CCP Loss Allocation and "End of Waterfall"

FRB Chicago OTC Derivatives Symposium Panel: CCP Loss Allocation and ‘End of Waterfall’ Scenarios
Presented by: Marnie Rosenberg
April 2014
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This presentation includes summary information regarding the loss allocation provisions of certain publicly available clearing house rules and procedures . You should not
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CCP R&R: Where are we and what is still needed to avoid “too big to fail”?
Industry & Regulatory Objectives: CCP Resolution and Recovery
1. Reduce likelihood that a CCP fails following a severe stress event, such as the default of multiple members in a short period
of time
2. Reduce likelihood of market contagion following a CCP failure; reduce the probability that the failure of a CCP destabilizes
other SIFI market participants that are members of the CCP and other FMIs
3. Reduce likelihood of liquidity runs following CCP stress or failure; avoid strong and sudden loss of market confidence in
the solvency or liquidity of other CCPs and thus liquidity runs from CCPs, resulting in severe stress or failure of multiple
4. Reduce likelihood that public money is used to address CCP failure
5. Preserve the operation of the systemically important functions of a CCP following failure.
Current State - Drivers of CCP Distress and Suggested Recovery Methods
 Non Default loss – investment loss or operational risk such as fraud
1. UK CCPs proposing loss allocation model to comply with May 1 requirement to cover investment losses
2. CCP regulatory capital limited to cover other non default losses
 Default loss - after use of member default fund\assessments, the following have been discussed as possible recovery methods:
1. Full loss allocation to members beyond default fund\assessment contributions
2. IM Haircutting - incompatible with EMIR, creates the wrong incentives, pro-cyclical, conflicts with IM segregation regimes)
3. Reduction of Unpaid Payment Obligations (VMHC) – incentivizes participation in default management process, and satisfies
accounting criteria for Basel III - but does NOT effectively address the basic remaining structural flaws with central
counterparties that remain – these are fairly fundamental and straightforward
CCP R&R: Where are we and what is still needed to avoid “too big to fail”?
Recommendations to Promote CCP Resiliency
It is known and widely discussed that CCPs commonly suffer from:
 Lack transparency to their members and other participants
 Lack a consistent stress framework amongst their peers;
 Insufficient skin in the game resulting in inappropriately aligned incentives with for-profit model; and
 Dependency upon unfunded member commitments for a portion of loss absorbency, recovery and
resiliency, which creates uncertainty as to whether money will be available when it is most needed
Addressing above would preserve CCP resiliency and reduce the likelihood of a CCP failure. To this point, I
would agree with some of Blackrock’s key recommendations described in its very thoughtful paper released
this week:
 CCPs should be subject to a standard, publicly-disclosed stress test framework; results of which would
be used to size aggregate resources
 Entire financial safeguard waterfall should be fully pre-funded
 CCPs’ contribution should be risk based and should be lower of either a fixed percentage of the fund
(approx. 10%) or the largest single clearing member contribution.
CCP R&R: Where are we and what is still needed to avoid “too big to fail”?
Potential Approaches to CCP Resolution
1. Liquidation of CCP and cessation of clearing activities, including those viewed as systemically important:
Rush to exit and closing of positions will lead to contagion
Alternative CCP will need have sufficient capacity to take on new trades as members look to reestablish positions given clearing mandate
2. Pre-funded recapitalization resolution strategy – BlackRock’s paper suggesting that a CCP could be
recapitalized post-failure through fully pre-funded recapitalization resources is extremely thoughtful and
should be fully explored:
Regulators would determine point of non-viability, at which time resolution and recapitalization utilizing
fully pre-funded resources would be triggered
Would promote and preserve market confidence, avoid pro-cyclicality, and ensure continued
operations to allow opening on the business day following failure