Challenges of Central Counterparties (CCPs)

Challenges of Central Counterparties (CCPs)

• High switching costs: Difficulty switching CCPs due to non-fungible collateral pools and lack of interoperability.
• Cross-border legal risks: Legal complexities related to netting and access to central bank liquidity across borders.
• Concentration and infrastructural risks: Potential risks associated with CCP outages.
• Liquidity costs: The need for highly liquid collateral for clearing can create liquidity challenges.
• Interoperability risk: CCPs may engage in a "race to the bottom" in risk management policies to attract trading volume.
• Adverse selection risks: Misjudging clearing members' eligibility and initial financial requirements can pose risks.
• Moral hazard risk: Potential for the CCP to undertake excessive risk if it does not have sufficient "skin in the game".
• Governance and access risk: Complex infrastructure can pose governance and access challenges.
• Tail risk: Shifting "most liquid exposures" from banks' balance sheets to CCPs can increase the tail risk remaining on banks' balance sheets.

Key Legislative Acts on Clearing of Derivatives

• European Market Infrastructure Regulation (EMIR)
  • Aim: Regulate OTC derivatives
  • CRD IV: Prudential requirements for exposures to CCPs.
  • BRRD: Regulation for recognition of National Resolution Authorities (NRAs).
  • MiFIR: Non-discriminatory treatment and trade reporting.
  • AMLD: Safeguards for central counterparties (CCPs) in relation to anti-money laundering (AML) frameworks.
  • SFT: Equivalence of OTC derivative definition within the Securities Financing Transactions Regulation (SFT).
• EMIR REFIT: Amendments to EMIR aimed at refining clearing obligations, suspension of clearing obligations, reporting requirements, risk mitigation techniques for non-cleared derivatives, and trade repository regulations.
• EMIR 2.2 EC Proposal: Proposed amendments to ESMA regulations concerning the authorization of CCPs and the recognition of third-country CCPs.
• EMIR 3.0: Focuses on strengthening risk management tools for CCPs and reducing cyclical effects on margin requirements.
• Regulation (EU) 2021/23: Provides a framework for the recovery and resolution of CCPs.

G20 Commitments

• Focus on strengthening transparency, responsibility, capital requirements, and prevention of future financial crises.
• Pittsburgh Summit (2009): Aim to clear all standardized OTC derivatives through CCPs by the end of 2012.

Default Fund

• Defaulting Members:
  • Contribution to the default fund.
• Non-defaulting members:
  • No use of margins posted by non-defaulting members.

Organisational Requirements

• Open Access:
  • Non-discriminatory and transparent access to CCP services.
  • Reverse Access: CCPs should have access to trading venues.
  • Exceptions for liquidity fragmentation within a single venue, requiring interoperability.
  • Denial of access can be based on:
    • Excessive anticipated transaction volume.
    • Operational risks and complexities.
    • Significant undue risks.
• Interoperability:
  • Designed to allow traders to exchange derivatives across different CCPs and collateralize their positions using assets held in multiple collateral pools.

Other Organisational Requirements

• Conduct of Business Rules:
  • Ensuring clear and transparent rules to manage conflicts of interest.
• Liquidity Risk Controls:
  • Restricting the use of money market funds (MMFs) and time deposits as liquid instruments.
• CCPs Investment Policy:
  • Investments should be in high-quality liquid instruments:
    • Government securities, central bank securities, multilateral development bank securities.
    • Low market risk, volatility risk, and inflation risk.
    • Freely transferable and in the required currency.
    • Active outright and repo markets.
    • Reliable information on prices.

Risk Mitigation Techniques for Non-Centrally Cleared Derivatives

• Margins: Initial and variation margins to reduce counterparty credit risk.
• Timely confirmation: Prompt confirmation of trades for accuracy and transparency.
• Daily valuation: Daily marking-to-market of trades to reflect current valuations.
• Portfolio reconciliation: Regular reconciliation to ensure accurate accounting and reporting.
• Portfolio compression: Reducing the number of trades and outstanding contracts.
• Dispute resolution

Trade Repositories (TRs)

• Legal entity in the EU: Legally established in the EU.
• Passport and ESMA supervision: Authorized to operate across the EU and subject to supervision by the European Securities and Markets Authority (ESMA).
• Data Compatibility: Data must be compatible with MiFID, potentially becoming Approved Reporting Mechanisms (ARMs).

Reporting Obligation

• Transaction reporting: All transaction data must be cleared and reported to TRs.
• Trade reporting: Aggregated positions must be reported, with breakdowns by type of derivative and at least weekly updates.

Data Formats

• Standardised Code: Unique Product Identifier (UPI) to identify OTC derivatives for transparency and clarity.
• Legal Entity Identifier (LEI): Used to identify the involved parties.

Initial Margin (IM)

• IM should be segregated to protect against defaulting members.
• IM contributed by defaulting CMs will typically consist of cash.
• Loss allocation across waterfall:
  • ** Defaulting CM's contribution to default fund**
  • Tranche of CCP's capital
  • Default fund contributions of surviving CMs
  • VMGH, Haircuts, Assessment rights, Auctions and tear-ups
  • ** Service closure**

CCP Recovery Planning

• Recovery planning is outlined in the CCP Rulebook.
• Resolution tools:
  • Variation Margin Gains (VMGH)
  • Haircuts
  • Cash calls
  • Auctions
  • Tear-ups
  • Service closure
• Recovery planning beyond immediate resolution tool:
  • CCP recovery and resolution plans should encompass additional measures to recover losses and protect the financial system.
  • Portfolio or replacement of the insolvent member.