Central Counterparties Recovery and Resolution – the final milestone

What is next for the Central Counterparties (CCP) Recovery and Resolution Regulation.

Since the introduction of EMIR in 2012 and equivalent regulations in the US and in Asia introducing new obligations for derivatives markets, CCPs have continued to grow in systemic importance and have contributed to the commitment of the G20 for more transparency and more stability for the financial system. The netting benefits of central clearing have also contributed to the increase of the concentration of financial activity in CCPs and have thereof favored the growth of few CCPs concentrating most of the liquidity.

With this in mind, in 2016 the European Commission (EC) issued its first draft regulation for the recovery and resolution of central counterparties (CCP R&R), highlighting the ever more central role and importance of clearing institutions and the need to adequately manage the risks related to failing CCPs. The Presidency of the Council and the European Parliament recently reached a political agreement on a regulation setting a new European framework for the recovery and resolution of CCPs. The regulation is expected to be adopted before the end of 2020 and the new framework should start applying 18 months after the date of entry into force of the regulation.

The European clearing landscape has also been recently impacted by Brexit. While the EC and ESMA have reassured the financial industry by providing an 18 months equivalence for UK CCPs starting from 1st of January 2021, the EC’s expectation goes towards a reallocation of exposure from EU clearing members established in Europe towards EU CCPs during this timeframe, illustrating the importance and strategic nature of CCPs to financial systems.

The CCP recovery and resolution regulation is complementary to EMIR and covers specific situations of distress for CCPs, which require the particular attention of regulators and participants to CCPs in order to safeguard the financial stability and prevent systemic risks. This regulation builds on the “Principles for Financial Market Infrastructures” (CPMI-IOSCO – 2012 and subsequent updates), the “Guidance on the Recovery of Financial Market Infrastructures” (CPMI-IOSCO – 2014), the “Guidance on CCP Recovery and Resolution Planning” (FSB – 2017) and the “Framework for Supervisory Stress Testing of Central Counterparties” (CPMI-IOSCO – 2018).

How to manage risks in the CCPs and clearing members’ best interests

The CCPs’ main objective is to adequately manage risks so that a defaulting clearing member does not harm the financial system and that an organised process is followed in such events (a default waterfall).

However, what if a CCP were to default? Although resilience is key to avoid recovery and resolution, should a CCP failure situation presents itself, there are some of the key measures foreseen by the new regulation:

  • Preserving of clearing houses’ critical functions in order to maintain financial stability
  • Introducing of a recovery and resolution framework based on prevention and preparation
  • Providing authorities with the possibility to intervene at an early stage and with an adequate set of resolution tools

In addition, CCPs will have a new range of mandatory rules under the control of the national competent authorities. CCPs will be required to:

  • Develop comprehensive recovery plans addressing all of their risks and anticipating the effects on clearing members (including indicators and recovery actions) and will be required to test the plan annually
  • Involve the various stakeholders who would bear losses as foreseen in the recovery plan. Clearing members will also be required to communicate to their own clients what measures from the CCP recovery plans may affect them
  • Regularly inform their national competent authority of changes in the plan or whether they intend to activate the plan

CCP R&R should also introduce some key measures aimed at preventing non-defaulting clearing members from being imposed unreasonable requirements in the event of a CCP recovery or resolution:

  • The introduction of a second tranche of direct CCP capital (“SITG” which stands for “Skin In The Game) used before clearing members’ assets
  • A clear list of resolution tools with the exclusion of recovery & resolution instruments which would have impacted non-defaulting clearing members, such as the initial margin haircutting and forced allocation. On the other hand, resolution tools should include a sizeable cash call to clearing members

What’s next for CCPs?

ESMA is expected to issue guidelines on scenarios for recovery plans, taking account of supervisory stress tests where appropriate and to develop draft Regulatory Technical Standards specifying:

  • A minimum list of qualitative and quantitative indicators triggering recovery actions
  • The calculation and maintenance of the second tranche of SITG

Requirements set for CCPs to identify, understand, manage and communicate their risks to all national competent authorities on an ongoing basis are meant to guaranty that there is a constant scrutiny of their financial and systemic situation. Stress testing frameworks for CCPs will also continue to evolve to further anticipate unidentified scenarios in order to always prefer recovery over resolution for any future distress situations that may arise and impact the financial stability.

This regulation represents one of the final pieces of the regulatory enhancements meant to strengthen the stability and solidity of the European financial system. Considering also that the CCP recovery and resolution topic is being discussed at the international level, notably within the Financial Stability Board, it is reasonable to expect the enactment of similar rules in other jurisdictions in the short term.