Central counterparties: the recent EU Commission proposal on recovery and resolution tools
By Oliver Dreher, LL.M. (King’s College, London)
Introduction
“Centralization” can be regarded as one of the most remarkable developments to have shaped the financial industry during the last decade. This has become particularly evident within the context of the crisis and, in the end, insolvency of the former investment bank Lehman Brothers.
The left side of the illustration to the right shows how market participants in the financial markets used to interact: Each single-market participant maintained its own (often numerous) bilateral agreements with a multiplicity of so-called counterparties (i.e., other market participants).
This setup was particularly common in the markets for OTC derivatives, i.e. the markets for non-exchange-traded bilateral agreements on the exchange of payments between the parties; this includes, inter alia, interest and currency swaps used by corporates and banks to hedge themselves against interest or currency risks arising in their day-to-day business.
Lessons learned from Lehmans
This oft-quoted lesson learned from the Lehmans insolvency concerns the financial soundness of market participants: Both avoiding an international financial crisis and dealing with its consequences are much more difficult if market participants and regulators alike do not know who bears which risks and, accordingly, who might be in trouble given the right (or wrong) circumstances.
In addition to market participants’ financial soundness (or lack thereof), it was observed that heterogeneous international laws, in particular insolvency laws, and the uncertainties resulting from this can contribute to the difficulties that have to be faced when trying to cope with the fallout of such a crisis.
However, the painful experiences from the Lehman insolvency helped the market rediscover a concept that had already proved reliable and beneficial in other parts of the market: Many markets dealing in exchange-traded products (securities and derivatives alike) have been relying on the concept of a central counterparty for many years.
The idea behind this concept is that many market participants engage in the same kind of transactions with one and the same counterparty, hence the term “central counterparty” (CCP). Such CCPs are deliberately established to assume an intermediate position between the relevant market participants. In addition, CCPs are subject to specific regulations and, ideally, rely on particular international insolvency rules aimed at ensuring common insolvency treatment despite the cross-border nature of their businesses.
On the basis of these and other aspects, CCPs act as safe “central” counterparties for basically all other market participants. To handle the bundling’ of CCPs’ legal and technical relationships, the majority of market participants are only indirectly linked to a CCP. Their link to a CCP is provided by a bank that acts as a clearing member (indirect participants are often referred to as nonclearing members).
In addition to the CCP’s interposition, the concept of a CCP also involves relying on standardized agreements and providing transparency with respect to the terms and volumes of the transactions con-ducted (or “cleared”) through it.
European Market Infrastructure Regulation
To broadly implement these concepts in the financial markets, the European Market Infrastructure Regulation (EMIR) was enacted in 2012 (full name of legislation: Regulation [EU] No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories).
Recently, the EU Commission followed up on this regulation, aiming to facilitate the next step in developing the CCP concept. Several thoughts went into this further development:
CCPs have become a cornerstone of the financial markets, and their importance is expected to continue growing. According to the EU Commission, more than 50% of the world’s OTC derivatives business had been cleared through CCPs in 2015. Given that such a significant (and, as is expected and fostered by regulators, continuously expanding) share of the international financial markets rely on CCPs, these institutions must be able to properly fullfill their role; to legitimately act as the markets’ supporting foundation, they must, above all else, be able to bear the resulting risks and burdens.
In light of this, the EU Commission has now come up with suggestions for new EU rules for the recovery and resolution of CCPs.
In doing this, the EU Commission addresses the possible scenario that CCPs – as system-relevant participants in the market infrastructure – may themselves run into financial difficulties.
The proposed legal framework now presented by the EU Commission in part strongly resembles the rules on the restructuring and resolution of banks. With the Banking Recovery and Resolution Directive (BRRD), such rules for banks have already been in force for some time now (full name of legislation: Directive 2014/59/EU of the European Parliament and of the Council of 15 May 2014 establishing a framework for the recovery and resolution of credit institutions and investment firms …).
Given, however, that CCPs have many characteristics that distinguish them from banks and other financial institutions, the new proposal also foresees a number of special instruments that should especially fit the particular business and features of a CCP.
Prevention and preparation
Banks are already doing this, but now CCPs will also have to draw up recovery plans. These plans foresee measures going beyond existing regulations for CCPs (e.g., EMIR) and will be reviewed by the applicable regulators. The plans must consider the risks inherent to the particular business and structure of a CCP, such as the possible default of one or more clearing members or the occurrence of other risks or losses for the CCP, whether as a result of fraud or due to IT security threats.
