As a result of the post-Global Financial Crisis' reforms many
securities and derivatives markets introduced Central Counterparties (CCPs).
The rationale of the change in market infrastructure is that the CCP inserts
itself between both trading counterparties, to protect them from the risk that
one defaults before the obligations are settled. CCP interoperability is
an arrangement that links different CCPs, allowing participants of one CCP to
deal with participants of another CCP. This can make it cheaper for traders to
participate in a wider range of financial markets, and can facilitate
competition between CCPs by opening up participant networks. However,
interoperability also introduces financial stability risks, primarily by
creating dependencies between the linked CCPs.
The introduction of Central Counterparties (CCPs) to the OTC
Derivatives market has been followed by further regulation on the issues that
are critical to the safety and soundness of the CCPs. One of the issues is how
to regulate and supervise the Interoperability Arrangements between CCPs.
In Europe, The European Securities and Markets Authority (ESMA)
issued the Guidelines and Recommendations (‘the Guidelines’), as mandated
under Article 54(4) of EMIR, ‘with a view to establishing consistent,
efficient and effective assessments of interoperability arrangements’ in which
EU central counterparties (CCPs) participate. As noted by ESMA, the Guidelines
do not introduce new requirements for CCPs in addition to the ones specified in
EMIR or the relevant technical standards. However, they specify how those
requirements should be met for the purpose of establishing robust and stable
interoperability arrangements.
The Guidelines and Recommendations define what National Competent
Authorities (NCAs) should analyze in assessing an interoperability arrangement
and therefore on what aspects of the interoperable arrangement the relevant
CCPs will need to focus their attention. In the UK the NCA is the Bank of
England.
In November 2014, the Bank of England published a consultation
paper on the supervisory approach that the Bank was considering taking to
implement the ESMA Guidelines in certain specific areas. In many of those
areas, UK CCPs were already operating in line with the approaches proposed.
The Bank of England (BoE) has published the feedback it received and
policy response to its November 2014 consultation. These are the five areas
discussed:
(i) The level of margin that
should be provided by CCP to the other (‘inter-CCP margin’): this is that
CCPs' are required to assess, collect or have access to inter-CCP resources
‘necessary to cover credit and liquidity risk arising from the interoperable arrangement,
including in extreme but plausible market conditions’. However, the requirement
to meet exposures in ‘extreme but plausible market conditions’ poses some
concerns. That requirement is achieved by the addition of other pre-funded
resources, notably a mutualized default fund. Unlike an ordinary Clearing
Member (CM), an interoperating CCP is not permitted to contribute to another
CCP’s default fund. Thus, although interoperating CCPs contribute some
additional source to the fund in 'extreme an plausible market conditions', the
risk management approach would not be as rigorous as it is to the ordinary
clearing members of each CCP.
The Bank of England proposed that
the CCP should collect at least the amount of inter-CCP margin from an
interoperating CCP as it would ordinarily collect in margin and default fund
contribution combined from a CM with the same positions. This may, however,
entail additional costs for CCPs (and their members) participating in
interoperability arrangements.
The respondents had different views regarding
this matter: One respondent suggested that the level of inter-CCP margins
should be higher than the Bank proposed. It should cover all potential losses
arising from the default of the interoperable CCP in extreme but plausible market
conditions. The respondent argued that this is justified because
interoperability exposes CCPs to incremental risk that is substantially greater
than the risk it is exposed to from a clearing member. Another respondent
also disagreed with the Bank’s proposed standard, arguing that the existing
inter-CCP margin collected by CCPs may already be too conservative, and in that
sense inter-CCP margins could be reduced from their prevailing
levels.
The Bank decided to adopt the initially
proposed standard as part of its supervisory approach towards assessing
interoperability arrangements for UK CCPs. The Bank explains that taking a
more conservative approach could lead to significantly higher inter-CCP
margin requirements than under the Bank’s proposed approach, which would
increase the cost of establishing such arrangements notwithstanding the
benefits they may bring. There would be other drawbacks. For instance, the
additional margin requirements would be more volatile and the mutualized
default fund could be significantly smaller, as interoperating CCPs would not
have uncovered stressed exposures to the CCP. The Bank did not agree that this
would strike an appropriate balance between safeguarding against the systemic
risk of contagion between CCPs and maintaining the benefits of interoperability.
