Challenges Of The Insolvency Regime for Central Counterparties
Although the prudential supervision of the Bank of England is focused on ensuring the safety and soundness of CCPs, priority has been given almost exclusively to the development of loss allocation and recovery rules.
Although the prudential supervision of the Bank of England is focused on ensuring the safety and soundness of CCPs, priority has been given almost exclusively to the development of loss allocation and recovery rules.
During the first years of the regime, the Bank has been reluctant to recognise that CCPs might fail, and thereby it has not designed a regime to rule on the resolution of CCPs. This approach overlooks the fact that a core feature of a stable financial system requires recognising that all financial institutions are resolvable, including those that are systemically important. The discussions in this article attempt to throw some light on the importance of key aspects to be considered in the resolution of CCPs.
Enforcement of Clearing Members’ rights
Regulators need to be particularly careful when adopting rules that restrict the possibility for CMs and clients to enforce their rights in front of the defaulting CCP. Particularly when the regime restricts the right to terminate contracts in the case of CCP’s insolvency, as suggested by the FSB1. Analysing the Australian experience, Farrell2 argues that the adoption of special resolution regimes for CCPs could lead to a competition between recovery and resolution rules. This is, for instance, the competition between the close-out netting rights of participants and the restrictions imposed on this matter in a new insolvency regime. The consideration is for regulators to design a resolution regime that interferes to a lesser extent with the existent recovery regime.
In the European Union, one obstacle to the effective resolution is the risk that counterparties exercise termination rights in derivatives contracts according to the Financial Collateral Arrangements Directive (FCAD)4. As the exercise of such rights would be greatly disruptive and bring the risk of contagion5, it is advisable to remove this obstacle in a resolution regime for CCPs6. However, the experience of the Banking Resolution Regime shows that the implementation of suspension of rights provisions might be problematic in a cross-border scenario7. The FSB8 recommended the use of contractual mechanisms to achieve cross-border recognition. Following this recommendation, ISDA developed a Resolution Stay Protocol9. The protocol enables counterparties to opt voluntarily10 into the stay and suspension provisions by agreeing a change to their ISDA derivatives contracts.
The form of the collateral also raises some concerns that affect the relationship between the clearing member and the CCP11. If the collateral is provided in cash there is a transfer of ownership from the clearing member to the CCP, and therefore the clearing member would assume the category of CCP’s unsecured creditor. In contrast, when collateral is in non-cash assets clearing members may retain property rights; they transfer the non-cash assets to an account of the CCP, and grant a security interest over those assets. As a result, CCP takes first fixed charge to secure the clearing members’ performance of its obligations, but as the clearing member keeps the proprietary rights those assets are protected in case of CCPs’ insolvency.
Clearing member’s play as the ultimate underwriters
There is the issue concerning the role clearing member’s play as the ultimate underwriters of CCP default risk. The structure of the CCPs recognised and authorised in the UK is that of the demutualised CCPs, which means that the ownership is separated from the clearing participation. CMs are not the owners of the CCP, but they participate in the mutualisation of losses. The default waterfall varies according to the CCP’s default rules, but in general it starts with the initial margin of the defaulting member; it then moves to the default fund contribution of the member, followed by default fund contributions of other members and the last resort for the equity of the CCP. When all these resources are exhausted, the CCP becomes insolvent. Then, one alternative is to ask clearing members for additional funds to prevent the closure of the CCP, and in that scenario CMs become underwriters of the CCP.
This de-mutualised structure and its relationship with the waterfall default bring some questions that are partially solved by the regulators in the UK. For instance, in the event a CCP cannot effectively manage the risk of insolvency, CMs would have to assume such a risk themselves. Hence, clearing members might want to see more CCP capital committed to the default resources, arguing that CCPs are not properly incentivised to manage risk.
Ben Bernanke argues that the requirement for the surviving participant to provide more funds to the insolvent CCP, as a measure to contribute to its recovery, does not extend to the CCP’s failure12. However, the international standards of the FSB, CPMI and IOSCO seem to be moving towards creating an additional fund, which will be largely formed with CMs’ contributions. Indeed, in recent discussions, CMs have argued that there is a need to review clearing membership requirements, collateral eligibility, the availability of certain recovery tools and the bespoke nature of CCP rulebooks13. At first sight it seems that, while regulators are privileging the stability of CCPs and re-insuring that these ‘too-big-to fail’ institutions are not going to be bailout, they are indirectly transposing the burden to CMs. The problem with such an approach is that, instead of promoting the use of central clearing, which is one of the initial objectives of the post-GFC reforms, it is discouraging market participants from trading in the OTCDM.
