CCP Resilience, Resolution Resources and Incentives for Central Clearing

Central counterparties’ (CCPs) clearing of over-the-counter (OTC) derivative transactions is a cornerstone of financial stability. Over the past few years alone, some stress events, e.g., the ‘dash for cash’ resulting from Covid-19, the turmoil in the UK gilt market caused by the LDI strategy of pension funds, turbulence in the commodities market, the failure of several regional banks in the US and the problems of Credit Suisse, have occurred in global financial markets. However, the global financial system kept its stability, unlike during the Global Financial Crisis. That is partly thanks to the progress of OTC derivatives market reforms since the Pittsburgh Summit, especially the enhancement of the central clearing mandate.

On the other hand, the progress made in the G20’s regulatory reforms, including the central clearing mandate of OTC derivative transactions, indicates the greater systemic importance of CCPs. While material advances have been achieved to enhance the resilience and recovery of CCPs, it is also necessary to ensure adequate resources and tools are available in resolution to maintain the continuity of critical functions. Against this background, this article briefly looks at two topics that have been recently on the global agenda of the Financial Stability Board (FSB) and relevant Standard-Setting-Bodies (SSBs), namely CCPs’ (i) margining practices and (ii) resolution resources, with a special focus on their potential impacts on the incentives of market participants to use central clearing.

CCP Resilience – Margining practices

Among the tools and resources that enhance the resilience of CCPs, margining practices have been under intensive discussions globally. This is because of the ‘pro-cyclicality’ of CCPs’ IM models observed in recent stress events, especially in the ‘dash for cash’ resulting from Covid-19 in March 2020. The FSB and relevant SSBs such as BCBS and CPMI-IOSCO published four consultation reports in first half of 2024. Among them, the BCBS-CPMI-IOSCO report titled ‘Transparency and responsiveness of initial margin in centrally cleared markets: review and policy proposals’ sets out 10 policy recommendations on the transparency and responsiveness of initial margins (IMs) in centrally cleared markets¹.

In the BCBS-CPMI-IOSCO report, some recommendations aim to assess the CCPs’ IM models, focusing on the trade-offs among three dimensions, namely coverage, cost and the responsiveness of margins. For example, if IM models aim to achieve ‘sufficient coverage against participants’ default with minimum procyclicality in terms of responsiveness,’ the design of the IM models would be to ‘build up a higher level of margins during normal periods, while not to increase them even in stress periods with elevated market volatility.’ However, if a CCP requires margins that are ‘extremely excessive’ for clearing members (CMs) during normal periods, the cost of central clearing for them would also be extremely high. This could undermine market participants' incentives to use central clearing, thereby triggering the circumvention of central clearing regulations.

The BCBS-CPMI-IOSCO report also includes recommendations for CCPs as well as CMs about transparency with enhanced disclosures on their IM models, with recognition of the trade-offs between these three dimensions. Needless to say, IM models by each CCP are very diverse, reflecting various reasons such as different risk-return profiles, e.g., fat tail nature of centrally cleared products. Accordingly, CCPs, CMs, authorities and other relevant stakeholders are expected to appropriately address the procyclicality of margins by identifying the right balance among margin coverage, cost and responsiveness for each product at each CCP, thereby preparing for sharp margin calls that may occur in future stress periods, while keeping and strengthening the resilience of CCPs. To achieve it, close communication, even during normal periods, based on appropriate disclosed information is of the utmost importance.

CCP resolution resources

In April 2024, the FSB published a report titled ‘Financial Resources and Tools for Central Counterparty Resolution²’. It recommends a flexible framework (resolution toolbox), whereby each resolution authority should be ready to have access to a combination of resources and tools from the toolbox as options to use in resolution. The resolution toolbox comprises a set of resolution-specific resources and tools available for resolution, i.e., bail-in bonds, resolution funds, resolution-specific insurance, resolution-specific third-party contractual support, resolution cash calls, statutory or contractual VMGH³ for resolution, and equity in a first-loss position in resolution, and, if available, financial resources from access to non-exhausted recovery tools.

This approach enables resolution authorities to flexibly select resources and tools in their jurisdictions, as needed, to complement those already available. It also provides authorities with the opportunity to consider the associated benefits and costs of each option for CCPs, CMs and indirect participants, as well as for the broader market, including the potential impact on the central clearing mandate. For example, the report states that ‘as the cost magnitude of a resource increases, it could raise the cost of central clearing. In general, prefunded resources that are predictable and come with potentially smaller impacts to financial stability have higher business as usual costs.’ This analysis clearly shows that it is necessary to take a well-balanced approach that fully considers both the benefits and costs of prefunded resources and tools. For example, if the costs of central clearing for market participants become too high, it can potentially result in fewer cleared transactions.

Summary

In the considerations to strengthen the resilience of CCPs and their financial resources for resolution, it is important to conduct a comprehensive analysis of the benefits and costs from various perspectives, so as not to undermine the effectiveness of the central clearing mandate. Each CCP faces unique challenges because of the different risk profiles of centrally cleared products, local regimes, and so on. Therefore, each CCP and authority is expected to enhance the resilience of the CCP and its resolution resources in the most appropriate manner, through close communications with relevant stakeholders.

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_{1 See BCBS, CPMI and IOSCO, ‘Transparency and responsiveness of initial margin in centrally cleared markets: review and policy proposals,’ January 2024.} 

_{2 See ‘Financial Resources and Tools for Central Counterparty Resolution,’ Financial Stability Board, April 2024.}

_{3 Variation Margin Gains Haircutting}