(ii) The means by which CCPs
source this inter-CCP margin: Interoperability exposes an interoperable
CCP to counterparty risk from its linked CCP(s) that is new and additional to
the counterparty risks arising from exposures to its CMs. These CM exposures
must continue to be margined and risk-managed in accordance with EMIR. The
Bank’s view is therefore that in order to satisfy this requirement, any margin
posted by one CCP to another CCP should be separate from and additional to the
margins already collected by a CCP to cover its exposures to CMs. This is
necessary because if margin provided by a CM is posted to an interoperating
CCP, it would no longer be readily available to protect against the default of
the CM which has provided it. This does not preclude a CCP from calling
‘additional’ margin from CMs, which could be used as inter-CCP margin. UK
CCPs are already operating on this basis, in line with the regulatory position
adopted by the Netherlands Authority for the Financial Markets (AFM), De
Nederlandsche Bank (DNB), the Swiss Financial Market Supervisory Authority
(FINMA), the Swiss National Bank (SNB) and the UK Financial Services Authority
(FSA) in 2010.
All respondents agreed with the Bank’s proposed standard on the
sourcing of inter-CCP margin. Accordingly the Bank’s proposed standard
will be adopted as part of its supervisory approach towards assessing
interoperability arrangements for UK CCPs.
(iii) The application of CCP
default resources (other than inter-CCP margin) to exposures to interoperating
CCPs: if an exposure to an interoperating CCP is amongst the two largest
exposures faced by a CCP, it would set the size of its default fund and other
pre-funded financial resources accordingly, and the default fund would be
available to meet such a loss. This would ensure that a CCP is able to
withstand the simultaneous default of its largest two counterparties,
irrespective of whether they are a CM or an interoperable CCP, in extreme but
plausible market conditions.
Some respondents noted that the precise design of
the proposed standard could be altered. The Bank said that its aim is to
implement the ESMA Guidelines, rather than to introduce new requirements.
Therefore, the Bank did not propose to provide such additional guidance. The
specific formulation of the CCPs’ default resources should be agreed between
the CCPs and its participants, within the requirements of EMIR. In other words,
the Bank is transposing ESMA Guidelines into national regulation with no
further consideration to the specificities of the UK CCPs.
Accordingly
the Bank’s proposed standard will be adopted as part of its supervisory
approach towards assessing interoperability arrangements for UK CCPs.
(iv) Arrangements to manage
the impact on one CCP of the deployment of loss allocation rules by the
other: UK CCPs have adopted ‘loss allocation rules’ that set out how any
loss that exceeds the CCP’s pre-funded resources will be allocated to
participants. Guidelines 3(a)(v)(a-b) state that interoperating CCPs
should agree any changes to the rules of one CCP that will directly impact the
interoperability agreement. Depending on their design, the loss allocation
rules could potentially impact interoperability agreement. In the Bank’s
view, interoperating CCPs should consider any interaction between their loss
allocation rules and the interoperability arrangement and make changes as
necessary to the interoperability agreement between them.
No respondents suggested that the Bank should
require CCPs to include interoperating CCPs within the scope of their loss
allocation arrangements, but some noted that there could be benefits to such
loss allocation arrangements agreed between CCPs on a voluntary
basis. Accordingly, the Bank will not expect CCPs to include interoperable
CCPs in loss allocation arrangements, but will review any voluntary
arrangements agreed between CCPs and their respective regulators on a
case-by-case basis.
(v) The
application of the Guidelines to interoperable arrangements for derivative
products.
Regarding the last area the Bank of England accepts that interoperability
for derivatives products raises similar risks as interoperability for
securities products, but on a potentially greater scale, given the larger
potential credit exposure on derivative products and the greater risk
associated with longer-term exposures in more complex
instruments. Therefore risk standards applied to interoperable
arrangements for derivatives should be at least as stringent as the standards
applied to interoperable arrangements for securities.
Accordingly, the
Bank proposes to apply the standards contained in the Guidelines as the minimum
necessary in any interoperability arrangement for derivative products in which
UK CCPs participate or propose to participate.
In other words, although the Bank recognizes the relevance that
interoperability for derivatives products has, it is not providing any further
guidance in this matter, not a clear interpretation on how this is different from
the regime of interoperability for securities products.
All respondents agreed with the Bank’s proposed standard on the risk
standards for interoperability arrangements for derivatives products.
Accordingly
the Bank’s proposed standard will be adopted as part of its supervisory
approach towards assessing interoperability arrangements for UK CCPs.
Bank of England
ESMA
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