Despite the critiques that the imposition of higher or additional contributions from CMs to common or ‘recapitalization’ funds might have, it seems to be the predominant alternative. The joint 2015 CCP work plan called for the FSB Resolution Steering Group (ReSG) to ‘assess the need for additional prefunded financial resources (including capital) and liquidity arrangements in resolution and to develop a proposal’14. The rationale is to create a fund that will operate only when the recovery mechanisms have been exhausted and the CCP is not viable anymore. The fund will include contributions from CMs and CCPs and will be triggered when the resolution authority considers it to be pertinent. Such recapitalization funds will be the new default funds while the CCP recovers stability. Additionally, CCPs can opt to obtain liquidity through financing. In this case, it is advisable to grant a security over the non-cash assets. Duffie15 explains that such securities can grant over initial margins or the default fund, and claims to future contributions of CMs.
Therefore, if the tendency of the coming regulation is to impose further funding requirements to CMs, it will be necessary that regulators intervene to ‘rebalance’ the relationship between CCPs and their members. In order to achieve such symmetry, regulators are expected to design more rigorous stress tests, with complete disclosure of results. Lastly, CMs and clients want to see all default management actions available to CCPs defined ex ante, arguing that this should eliminate the need for CCPs to have emergency powers16.
The CCPs’ insolvency regime should be consistent with international efforts to deal with cross-border issues17. The FSB have published guidance pursuing its commitment to develop policy proposals on how legal certainty in cross-border resolutions can be further enhanced18. Hence, the FSB published the Principles for Cross-Border Effectiveness of Resolution Actions19 that set out statutory and contractual mechanisms that jurisdictions should consider including in their legal framework to give cross-border effect to resolution actions in accordance with the Key Attributes20 and its FMI Annex.
In this regard, the ReSG agreed to establish by the end of 2015 a working group called Cross-border Crisis Management Group for FMIs (fmiCBCM). The fmiCBCM will monitor progress in the development of resolution strategies and operational resolution plans for CCPs and of institution-specific cross-border cooperation agreements (COAGs), and the establishment of Crisis Management Groups (CMGs) for CCPs. Similarly, the fmiCBCM will clarify how the resolution powers of the Key Attributes and their FMI Annex would be exercised. The FSB anticipates some of the issues that will be further analysed by the fmiCBCM. These relate to legal structures, the arrangement of clearing activities or other services, relationships and interdependencies between the CCP and participants, links with other FMIs, CCP rules including default management and recovery procedures, and financial resources including liquidity arrangements.
Although the work of the fmiCBCM in cooperation with CPMI-IOSCO is expected by the end of 2016, it might be anticipated that the final proposal will highly likely involve additional pre-funded resources and arrangements, as well as further guidance about resolution planning.
Clearing Members’ Insolvency
Finally, in the process of regulating the insolvency of a CCP, it is advisable that UK regulators consider the risks that CCPs face in the event of CMs’ insolvency21, and how it might threaten the stability of the CCP22. The relevant insolvency rules governing the contracts in which a clearinghouse is part are contained in the Companies Act 1989 Part VII (CA 1989 P VII). These rules apply to the insolvency of clearinghouses and their counterparts in the exchange markets and to the counterparts of CCPs operating in the OTCDM23. The CA 1989 P VII operates in conjunction with the Recognition Requirements for Investment Exchanges and Clearing Houses of the FSMA 2000 and Recognition Regulations 2001. CA 1989 P VII disapplies the general law of insolvency from the operation of the default rules of recognised investment exchanges and clearing systems24. The default rules are the clearing house rules which provide for the taking action in the event of a person appearing unable, or likely to be unable, to meet his/her obligations in respect of one or more market contracts connected with the exchange or clearing house25. According to Section 188 (2) of the CA 1989, in the event of a person’s default the clearing house concerned must close out on the defaulter’s position and realise the defaulter’s property prior to any action, which an insolvency office-holder may take under general law.
The aim of the CA 1989 is to safeguard the operations of financial markets. Hence, the Act rules the insolvency, winding up or default of a counterparty to transactions in the market26. It also rules the effectiveness or enforcement of certain charges given to secure obligations in connection with market transactions – these are market changes27. Regarding market property, the CA 1989 includes the rights and remedies28 in relation to assets provided as margin or default fund contribution in relation to such transactions or subject to such a charge.
In this regard, CME Clearing Europe in its Accounts Disclosure Document29 noted some of the consequences and foreseeable issues arising from CMs’ insolvency. The first concern is the operation of the automatic set-off30 that under English Law does not allow the distinction between the various client accounts and will most likely set off amounts across all those accounts and against the CM’s House Account. The CCP will not be able to calculate net sums per client account and the porting system will not operate as expected. When porting has not been possible, in the event of the insolvency of a CM it is probable that any payments made to the CM for the account of the client get trapped in the insolvency proceedings31. As a result, the client will be an unsecured creditor of the amounts owed to it by the CM, assuming the risk of not being repaid at all. The second potential issue concerns the rules of transaction avoidance and claw-back – these include transactions at undervalue and preferences32. The claw-back provision33 would allow the liquidator or administrator of the CM to challenge transactions entered into by the company property.
