Central counterparties (CCPs) are a fundamental part of global
financial markets, facilitating most over-the-counter (OTC)
derivatives transaction flow and risk positions. If a CCP shuts
down, it may not be able to continue its important services without
the help of resolution authorities or public money. To address this
threat, the International Swaps and Derivatives Association, Inc.
(ISDA) published a position paper CCP Default Management, Recovery
and Continuity: A Proposed Recovery Framework (Proposed Framework)
on January 26, 2015. The Proposed Framework, a copy of which can be
found [here], provides a comprehensive recovery plan
in the event that a CCP faces a threat to its viability.
ISDA stresses that the recovery of a CCP is preferable to its
closure (i.e. clearing service termination). This is particularly
important in times of market distress and instability. The
continuity of critical CCP clearing services would be less
disruptive and costly to a turbulent financial market and to market
participants that use cleared OTC derivatives to manage and hedge
risk exposure. In that vein, CCPs must adopt effective default
management processes and have measures in place to prepare for the
default of one or more clearing members.
An effective default management process involves the ability of
a CCP to re-establish a matched book. According to the Proposed
Framework, CCPs can re-establish a matched book by:
holding a voluntary portfolio auction and transferring
defaulted clearing members' positions to solvent clearing
making limited cash calls to solvent clearing members to
increase default resources;
implementing loss-allocation mechanisms in the form of a
pro-rata reduction in unpaid payment obligations of the CCP;
considering partial contract tear-up, subject to applicable
legal, regulatory capital and accounting treatment.
CCPs should fully compensate affected clearing participants if
recovery measures involve loss allocation or partial contract
tear-up. Affected clearing participants should receive a pro-rata
share in the CCP's claims against the estate(s) of the
defaulting clearing member(s) and future CCP revenues or profits as
a form of compensation.
ENTRY INTO RESOLUTION
If a default management process fails to re-establish a matched
book, the CCP may have to consider closing down the affected
clearing service (i.e. full tear-up). It is at this time that the
relevant resolution authority may have to step in and evaluate
whether resolution (as opposed to clearing service termination)
could restore the affected clearing service.
SEGREGATED CLEARING SERVICES
The Proposed Framework encourages the segregation of clearing
services if a CCP offers multiple clearing services. A segregated
clearing service structure would mitigate the risk of contagion
across other clearing services and allow a CCP to continue despite
the termination of a single clearing service.
IMPORTANCE OF TRANSPARENCY AND PREDICTABILITY
The Proposed Framework reiterates the importance of clearly
defined recovery measures in CCPs' clearing service rule book.
ISDA suggests, at the very least, a clear definition of the maximum
time frame for the default management process before recovery
measures are considered to have failed, and the applicable legal
construct, source and utilization of resources. A maximum time
frame should contain certain milestones, such as having a voluntary
portfolio auction take place over a five-day period.
A well-defined clearing service rule book is also helpful in
determining the viability of a clearing service. CCPs can compare
the actions planned in its clearing service rule book with expected
outcomes during the default management process by using actual
events as a reference. If expected outcomes are achieved, the
default management process can be deemed effective.
SCOPE OF THE PROPOSED FRAMEWORK
The Proposed Framework is consistent with Recovery of
financial market infrastructures, the report published by the
Committee on Payments and Market Infrastructures and the
International Organization of Securities Commissions in October
2014. However, ISDA focuses on addressing the default of clearing
members and providing tools to re-establish a matched book. The
Proposed Framework does not address other types of losses, such as
those related to liquidity shortfalls or those not caused by a
clearing member default.
The Canadian Office of the Superintendent of Financial Institutions ("OSFI") recently ruled that a bank cannot promote comprehensive credit insurance ("CCI") within its Canadian branches under the Insurance Business (Banks and Bank Holdings Companies) Regulations (the "Regulations").
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