I recently had the honour of participating in a panel discussion of “[r]ecovery and resolution: the parable of the incentives” at the World Federation of Exchange’s 2021 Clearing and Derivatives Conference. Among other things, the conference organisers asked panellists to discuss the proposition that “. . . as we design risk management strategies to deal with tail events, it is crucial to ensure that incentives across the CCP ecosystem are aligned in a way that promotes financial stability – including in extreme circumstances.”
The conference programme also raised a related issue – one that concerns the expectations of participants in the central clearing ecosystem that their obligations will be determined under the rules of the relevant central counterparty (CCP) and that their rights under those rules will be respected in most circumstances. Accordingly, the organisers asked panellists to consider how “…we ensure the market gets the certainty it needs and under what scenarios?”
With these framing considerations in mind, the panellists addressed a number of policy issues relating to CCP default management, recovery and the potential – at the “end of the default waterfall” – for intervention by public authorities to resolve a CCP for financial stability purposes.
A central theme of the panel discussion concerned the incentives of participants in central clearing arrangements, including CCP owners and managers, CCP members, end-users and others. In particular, panellists were asked to consider how to “ensure [that participants’] incentives stay adequately aligned at times of crisis?”
Strategies for tail events
Together with the concern for reasonable certainty of outcomes under established rules, this framing made the incentive structure embedded in CCP rules and procedures, and the interaction between those rules and procedures and public law, such as proposed policies for CCP resolution, a central consideration in the panel’s discussion of CCP default management, recovery, and potential resolution.
In my opinion, this is the right approach to a productive consideration of the many thorny technical, legal and policy issues that arise in connection with “risk management strategies to deal with tail events” in centrally cleared markets.
The problem of incentive alignment in central clearing (and other financial institutions), however, poses important challenges for participants in the clearing ecosystem, market regulators, and other policymakers. Many different – often conflicting – interests intersect in central clearing. At the most fundamental level, for example, the interests of CCP clearing members (and the end-users for which members may provide clearing services) have different objectives concerning the direction of market fluctuations.
In typical market terminology, members and end-users that are “long” (i.e., those that hold positions meant to capture the gains from upward price movements) are directly and symmetrically opposite to the interests of those that are “short” (i.e., those that hold positions that would benefit from price movements in the other direction). This opposition is inherent in the nature of the contracts that are cleared by CCPs. This opposition is, in fact, the basic rationale for entering into such contracts.
Sources of potential conflict
The conflicting interests of “longs” and “shorts” is not problematic in principle; however, that conflict may become problematic in default management situations, as in the crisis faced by the New Zealand Futures and Options Exchange and its clearinghouse in 1989, a little-known event that also demonstrated how the desire of market participants for profit (or market share) and the exchange and clearinghouse’s interest in increasing trade volume (and associated fees) can complicate default management and the restoration of a “matched book” following the default of a clearing member.
Superimposed on this opposition, the most fundamental of conflicting interests, are various other sources of potential conflict, including: whether a market participant’s positions are entered into for hedging purposes (with respect to a position in another market) or for speculative purposes; whether a market participant is a clearing member that has a direct contractual relationship with the CCP or has rights derived in some indirect fashion from the clearing member’s relationship with the CCP; and whether market participants that are end-users (i.e., the ultimate economic beneficiaries of the contracts cleared by the CCP) are acting for their own interest, either personal or commercial, or on behalf of others (as in the case of asset managers).
All of these different – and potentially conflicting – interests are at play in central clearing. Again, this is not necessarily problematic, absent a member default or other situations that may call into question the ongoing viability of a CCP. In such situations, however, as Darrell Duffie has noted, “…market participants are not fully aligned with each other… [with respect to various CCP] recovery approaches.” [6, p.95] In particular, Duffie notes the concerns that have been expressed by BlackRock and other asset managers, which prefer to be “money whole,” rather than “position whole.”  As Duffie explains, this means that BlackRock and some other market participants “…would prefer to have the CCP immediately wound down than to be exposed to a CCP with a heavily impaired guarantee fund.”
