World Federation of Exchanges IOMA Conference, 2015
Thank you very much for inviting me to speak to you at this derivatives and clearing conference and to participate later in the panel on recovery and resolution of CCPs.
As an elected politician trying to put in place pan-EU legislation on financial services it is important for me and my colleagues to engage with industry to ensure that policy initiatives can and will deliver the desired outcome when implemented.
What has become very clear over the past few years is that whatever global agreement is reached in principle in the G20 forum, the different ways in which regions have implemented those ambitions has in some cases led to a less coordinated approach than would have been desired.
I am not suggesting that we should have a fully harmonised set of rules for derivatives trading and clearing but I am saying that increased cooperation in devising the legislative and regulatory framework is be desirable.
When politicians have set national legislation to achieve the desired G20 outcome or indeed in my case, a regional legislative framework for 28 national regimes, we need to ensure that if anomalies arise that all politicians have a method of correcting parts of their legislation without losing face.
In the EU we have recognised that we don’t always get legislation perfect the first time around and that markets evolve and may need new legislative responses therefore, we built a three year review clause into the legislation to enable us to revisit and amend it if necessary. I would suggest that this is a review method worth replicating in other major jurisdictions.
In trying to put in place adequate risk mitigation measures for derivative instruments, the G20 recognised the risk mutualisation role of existing central clearing houses. It was a huge compliment to CCPs when they chose to mandate central clearing in order to improve financial stability and transparency in the global system.
However we now need to recognise that this enhanced systemically critical role means that even long standing CCPs that are held in high repute, need to demonstrate that they will be exceptionally robust and are able to cope with extreme losses.
Politicians have changed the parameters that CCPs operate within by demanding enhanced end user asset protection through various segregation measures, by insisting as we have in the EU, on CCP participation in the default waterfall, and by mandating that more derivative products are centrally cleared when they may not have been historically.
Therefore the rules and risk management tools used at a CCP need to reflect this new environment whilst preserving the benefits of central clearing by providing the right incentives for the management of CCPs and their clearing members, and thereby strengthening the financial system as a whole. This needs to be done within an enhanced BASLE influenced prudential regime which affects both the CCP and bank clearing members through specific product capital allocation.
Policy makers and regulators have created conflicting demands of investor protection and prudential regimes for CCPs and their members and so it is within this context I would like to turn to recovery and resolution of CCPs.
There is a natural tension inherent to how a CCP works between the CCP itself, its clearing members, and their clients. This is fundamental to the basic concept and purpose of a CCP – mutualisation of risk. Each of the three parties want to reduce how much they are exposed to each other should they fail, but they each also want to reduce their everyday contribution to the measures put in place to prevent each other’s failure.
Most of the participants to the three categories have a duty to their shareholders or investors to reduce such contributions and would be acting against their interests and mandate if they did anything other than fight for lower margins, lower default contributions or less skin in the game.
But this misses the wider obligation that CCPs, clearing members and their clients have to their shareholders and investors. The very reason why the market set up CCPs in the first place. The common goal of reducing the likelihood that anyone’s capital would be lost by mutualising the risk. It is the financial sectors’ very practical realisation of the classic philosopher’s prisoners dilemma.
Every time I speak on recovery and resolution of CCPs I feel like the man on the high street with a placard that says “The end is nigh”, predicting future Armageddon. Many people have told me that this is a good parallel to the global financial Armageddon that would have to be taking place for this topic to come into play, however, we all lived through the events of 2008, which is as close as we have come to financial Armageddon in a generation, therefore I believe that the onus is upon us to do our best to find ways to reduce the chances of Armageddon occurring and ensure that we have the tools in palce to deal with it if it does happen. Therefore, the very clear message on the back of my “end is nigh” placard is “ we can prevent it”.
Currently, every sector of the market is fast and furiously producing white papers, non-papers, discussion documents and action points, pointing out which tools should be used in that Armageddon scenario. The evaluations and consequences these papers provide insight into on how different players will react to the use of certain tools is invaluable to policy makers – even though the conclusions are often predictably self-interested.