Finally, a third cause of concern is the applicability of the protection included in CA 1989 Part VII. CME34 considers that it is not clear whether Part VII eliminates the risk that an insolvency official might challenge the close out after completion of the default proceedings, which is a challenge that is allowed in English insolvency law. One possible interpretation is to understand that the protection of Part VII benefits the CCPs’ porting arrangements, because they are part of the settlement of a CM clients position under the default rules.
Strengthening the resilience of CCPs implies a comprehensive regulatory framework that allows supervisors to conduct CCP’s insolvency proceedings in an orderly manner and, more importantly, ensures the continuity of services. Both recovery and resolvability regimes are tools for the effective management of CMs’ default, and seek to guarantee that CCPs are sufficiently solvent to contain losses and liquidity shortfalls. Moreover, recovery and resolution rules aim to ensure that the core functions of CCPs are maintained in times of financial distress and crisis.
Furthermore, the design of a special resolution regime for CCPs should address questions related to the efficient allocation of losses, how to mitigate fire-sales and how to ensure the continuity of services. The international regulatory trend seems to be moving towards the design of a credible recapitalization strategy that seeks to favour recapitalization over liquidation. Despite the critiques to this method, the rationale is to create a fund that will operate only when all the recovery tools have been exhausted and the CCP is not viable any more.
There are multiple challenges that a special resolution regime of CCPs might face in practice. Regulators need to be especially careful when adopting rules that limit the possibility for CMs and clients to enforce their rights in front of a defaulting CCP. (e.g. the right to terminate contracts in the case of CCP’s insolvency suggested by the FSB Key Attributes, or termination rights in derivatives contracts in the FCAD).
Furthermore, there is the issue related to the role CMs play as the ultimate underwriters of the CCP default risk. The argument put forward here is that, if the tendency of the coming regulation is to impose further funding requirements onto CMs, as a measure to contribute to the CCPs’ recovery, it will be necessary that regulators intervene to ‘rebalance’ the relationship between CMs and CCPs. This could be achieved by means of designing more rigorous stress tests and enhancing the disclosure of CCPs’ management actions ex ante, so CMs are sufficiently informed about the functioning of the CCP.
- FSB, ‘Application of the Key Attributes of Effective Resolution Regimes to Non-Bank Financial Institutions: Consultative Document’ http://www.financialstabilityboard.org/wp- content/uploads/r_141015.pdf accessed 4th November 2015. ‘In 2013 the FSB announced that one of its tasks was to develop proposals for contractual or statutory approaches to prevent early termination of financial contracts’. FSB, ‘Progress and Next Steps Towards Ending ‘Too-Big-To-Fail (‘TBTF’) (n 99)
- Farrel, ‘Too Important to Fail: Legal Complexity in Planning for the Failure of Financial Market Infrastructure’ ( n 109) 467.
- BCBS-IOSCO Final Report on Margin for Derivatives (September 2013).
- Directive on financial collateral arrangements (2002/47/EC). Implemented in the UK by the Financial Collateral Arrangements (No. 2) Regulations 2003.
- Tucker, ‘Central Counterparties in Evolving Capital Markets: Safety, Recovery and Resolution’ Resolution’ in OTC derivatives: new rules, new actors, new risks’ (n 116).
- For Banks Chapters V and VI of the RRD confer the power to authorities to suspend termination rights.
- Financial Services and Markets Group Backer McKenzie, ‘Bank recovery and resolution – ending the spectre of “too big to fail’ (May 2015) http://www.bakermckenzie.com/files/Uploads/Documents/Alumni/Legal%20Alert.pdf accessed 5th November 2015.
- FSB, ‘Cross-border recognition of resolution action’ (FSB, Consultative Document, 29 September 2014).
- ISDA 2014 Resolution Stay In Protocol https://www2.isda.org/functional-areas/protocol- management/protocol/20 accessed 5th November 2015.
- ‘The first wave of voluntary adoption of the Protocol occurred in early November 2014 and includes eighteen major banks and certain of their affiliates’. Financial Services and Markets Group Backer McKenzie, ‘Bank recovery and resolution – ending the spectre of “too big to fail’ ( n 193); ISDA designated a cut-off date under the protocol of November 2, 2015.
