TL;DR A group of major firms are exhorting regulators and therefore CCPs to improve their resilience, recovery and resolution planning.

The GFC has caused the expansion of central clearing to transform credit risk. The intention being to avoid a future systemic failure. Global regulators have set the standards and rules for clearing and margining so far.

But now major CCP users have published a letter describing their views on how CCPs need to improve. The letter references the default at Nasdaq Clearing AB in 2018 and acknowledges work done since to improve their resilience.

TL;DR A group of major firms are exhorting regulators and therefore CCPs to improve their resilience, recovery and resolution planning.

The GFC has caused the expansion of central clearing to transform credit risk. The intention being to avoid a future systemic failure. Global regulators have set the standards and rules for clearing and margining so far.

But now major CCP users have published a letter describing their views on how CCPs need to improve. The letter references the default at Nasdaq Clearing AB in 2018 and acknowledges work done since to improve their resilience.

Signatories to the letter include:

• Allianz Global Investors
• BlackRock
• Citi
• Goldman Sachs
• Societe General
• JP Morgan Chase & Co
• State Street
• T. Rowe Price
• Vanguard

The letter covers three steps in the timeline of threat to a CCP:

• Resilience: preventing member default or CCP failure
• Recovery: resolving a member default
• Resolution: resolving the failure of a CCP itself

You might expect the paper would be asking for advanced techniques to be introduced. In fact the goals for CCPs seem to be motherhood and apple pie, for example: CCPs should:

• Have an effective and credible default management processes (DMP).
• Limit clearing to liquid products with adequate market capacity to absorb defaulters’ portfolios in times of stress.
• Size the default fund (DF) to a minimum “Cover 2” standard, using extreme but plausible scenarios.
• Publish meaningful, standardised and audited disclosures on CCP risk methodologies, back testing and stress testing to all relevant stakeholders.
• Incorporate liquidity and concentration factors into initial margin (IM) calculations and applying appropriate margin periods of risk that factor in time needed to liquidate portfolios.

These aren't incredible demands – they are steps all CCPs should have taken a long time ago. If these aren't part of global regulations then they should be.

The paper goes on to expand on the bullet points and gives regulators an easy to read guide on what they mean. Another face-palm section says:

Regulators should ensure that CCPs size IM requirements con- servatively to cover, with a high degree of confidence, any potential loss that a CCP could incur in liquidating an individual portfolio. To do this, a CCP must incorporate into its IM methodology an appropriate margin period of risk that accurately factors in the time needed to liquidate the relevant portfolio based on product market depth and complexity, independent of whether the product is listed on an exchange or traded over the counter.

DUH! Isn't that what CCPs should be doing already?

The other theme in the paper is that of incentives for the operators of CCPs. Central clearing works best when the network of users is broad, to deliver the best risk offsets and therefore lower IM. But, lower IM can be seen as exposing the CCP to more risk, if the IM has a commercial point to attract new business.

The paper concludes by saying:

Unlike most for-profit shareholders, most CCP owners bear only a small portion of the CCP’s losses because the DF and recovery tools available to a CCP serve to externalize a large portion of a CCP’s losses to clearing members and end users. As a result, for-profit CCP incentives have the potential to be materially misaligned. Although CCP shareholders take 100% of the returns a CCP earns from clearing revenues, they bear only a small portion of the losses the CCP incurs as a result of a default.

The paper is aimed at CCPs, regulators and policy makers to improve the risks from central clearing. Seeing any outcome from this will take years of lobbying.

Industry reaction:

• Nasdaq Clearing AB declined to comment on the letter.
• LCH provided two links which explain how they address the various points in the PDF

  • http://www.lch.com/sites/default/files/media/files/Best%20Practices%20in%20CCP%20Risk%20Management_3.pdf

  • http://www.lch.com/sites/default/files/media/files/Recovery%20and%20Resolution.pdf

• Gillian Tett at the FT has her own views on the letter:

  • https://www.ft.com/content/f6712622-f5b4-11e9-9ef3-eca8fc8f2d65