CCP intervention rules must be sharper and savvier

The proposed CCP resolution and recovery framework put forward by the European Commission last week should be a big step towards averting disaster during periods of market disruption. 

Having a draft resolution framework in place will focus banks, clearing houses and lawmakers on developing a robust approach to handling CCP failure, as well as helping Europe play catch-up with the US in this important area.

But the Commission’s framework is far from a finished product and the industry needs to do a lot more work before it can truly have confidence in its CCP safety net. Lobbying may play badly with the public mood, but CCPs both big and small have every reason to redouble their efforts in asking for more nuance and sophistication.  

First up, there has to be a better way of measuring what impact a resolution or recovery decision will have on clearing members and wider financial markets.

By the Commission’s own reckoning, the scale and importance of CCPs in Europe and globally has nearly doubled since the post-crisis G20 commitment to clear standardised OTC derivatives. But although this risk is distributed between the 17 CCPs registered in Europe, the Commission appears unable or unwilling to differentiate between the levels of systemic risk that each of these businesses present.

The proposed regulation says simply that: “As the systemic importance of a CCP failure cannot be determined with full certainty in advance, the proposed framework should apply in principle to all CCPs, irrespective of their size and complexity.”

That's not consistent with the observable realities about which CCPs concentrate most risk. The spectrum of sizes and scopes in the market requires a tiered approach to handling recovery and resolution, including who pays up when intervention becomes unavoidable.

While it is easy to imagine circumstances in which smaller or product-specialised CCPs become distressed for idiosyncratic reasons, for a major CCP to get into trouble, it's safe to assume that market conditions must have already reached a systemic extreme. And clearly any decisions made on a major CCP would have much greater systemic implications than for one of the smaller operations.

This is of crucial importance as already big exchange groups such as London Stock Exchange Group and Deutsche Börse pursue consolidation. Continuous measurement of a CCP’s “too big to fail” status should be a prerequisite in resolution planning, to inform a tiered approach to determining how different institutions are treated.

It also suggests that decisions on resolution or recovery require a globally coordinated discussion for bigger CCPs rather than localised responsibility, and it might, in turn, require banks to allocate more capital against exposures to the largest institutions. If resolution is different for each CCP then the cost of an exposure should also vary.

The proposed rules for CCPs do well to recognise that they are very different businesses to banks and require specific tools — rather than ones simply comparable to the Bank Recovery and Resolution Directive (recovery and resolution rules for banks). 

But the very fact that CCPs are specifically intended to mitigate systemic risk means that a collapse of a major institution would reap devastating psychological as well functional damage — arguably much more than the collapse of a major bank.

That acknowledgement demands a more technologically savvy approach to modelling both the likelihood of a CCP's collapse and its impact. While there is numerous mention of ‘stress’ and ‘distress’ in the proposed framework, there is no discussion of the importance of stress testing and how stress tests would work.

Stress testing is vital to determining the financial resources a CCP needs to survive a default of a major clearing member. While CCPs are already required to check that their holdings against credit and liquidity risk, the market needs more detail on what factors the tests should include and how they should be conducted. No two CCPs are subject to the same degrees or sources of risk, after all.

The behaviour of financial markets in the face of rising systemic risk is a problem of non-linear rather than linear mathematics, meaning that it is hard to reduce likely CCP distress scenarios to a set of equations. Appropriate stress testing therefore should be informed not just by abstract modelling but also data from sophisticated test-environment simulations using a wide array of inputs and parameters, including different time variables for intervention.

This analysis would take time and money, of course. But all the more reason to factor it in now, before clearing becomes 70% of the €500tr over-the-counter derivatives market, and before systemic risk becomes concentrated in fewer institutions. It is in everyone’s interests to have such analysis and for it to guide how CCP regulations are formulated.

This is not a time for blunt tools and a one-size-fits-all approach. Regulators themselves have noted that the rules must balance certainty of approach and case-by-case flexibility, without automatic triggers. 

If ever a meeting of the best minds and technologies was required it is here, on securing the global financial system’s final backstop.