This divergence of interests – between market participants that wish to assure the continuity of cleared contracts, even if that means incurring the costs arising from loss mutualisation, and those that prefer instead to terminate open positions and crystallise a pecuniary gain or loss – is not problematic where participants may choose between bilateral, non-cleared markets and centrally cleared markets. The adoption by the Group of Twenty (G20) of mandatory central clearing of certain “standardised” swaps contracts in 2009, however, complicates the situation for end-users of swaps that are subject to the G20 clearing mandate.
What are CCPs? In this paper, we claim that a CCP, viewed from an economic perspective, is a “commitment mechanism”.
The ultimate function of a CCP is to assure the performance of contract obligations.
[G]iven their unique role in a financial market, CCPs require regulation tailored to their function;
principles from banking regulation are not necessarily appropriate for the regulation of CCPs.
– Cox & Steigerwald [5, p.2 (citations omitted)]
As my colleagues and I have argued elsewhere, a CCP is – in economic terminology – a “commitment mechanism” that is designed to assure the continuity and performance of cleared contract obligations, notwithstanding the default of one or more members of the clearinghouse. But, as Duffie observes, not all market participants consider “. . . recovery and continuity of CCP operations . . . paramount. . . . “[6, p.95]
That is a legitimate preference, one that is aligned with the legal and regulatory responsibilities to which asset managers and other fiduciaries are subject. That preference, however, cannot be realised – at least for contracts that are subject to mandatory central clearing. The nature and purpose of central clearing under rules adopted to maintain contract continuity and, in the event of a member default, to restore the CCP’s matched book, is fundamentally inconsistent with the right of any particular member (or end-user client) to unilateral termination, an action which would undermine the multilateral nature of central clearing.
Other potentially conflicting interests among participants in the CCP ecosystem (broadly construed) can be identified. Consider, for example, the possibility that central clearing of financial contracts, although directly beneficial to participants in the clearing arrangement, may have adverse implications outside the clearing ecosystem itself. For example, central clearing may deepen interdependencies in the financial system through which systemic risk may be transmitted. It is generally accepted that the public has a legitimate interest in regulating CCPs to avoid or mitigate such effects.
The public’s interest in regulating CCPs for financial stability purposes, however, may not fully align with the interests of the CCP, its owners and members in the sound, cost-effective, and orderly operation of the CCP.
And there is another kind of conflicting interest or perspective – one that is directly relevant to the issue of CCP resolution – namely the difference between ex ante and ex post implications of CCP regulation. Like bankruptcy or insolvency administration law and policy, CCP resolution is largely focused on the latter perspective; something has happened to call into question the continued viability of a business enterprise. That “something” may be insolvency – however defined – or, as in the resolution regimes for market infrastructures that have been adopted in the wake of the Great Financial Crisis, depending on applicable law, it may be “default” on contracts (or the possibility of default) or, more or less equivalently, “failure” (or the possibility of failure).
This perspective is inevitable, given the intended purposes of resolution. However, market participants will structure their business affairs and counterparty relationships ex ante in recognition and anticipation of likely ex post consequences in resolution or other kinds of insolvency proceedings. For this reason, among others, market regulators, resolution authorities and other policymakers should take account of the impact that resolution policies and procedures may have on the behaviour of participants more generally. As Jo Braithwaite & David Murphy have noted (in connection with the recent EU Draft Recovery and Resolution Regulation), resolution authorities face the difficult challenge in such situations of having to “. … referee the various conflict of rights [of market participants] while providing a high likelihood of a successful resolution.” 
The clearing and settlement process [has been] . . . ignored by most financial economists and even
market participants as an institutional detail . . . .
– Ben Bernanke 
To gain an appreciation and understanding of clearing using an economic model, we must add some frictions to it. One [such] friction...is the
lack of commitment, which is the possibility that people may break their promises and fail to perform their contractual obligations.
– Nosal & Steigerwald
A detailed evaluation of how the proposals for CCP resolution currently under consideration may fare in the attempt to deal with the conflicting interests (and associated incentives) of market participants is not possible in this short commentary on the panel discussion at the recent WFE Clearing and Derivatives Conference.