The key component that seems to be missing from the vast majority of these papers is trust.
How can an asset manager trust that their clearing member is acting in their best interests on the risk committee when their goal is to reduce the amount of regulatory capital tied up in the CCP?
How can a clearing member trust a CCP to correctly and conservatively calculate margin on a new product when it is in competition with other CCPs to release new innovative products?
How does the CCP know its margin calculations are being fairly attributed and passed through by clearing members from their clients?
In stressed circumstances, as we saw in 2008, trust deteriorates rapidly, therefore the only solution I can see for dealing with this fundamental tension is transparency and predetermined remedies for different scenarios.
The existing CPMI IOSCO principles already y put in place a framework for transparency in CCP risk methodologies, however, current dialogues suggest that the market could go further and enhance transparency to clearing members and clients even more.
Since the 17th century we have accepted the idiom that – “prevention is better than a cure”, in this case I would say prevention is better and more cost effective than a cure.
I see two tools that need further work to increase the chances of preventing a CCP from going into even the recovery stage, namely accessible and usable capital and system-wide stress testing.
So far, international work on capital held by a CCP has not been granular enough to prevent fundamental disagreements between jurisdictions over not just the amount of capital held but also the accessibility of that capital should it be called upon.
That being said, I have found the views of numerous central bankers, including those of Benoit Couree of the ECB, Andrew Gracie of the Bank of England and Jerome Powell of the Fed on Total Loss Absorbing Capacity, the so-called TLAC or MREL, and how this could be applied to CCPs surprisingly similar, and informative.
While these issues are normally discussed in the context of the recovery and resolution debate, I think the concepts they raise add a lot to the discussion on ongoing access to capital and liquidity, and how much accessible capital it is prudent for a CCP to hold to cover its daily business.
The instruments and ways that a CCP achieves an internationally agreed minimum level of capital should be flexible and should to an extent depend both on the business model of the CCP and the legal and regulatory environment it operates in. However the amount of capital that should be made available and accessible to the CCP should be equivalent wherever the CCPs is based, and meet the demands of those prudential as well as market supervisors.
The only way to determine the resiliency of a CCP’s available capital and how it will actually function in a crisis is via stress testing. This terminology is again borrowed and has been made popular in the banking world, yet in the CCP context it is infinitely harder. By placing CCPs at the heart of the financial system, stress testing a globally, systemically important CCP is not just about individual central bank looking at failure scenarios and assessing minor ripple effects. It is an operation that needs to bring together multiple market participants from across jurisdictions with knowledge over how interactions between different rules like insolvency and asset protection regimes are supposed to work. While the onus should be upon CCPs to show that they are able to deal with stressed markets and push those stresses to the limit, supervisors also need to run coordinated stress tests that take into account the fact that the largest clearing members of all of the large CCPs are pretty much the same. The old adage that banks are international in character until the collapse when they become national cannot be allowed to hold true for most CCPs. I do not want to see a scenario where the banking regulator of a large clearing member refuses to allow that member to participate in refills of a CCPs default fund as it is concerned about that bank having enough capital to refill one of its own domestically supervised CCPs. No matter how unlikely this conflict may be, this scenario would firmly move the debate into recovery if not resolution of the CCP in question.
Prevention and Transparency should also be at the heart of the recovery process. CPMI IOSCO has outlined and evaluated the different recovery tools that could be available to CCPs. Personally, the key message I, as a legislator took from these, is we need a tool box approach for recovery planning.
Not all recovery tools will be applicable to all CCPs and different tools will be more or less effective in different circumstances. In case of operational or investment failure on behalf of the CCP the tools required will be different to cases where a significant clearing member defaults.
This is not just about taking a proportionate approach to applying rules but more about ensuring that there is legal certainty in the way different tools will work in a crisis. This means clear and transparent contractual arrangements, even in the use of voluntary tools so that the CCP, its clearing members and their clients are fully aware of what their responsibilities and liabilities are in a recovery scenario.
