and their owners, as the CCPs in preparation have to:

• Prepare a detailed recovery plan and adjust their operating procedures and rule books to ensure compliance with the proposed regulation and to enable the application of the recovery and resolution tools.
• Address or remove any substantive impediments to resolvability (identified by the Resolution Authority and Resolution College)

The Resolution authority can also use write-down and conversion tools, that are similar to the “bail in” tool known from BRRD. The Resolution Authority can use the tool in respect of instruments of ownership and debt instruments or other unsecured liabilities (also issued by the parent of the CCP) in order to absorb losses, recapitalise the CCP itself or a Bridge CCP, or to support the use of the sale of the CCP at commercial terms.

The Resolution Authority may take full control over the CCP, by

• Appointing a special manager to replace the board of a CCP under resolution. The special manager will have all the powers of the shareholders and the board of the CCP.
• Requiring the CCP under resolution, or any of its group entities or clearing members, to provide any services or facilities that are necessary to enable a purchaser or bridge CCP to operate effectively the business transferred to it.

Overall the Resolution Authority may directly or indirectly through the special manager exercise control over the CCP under resolution to:

• Manage the activities and services of the CCP, exercising the powers of its shareholders and board and to consult the risk committee;
• Manage and dispose of the assets and property of the CCP under resolution.

Finally, the Resolution Authority might use its control to sell the CCP to a third party at commercial terms (sale of business tool) or transfer its business to a Bridge CCP (bridge CCP tool). The Bridge CCP must be a legal entity, which is controlled by the Resolution Authority and is wholly or partially owned by one or more public authorities, and it must have been created for the purposes of being a Bridge CCP. The transfer may take place without obtaining the consent of the shareholders of the CCP under resolution or any third party other than the bridge CCP and without complying with any procedural requirements under company or securities law.

Last but not least it is also important for taxpayers to read and comment on the proposed regulation, as it currently includes the government financial stabilisation tools, an option for extraordinary public financial support under certain conditions. 

This bears the risk that the proposed regulation creates a wrong incentive structure. The currently included option of extraordinary public financial support through the government financial stabilisation tools under certain conditions might create a moral hazard situation, by wrongly incentivising clearing participants to not contribute to recovery and resolution of a CCP in an early stage, and to wait and see if and in how far extraordinary public support is provided. There should be a concern that parties might try to avoid /delay the covering of financial losses within the CCP ecosystem either through the CCPs default waterfall early on, or through recovery and resolution plans, thereby willingly accepting or even provoking the spill over of losses to (other) none-defaulting Clearing members or even into the public sphere.

References:

1. See: https://ec.europa.eu/transparency/regdoc/rep/1/2016/EN/COM-2016-856-F1-EN-MAIN.PDF
2. See: http://www.fsb.org/2016/08/fsb-publishes-discussion-note-on-essential-aspects-of-ccp-resolution-planning-and-progress-report-on-ccp-workplan/
3. For list of CCPs and regulators, please see: https://www.esma.europa.eu/sites/default/files/library/ccps_authorised_under_emir.pdf
4. For details please see: https://www.esma.europa.eu/press-news/esma-news/esma-identifies-areas-improvement-in-eu-ccp-supervision

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