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July 2, 2014

Who’s Picking up the Tab? | CCP Investment & Operating Costs

A recent Risk Magazine article describes an alarming piece of legislation came into force last month.

In essence, The Financial Services and Markets Act 2000 orders UK CCPs to pass their investment and operating losses not covered by the default-waterfall onto clearing members, if those losses threaten the stability of the clearing house.

The exact wording of the legislation, found in Section 6 Paragraph 23B, is as follows: 

"The clearing house must maintain effective arrangements … for ensuring that losses that (a) arise otherwise than as a result of the default of a member of the clearing house*; and (b) threaten the clearing house’s solvency; are allocated with a view to ensuring that the clearing house can continue to provide its exempt activities.”

An explanatory note is also provided:

… Clearing houses which act as central counterparties must have in place effective arrangements for the allocation of losses arising for reasons other than member default; they must have in place plans for maintaining the provision of certain specified services when the continuity of service provision is threatened and must include in their default rules provision allocating losses that arise as a result of member default and which are not covered by the provision made in Article 45 of the EMIR regulation. 

CCPs have allocated capital buffers for absorbing the "first tranche" of investment losses, but after the capital buffers have been depleted the remaining losses will be passed onto clearing members.

Clearing members (i.e. banks) suggested two main solutions to the issue:

  1. Sharing in CCP investment gains in addition to covering losses beyond the capital buffer
  2. Passing losses onto end-clients

The situation poses challenges for UK-based CCPs affected by this legislation. Clearing houses' investment policies tend to be very conservative, with strict guidelines on asset allocation and position limits (here are some typical examples – Nasdaq OMX's investment policy and Eurex Clearing's investment policy, page 16 of this LCH PDF shows their portfolio here). The investment strategies are focused on safeguarding the value of the collateral deposited by clearing members, rather than making returns for the clearing house.

If solution 1 goes into action, this would transform the CCPs' internal treasury functions into investment managers, and they would need to be regulated as such. 

*Bold-type added for emphasis by the author of this post


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