European legislation makes clear that clearing members cannot have unlimited liability to CCPs – this is why other tools to return to a matched book than multiple assessment rounds and auctions need to be explored and made viable – no matter how strongly they are resisted.
I, and my colleagues in the European Parliament, have always expressed strong concerns with the idea of variation margin haircutting as a recovery tool. The reason for this goes firmly back to the alignment of incentives within a CCP. While clearing members have the ability to exert key influence over the governance and risk management of the CCP, their clients do not. Therefore utilising their assets in a recovery scenario should not factor into the mutualisation of risk and responsibility that is at the heart of good governance within a CCP.
However, this argument probably does not hold for clearing members’ proprietary trading accounts, so perhaps variation margin haircutting, given its clear anti-procyclical nature when applied to certain instruments, could be put at the disposal of the CCPs for recovery planning. However, I would be severely concerned about the potential for moral hazard should variation margin haircutting be used any more widely than this.
This takes me neatly to the place that I sincerely hope no systemically important CCP ever gets to – resolution.
I’m not sure if resolution is necessarily the word I want here, as I would see the failure of recovery tools by the CCP, or imminent failure, as the point at which the supervisor takes over to ensure the continuity of critical functions of the CCP.
While this will almost certainly mean the end of the CCP in terms of its management and shareholders, it does not necessarily mean it should be wound down.
The parallels between banking resolution and CCP resolution are nowhere near as strong as in the recovery stages. Working out how to extract a global bank as a market participant from its web of markets and obligations is complicated – but noting in comparison to that of a CCP.
For this reason, my dividing line is those recovery tools that involve end-client assets should only be used by a supervisor – for example variation margin haircutting of client positions, and even, in extremis, access to initial margin should not be under the control of a commercial entity as this would be introduce moral hazard and perverse incentives to the system.
Even with all of the tools available to a CCP and market participants there will still be significant problems without appropriate regulatory cooperation.
I have the dubious benefit of being a legislator and not a regulator or supervisor in this scenario, meaning that as a politician I help set the framework asking EU supervisors and national competent authorities to work in international forums and establish crisis management groups for cross border entities. However, I am not the person in the room who has to work with another team of equally competent supervisors and regulators coming from what could be a very different set of rules and jurisdictional biases.
On a daily basis within the EU legislative process, I have to work with colleagues from 28 very different legal jurisdictions to formulate one regulation or directive that works for everyone. Some of these compromises work well for everyone, while others work equally badly.
This should not be an option when it comes to global supervisors dealing with the potential collapse of a CCP.
The G20 came together in Pittsburgh to mandate the use of CCPs, they now have a responsibility to work together on risk standards and achieving regulatory convergence as well as structures that are credibly able to function in my Armageddon scenario.
5 years ago, when we started work on EMIR and Dodd-Frank was still being negotiated in the US political system, this did not seem like an unrealistic goal. There was a commonality of purpose to reform derivative markets and make them more resilient. Bodies like the FSB, IOSCO and BASLE were being strengthened and tasked with doing more detailed work to reduce regulatory gaps. It may have been aspirational to think we genuinely were going to get globally coherent rules to cover the whole range of issues involved in the different market practices and legal traditions that govern central clearing, but I still believe that global prudential standards for CCPs are within our grasp – I hope I am not the only one who has not lost faith on this.
The issues we have all seen emerge between banking supervisors and market supervisors, as well as between different jurisdictions should be sending your industry a solid message. In that Armageddon scenario there is no prospect of international bail outs for CCPs or their clearing members.
Prevention and credible recovery tools, agreed between CCPs, their clearing members and global supervisors and communicated transparently to their clients is the only viable option.
We all need to work together to ensure that CCPs are worthy of the trust our citizens have ultimately put in you to help mitigate the risk in our global financial system.