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How would the creation of a recovery framework for central counterparty clearing houses (CCPs) achieve greater transparency and financial stability? Farid Anvari, Of Counsel at Baker & McKenzie, comments on proposals for loss distribution and recovery of a CCP after it has suffered member-default losses.
ISDA proposes new recovery framework for defaulting CCPs
A CCP Default Management, Recovery and Continuity paper proposes a framework for central counterparty clearing houses’ (CCPs) recovery and sets out the tools that can be used to re-establish a matched book following the default of one or more clearing members. Produced by the International Swaps and Derivatives Associations (ISDA), the paper outlines measures that are consistent with the recommendations made by the Committee on Payments and Market Infrastructures and the International Organisation of Securities Commission in October 2014.
The systemically important nature of several CCPs, along with the very large losses which CCPs can suffer relative to their capital, necessitates a formal framework for CCP recovery—particularly if taxpayers are not to bear a heavy burden for bailing them out. Ultimately, CCPs are essential to wholesale financial markets so a framework for dealing with CCPs which are at risk of failure and ensuring continuity of that CCPs’ services to the market would significantly improve financial stability.
ISDA has put forward a set of proposals for loss distribution and recovery of a CCP after it has suffered member-default losses. ISDA is keen for cash calls on members (sometimes called ‘loss allocation’) to be limited and also proposes partial tear-up of cleared contracts to help re-establish a matched book by the CPP. ISDA is very keen for CCPs’ recovery procedures to be transparent (so that CCP members can assess the potential costs that a CCP can impose on them).
Interestingly, ISDA raises the possibility of CCP recovery being abandoned in favour of letting a CCP fail and close down where a CCP can no longer return to viability which it thinks should be determined by an inability of the CCP to re-establish a matched book—which, of course, reflects ISDA’s concern that its members might have to continue paying for a CCP in recovery. However, there are some CCPs which are undoubtedly of pan-European systemic importance so it is unlikely those CCPs will ever be allowed to fail by governmental authorities. Where CCPs are not of pan-European systemic importance they tend to be monoline national CCPs so, for reasons of national pride alone, it seems unlikely that the relevant government would be happy to allow the CCP to close rather than try and keep it going at the expense of participants. So letting CCPs fail as ISDA suggests may not become the preference of policy-makers, even if there are commercial and regulatory reasons for it.
Segregating clearing services involves establishing a separate loss waterfall for different services in the same CCP. This will enable the closure of a particular service within a CCP rather than the entire CCP closing—so problems in one service do not contaminate other services. There is a legal limit to what segregation measures in a CCP rulebook can achieve when services are being carried out in the same CCP. Ultimately, a CCP can, as a legal entity, go insolvent which would affect all of its services. Until a new legal model, such as a cell structure company, is introduced, true service segregation will not be achieved.
Interviewed by Nicola Laver.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
First published on LexisPSL Banking & Finance. Click here for a free trial.
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