Early intervention
Should it become apparent that a CCP is experiencing or will experience financial difficulty, additional measures are available to facilitate early intervention. This includes giving the relevant authorities specific powers to intervene in the operations of a CCP when – and this is important – the condition of the CCP suggests it is at risk of failing, but before it actually does. In addition, the relevant authorities will be in a position to require the CCP to implement specific measures or include such measures in their recovery plans in order to facilitate early intervention in a (yet developing) crisis.
Resolution powers
Just as under already-existing rules for the recovery and resolution of credit institutions, CCPs will also have to operate within a framework that allows – when extreme circumstances call for this – the placement of a CCP in resolution if it defaults or threatens to default. A related possibility is foreseen in cases where a CCP’s default may not be prevented by implementing other measures (without risking the stability of the financial system). Similar to the corresponding framework for banks, possible measures will, according to the EU Commission, be implemented in a manner that aims to minimize any burden on taxpayers while also holding shareholders and other investors responsible.
International cooperation of relevant authorities
Most CCPs are active across borders and many even act globally. This needs to be considered by the relevant authorities, in order to ensure that regulation and possible interventions are efficient and do not lead to counter-productive results. This is acknowledged by the EU Commission: The proposal also contains rules that are intended to facilitate a coordinated and efficient international approach by the relevant authorities.
Resolution tools
The framework governing CCPs today already attempts to minimize the risk of a CCP potentially defaulting. With a view to the – albeit unlikely – case of a CCP experiencing a financial crisis, the new proposal does, however, foresee the following measures that can be implemented if necessary:
- Sell the CCP or single business areas of the CCP.
- Establish a bridge solution that foresees particularly important business areas spun off and continued while nonrelevant areas may be liquidated or left to face separate insolvency proceedings.
- Reallocate positions (including the full or partial termination of transactions) to rebalance the CCP’s transaction portfolio.
- Reallocate losses to limit or cover the CCP’s losses and, potentially, recapitalize the CCP and reposition it so it can again meet its obligations.
- Write down the CCP’s capital as well as convert portions of the CCP’s debt capital into equity in order to improve the CCP’s ability to absorb losses and to support other possible measures by strengthening the CCP’s equity.
The road ahead
The new proposal will be submitted to the EU Parliament and Council for their approval and adoption.
What the proposed rules can really do remains to be seen.
Concerns are being voiced in the market that regulators would be better off concentrating on operational risks within the framework. Some of the proposed rules, these voices assert, could turn out to be counterproductive by actually alienating clearing members by imposing additional margin requirements and threatening clearing members with the prospect of having to share any of the failing CCP’s exposure with other members at the point of a failure.
Further aspects being discussed in the market include:
- Confidentiality of margin calculations may be at risk depending on how the related transparency rules would work. As a result, business models may be affected and arbitrage may be furthered.
- The reallocation of losses and positions to clearing members may lead to a mere shifting of risks (from CCPs to their clearing members) and result in conflicts of interest among the various sets of rules all designed to increase stability.
- Despite the need for a consistent international approach, a real risk exists that a permanently heterogeneous and increasingly complex environment is being created, which may be costly, inefficient and even create additional risks.
- Concerns about harmonization are even greater when looking beyond EU borders: Approaches in regulation and market practice in the US and Asia deviate substantially from European approaches, while the interdependencies among these large pillars of the world markets continue to increase.
As has been the case with the related recovery and resolution rules for banks, the new framework for CCPs will, in any event, mean a lot of work for everyone concerned. This mainly affects, of course, the CCPs themselves. However, as experience with banks has shown, these rules will also have significance for many other market participants.
In the case of banks, it is mainly their customers and investors who are realizing they have to understand the recovery and resolution rules and the practical impact they have on their risk position.
In terms of CCPs, all direct and indirect participants will, in particular, be significantly impacted by the rules that will, of course also have major implications for the CCPs themselves as well as their shareholders.
In turn, this also means many companies in the real economy will be affected. These companies are supposed to benefit from the new rules, at least indirectly. However, experience with other regulatory initiatives shows that such changes never come without a broader impact on the market and its participants as a whole. In addition, the new proposal on the recovery and resolution of CCPs will inevitably influence the whole market and the variety (and price) of options that will be offered to banks and corporations for their financial transactions. This means that all players should closely follow developments on CCPs and the proposal on their recovery and resolution.