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August 13, 2013

Deus Ex Macchiato » Firms Could Lose IM in a Default

A new CPSS-IOSCO consultative report puts forward a proposal for using non-defaulting clearing members IM to cover losses at a CCP. D.E.M. also spotted a story over at Bloomberg which seems to completely miss the point, for your amusement it's here: http://www.bloomberg.com/news/2013-08-12/derivatives-margin-losses-could-help-save-ccps-regulators-say.html (Their story basically says members lose IM in a default – a shocker I know). The real story is in this CPSS/IOSCO PDF: Recovery of financial market infrastructures  which in addition to VM haircutting, also suggests IM haircutting too:

Initial margin haircutting by CCPs (extract)

3.5.19 In general, initial margin is provided to cover the obligations of the participant who posted it. In many jurisdictions, the legal or regulatory frameworks protect initial margin from being used to cover obligations other than those of that participant. Restrictions on or prohibition of the haircutting or mutualisation of initial margin as a recovery tool would not preclude, where legally permitted, either rules-based use of initial margin for liquidity purposes or the use of initial margin as collateral to secure a participant’s obligation to the FMI to meet a cash call or other loss allocation, even if the liquidity need or loss allocation is triggered by the failure of another participant (see paragraph 3.5.13). 3.5.20 In other jurisdictions, some or all initial margin may, in the event of the CCP’s insolvency, be exposed to the claims of creditors other than the participant who posted such initial margin. In such jurisdictions, initial margin haircutting may be used as a tool in recovery. Haircutting initial margin involves the CCP writing down initial margin provided by non-defaulting participants, who are then required to replenish the initial margin. The rules would need to specify that initial margin haircutting is permitted and how the size of the initial margin haircut on each participant would be determined. A simple option would be a pro rata haircut across participants, but it could also be position-based or activity-based. Where permitted in a legal jurisdiction, the effectiveness of haircutting in recovery may also depend upon the method by which the initial margin is posted (for example, whether the CCP has legal ownership or possession of the collateral as opposed to a security interest over the collateral held by the collateral giver or some third party). 3.5.21 Initial margin haircutting could be limited to the initial margin of direct participants. On the other hand, the tool could be applied to the margin of all participants (direct and indirect) providing this is consistent with the laws and regulations to which the CCP is subject and the rest of the CCP’s rules. Like variation margin haircutting, even where the CCP applies margin haircuts only to direct participants, the contractual arrangements between direct participants and indirect participants may cause the haircutting to have an impact on indirect participants. 3.5.22 Initial margin is likely to constitute a very large pool of assets which would, if it can be used, provide a high degree of loss-absorbency. This loss-absorbency might be considered by market participants as contributing to a robust clearing system. The tool might be considered as effective, since it uses resources in the control of the CCP rather than relying on participants to meet a cash call by the CCP. Since the size of the loss faced by a participant would be capped at the size of their initial margin, this would not be an uncapped or uncontrollable exposure and participants would be able to determine their maximum loss from the use of this tool. This combination of effectiveness and high degree of loss absorbency could provide important incentives for participation in CCPs that include this tool in their recovery plans, helping the realisation of the G20 goal of expanding clearing of standardised swaps. 3.5.23 Any use of initial margin carries with it certain potential costs. Participants whose initial margin is consumed will be required to replenish it. The timeframe within which the consumed initial margin must be replaced raises important issues. Until it is replaced, the CCP is under-protected against future defaults. But if initial margin is required to be replaced immediately, this could cause a large liquidity strain during stressed conditions, which may have pro-cyclical effects, potentially leading to cascading defaults. Additionally, if the CCP arranges for initial margin not to be bankruptcy remote so that initial margin haircutting can be used during recovery, this would create capital charges for participants. 3.5.24 Moreover, and importantly, participants, in particular indirect participants, may be unable or unwilling to participate in a CCP if their initial margin is subject to loss for reasons other than their own default. By creating disincentives to participate in clearing, this approach could prevent the realisation of the G20 goal of expanding clearing of standardised swaps. 3.5.25 On the other hand, where the option of initial margin haircutting is either not legally permissible, or is permissible but not included in the CCP’s rules, it will be important for the CCP to identify alternative ways of achieving an equivalent degree of loss absorbency – for example, through assessment rights.

The new default waterfall

If we add to the traditional waterfall, VM & IM haircutting, maybe this is the order in which assets are consumed. I am assuming a haircut on IM is a bigger pool than that of VM which is a daily flow of value, even if losing IM is a bigger funding cost hit:

  1. Defaulters Variation Margin
  2. Defaulters Initial Margin
  3. Defaulters Default Fund Contribution (but might come after CCP Equity in many cases)
  4. CCP Equity
  5. Other members Default Fund Contributions
  6. IM Haircut (according to IOSCO might only be Members who pay, or maybe Clients too)
  7. VM Haircut
  8. Cash call on surviving members (at this point in market subject to a most extreme event)
  9. Service Closure? (See below)
  10. Any remaining CCP assets
  11. Sell off the PCs, tables, chairs and any loose change

Service Closure: Some CCPs have more than one Clearing Business (such as CME, ICE, LCH), which in some cases is legally distinct from the CCP itself, so a good question is at what point does a specific clearing business line get closed, as a back-stop in preserving a wider corporate group? Interestingly this very topic is covered in a new book,  on page 149 covers this exact topic: OTC Derivatives Bilateral Trading and Central Clearing Hat tip to David at D.E.M. who spotted the combination of stories here: Deus Ex Macchiato » Not yelling fire.


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