The value of economic analysis
It is natural for someone in my position to consider whether economic analysis has the potential to provide guidance regarding how CCP resolution should be conducted. This, however, turns out to be problematic, given the state of economic understanding of central counterparty clearing arrangements.
As Andrew Haldane and Vasileios Madouros have noted: “[m]ainstream economics and finance is dominated by models of decision-making under risk.”[7, pp.1-2] Those models assume away certain “frictions” that may impede efficient outcomes. In particular, they do not address the problem of “commitment,” such as the possibility of default on contractual obligations – whether because of insolvency or for other reasons. That poses a fundamental challenge to our efforts to use economic models to understand clearing and guide us in the development of policies relating to CCP resolution that are both effective and consistent with the fundamental purpose of central clearing.
Market regulators and other policymakers also confront another potential problem in the effort to develop a strategy to resolve a CCP for financial stability purposes. Like other business entities, a CCP may become insolvent for any number of reasons. However, the threat to the ongoing viability of a CCP that is posed by the persistence of an unmatched book – a situation that uniquely follows upon the default of a clearing member – need not result in the CCP’s insolvency. CCPs typically have extraordinary recovery powers that may be deployed in such circumstances, without any adverse consequences for CCP solvency.
Unlike CCPs, banks and other financial institutions do not have such unilateral powers; instead, they use their balance sheets …to provide a buffer against loss, to protect creditors in the event of failure, and for related regulatory purposes…”[5, p.10 (citations omitted)] Accordingly, shareholder equity is a residual claim and senior creditors of an insolvent bank, such as depositors, have recourse to bank capital to satisfy their claims as creditors in the resolution of a bank. It is for this reason, moreover, that a general principle of bank regulation has emerged to the effect that shareholder equity should be “fully loss-bearing” in resolution.
[S]olvency risk for CCPs is an extreme tail event because insolvency does not necessarily arise from a member default.
CCPs [also] typically have rule-based recovery powers that allow them to respond as needed to particular circumstances without impairing
their balance sheets and without defaulting on their ongoing obligations to members or their general creditors.
– Cox & Steigerwald [5, p.8]
Unlike bank depositors, members of a CCP do not typically have direct recourse to the CCP’s capital – aside from voluntary contributions to the CCP’s “default waterfall” of financial resources in the form of so-called “skin-in-the-game.” The end-user clients that obtain access to clearing services through clearing members do not even have direct contractual relationships (which Anglo-American lawyers call “privity”) with the CCPs through which their positions are cleared. This is sometimes regarded as problematic.
It is, of course, a departure from the principle of bank regulation that shareholder equity should be “fully loss-bearing” in resolution. But CCPs are not banks.[6, p.2] Moreover, it is generally recognised that creditor expectations and entitlements are established by substantive law outside of insolvency, and that the resulting “hierarchy of creditor claims” should be respected in insolvency and resolution proceedings.
Aside from these considerations – which are mainly technical aspects of insolvency law – there are practical reasons why regulators and policymakers might find it desirable to protect CCP capital and not interfere with CCP’s exercise of its recovery powers (such as the power to terminate, or “tear up” open contracts if it is unable to restore a matched book by other means).
Although a full discussion of the issue is not possible here, one benefit of non-recourse to a CCP’s capital is that it supports the orderly ongoing operation of a CCP that continues to provide socially valuable clearing services, despite being unable to restore a matched book for the contracts that it inherited as a result of a member default. This tends to assure – but not guarantee – that the market will continue to have access to clearing services provided by the CCP if it chooses to utilise those services in the future. If the CCP is able to maintain market confidence following the exercise of its recovery powers, it may be beneficial for it to continue in operation, assuming that it is solvent and continues to comply with applicable legal and regulatory requirements.
The issue of NDLs
It should also be noted that a CCP may become insolvent as a result of so-called “non-default” (or NDL) losses (i.e., those not arising from the default of a clearing member). The actual insolvency of a CCP would, of course, necessitate the administration of claims raised not only by non-defaulting clearing members, but also the ordinary creditors of the CCP, including tax authorities, employees, landlords and equipment vendors, and other providers of goods and services to the CCP.