- Joanne Braithwaite, ‘Private Law and the Public Sector’s Central Counterparty Prescription for the Derivatives Markets (LSE Legal Studies Working Paper No. 2/2011) http://ssrn.com/abstract=1791740 accessed 13th January 2016.
- Ben Bernanke, ‘ Clearing and Settlement during the Crash’ (1990) 3 The Review of Financial Studies 1, 133.
- FIA, ‘FIA Global CCP Risk Position Paper’ (April, 2015) https://fia.org/articles/fia-global-issues- recommendations-central-clearing-risks accessed 5th October 2015. These issues also were discussed at the Federal Reserve Bank of Chicago’s 2015 Clearing Symposium.
- FSB, ‘Progress Report on the CCP Workplan’ (2015) (n 154).
- Duffie, ‘Resolution of Failing Counterparties’ (n 107).
- ‘The joint 2015 CCP workplan called for the FSB Resolution Steering Group (ReSG) (i) to conduct a stock-take of existing CCP resolution regimes and resolution planning arrangements; (ii) to consider the need for, and develop as appropriate, more granular standards or guidance for CCP resolution planning, resolution strategies and resolution tools, including cross-border coordination and recognition of resolution actions’ FSB, ‘Progress Report on the CCP Workplan’ (2015) (n 154).
- At the St Petersburg G20 summit in 2013 the FSB made the commitment. FSB, ‘Progress and Next Steps Towards Ending ‘Too-Big-To-Fail (‘TBTF’) (n 99).
- FSB, ‘Principles for Cross-Border Effectiveness of Resolution Actions (3rd November 2015) http://www.financialstabilityboard.org/2015/11/principles-for-cross-border-effectiveness-of-resolution- actions/ accessed 5th November 2015.
- FSB, ‘Key Attributes of Effective Resolution Regimes for Financial Institutions’ (n 87). The Key Attributes incorporate guidance on their application to non-bank financial institutions and on arrangements for information-sharing. The first annex sets out guidance on resolution of financial market infrastructures (FMIs), including Central Counterparties (CCPs), and resolution of systemically important FMI participants, and the third annex sets out guidance on client asset protection in resolution.
- The Insolvency of Clearing Members (CMs) is ruled by Part VII Companies Act (CA)1989 or if the CM is a Bank the Special Resolution Regime of the Banking Act 2009.
- ‘It is worth reemphasising that CCP recovery and resolution cannot be considered in isolation from the recovery and resolution regimes that have already been introduced for their clearing members’. LCH Clearnet, CCP Risk Management, Recovery and Resolution’ (LCH Clearnet, Whitepaper 1.2 Policy Issues) http://www.lchclearnet.com/documents/731485/762448/final+white+paper+version+three.pdf/1d1700a a-a1ae-4a6c-8f6f-541eec9b7420 accessed 29th February2015.
- The Recognised bodies and insolvency practitioners have agreed a protocol. This guidance has been drawn up to facilitate a closer understanding of the regime in Part VII of the Companies Act 1989 and management of the respective responsibilities of recognised bodies (RBs) providing central counterparty services and insolvency practitioners (IPs) in a default situation. FSA, ‘Cooperation Guidance Between Recognised Bodies and Insolvency Practitioners to Assist Management of Member Defaults by Recognised Bodies (Recognised Clearing House Version) http://www.bankofengland.co.uk/financialstability/Documents/fmi/Insolvency%20practitioners.pdf accessed 6th November 2015.
- Bailey and Groves, Corporate Insolvency: Law and Practice ( n 132)1411.
- Companies Act 1989 (CA 1989), s 188 (1).
- CA 1989, ss 155-172.
- CA 1989, ss 173-176.
- CA1989, ss 177-181.
- CME Clearing Europe Ltd. Accounts Disclosure Document (n 36).
- Set-off is the discharge of reciprocal obligations to the extent of the smaller obligation. It is a form of payment’. In insolvency, set-off is a means by which a creditor is paid on the insolvency of a debtor and the choice is between paying the creditor or paying the insolvent debtor’. Philip Wood, Set-off and Netting, Derivatives, Clearing Systems (Sweet & Maxwell, 2007) 5.
- CME Clearing Europe Ltd. Accounts Disclosure Document ( n 36)
- ‘Can a liquidator or an administrator challenge or unwind transactions entered into by the company before it was wound up or entered into administration?’ Lexis Nexis Practice Notes https://www.lexisnexis.com/uk/lexispsl/restructuringandinsolvency/document/393783/55MK-MBW1- F18D-T2XC-00000- 00/Can+a+liquidator+or+an+administrator+challenge+or+unwind+transactions+entered+into+by+the+ company+before+it+was+wound+up+or+entered+into+administration%3F accessed 20th October 2015 34 CME Clearing Europe Ltd. Accounts Disclosure Document ( n 36).
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