The resolution of an insolvent CCP would likely involve problems similar to those faced in bank resolution. This is likely to be considerably more complicated than the problem of restoring the CCP’s matched book, assuming that the CCP is permitted to utilise its rule-based recovery powers. In particular, it is unlikely that a CCP placed in resolution to deal with catastrophic NDLs could maintain market confidence and remain in operation. Although there are different kinds of NDL and different views about whether the CCP or others are ultimately responsible for such losses, there is no general principle of non-recourse to CCP capital. Who pays for what kinds of NDLs remains to be worked out in discussions among CCPs, clearing members and end-users, and policymakers. That work is ongoing at present.
To be sure, the coincidence of a member default and circumstances that actually impair (or threaten to impair) the solvency of a CCP would present unusual and difficult circumstances that regulators, resolution authorities, and other policymakers must be prepared to handle. The resolution authority would face both the problem of restoring the CCP’s matched book or exercising the CCP’s rule-based recovery powers to force a return to matched status.
The simultaneous depletion of a failing CCP’s capital and other financial resources would make such a resolution very challenging indeed. It seems that more work must be done to analyse carefully what resolution tools and policies are needed to assure that the situation can be handled without causing unnecessary harm in other parts of the financial system.
The panel discussion on CCP recovery and resolution at the WFE’s 2021 Clearing and Derivatives Conference provided a unique opportunity for panellists to share a variety of perspectives on the key issues. As the conference programme noted, “. . . it is crucial to ensure that incentives across the CCP ecosystem are aligned in a way that promotes financial stability – including in extreme circumstances,” such as those that come into play in CCP default management, recovery and resolution. That will not be an easy task.
 Bernanke, Ben, 1990, “Clearing and settlement during the crash,” Review of Financial Studies, Vol. 3, No. 1, (January), pp. 133-51, available at: https://academic.oup.com/rfs/article/3/1/133/1577153
 BlackRock, 2014, “Central Clearing Counterparties and Too Big to Fail,” BlackRock
Viewpoint (April), available at: https://www.blackrock.com/corporate/literature/whitepaper/viewpoint-ccp-tbtf-april-2014.pdf
 Braithwaite, Jo, & David Murphy, 2020, “Whose Ox Gets Gored? Conflict of Rights in CCP Recovery and Resolution,” Presentation at LSE Law Seminar, London School of Economics and Political Science (9 November)[unpublished]
 Budding, Edward, Robert T. Cox, & David Murphy, 2016, “Central counterparties in crisis : International Commodities Clearing House, New Zealand Futures and Options Exchange and the Stephen Francis Affair,” Journal of Financial Market Infrastructures, Vol. 4, No. 3, p. 65-92, available to subscribers at: https://www.risk.net/media/download/935301
 Cox, Robert T., & Robert S. Steigerwald, 2018, “A CCP is a CCP is a CCP,” Journal of Financial Market Infrastructures, Vol. 6, No. 4 (June), pp. 1-18, available at:
 Duffie, Darrell,2015, “Resolution of Failing Central Counterparties,” in Kenneth E. Scott, Thomas H. Jackson & John B. Taylor, Making Failure Feasible, How Bankruptcy Reform Can End “Too Big to Fail,” (Stanford, CA: Hoover Institution Press); Working Paper (17 December, 2014), available at:
 Haldane, Andrew G., & Vasileios Madouros, 2012, “The dog and the frisbee,” Federal Reserve Bank of Kansas City, Economic Policy Symposium Proceedings: The Changing Policy Landscape, Jackson Hole, Wyoming (30 August to 1 September), available at:
 Nosal, Ed, & Robert S. Steigerwald, 2010, “What is clearing and why is it Important?,” Federal Reserve Bank of Chicago, Chicago Fed Letter, No. 278 (September), available at: http://www.chicagofed.org/digital_assets/publications/chicago_fed_letter/2010/cflseptember2010_278.pdf
* The views and opinions expressed in this article are solely those of the author and not necessarily those of the Federal Reserve Bank of Chicago or any other part of the Federal Reserve System.