We cannot overemphasise the fact that Resilience, Recovery, and Resolution (R3) are essentially damage control exercises, and while one needs to plan for them, it is better that those plans remain only on paper. A CCP’s financial resilience is the step prior to reaching R3, and therefore this financial resilience should be given due importance. This is a delicate balance to achieve, as any excessive margining for financial resiliency will lead to a reduction in liquidity and leverage, which can lead to crisis in case of extreme volatility.
In the financial crisis of 2008, many financial organisations were under stress and had to be bailed out by public funds. CCPs remained resilient throughout the entire period. However, exposures at CCPs have now grown multifold because of both organic business growth and the obligations to centrally clear OTC derivatives. The risks that CCPs will face in the future are likely to be much higher compared to the previous crisis. CCPs must therefore put in place safeguards to ensure that they remain resilient, or if any risk events were to materialise, recover and resolve without use of public funds.
In India, the regulatory framework gives primary importance to financial resiliency of the system through various measures such as real time computation of margins, upfront margin requirements, and client-level calculation of positions and margins. Although the CCPs in India clear only exchange-traded products, the prescription is to compute the default fund with a cover-2 test and adoption of a margin period of risk of two days. The margin requirements are subject to margin floors that are conservatively calibrated.
Conservative controls do not come cheap, and can result in an increased cost for investors. Therefore, there is a need to apply the right balance. Some of the costs of central clearing may appear higher because CCPs must put in place anti-procyclical risk measures that remain stable throughout the business cycle. Even if CCPs could, with 100% accuracy, predict short-term volatility over the margin period of risk, the risk measures must be stable and calibrated with historical volatility. CCPs must not create excessive leverage in tranquil periods, which is suddenly de-leveraged during stress periods, affecting liquidity and de-stabilising the financial system.
It is undoubtedly important that market infrastructure institutions, as well as market participants are committed to ensuring systemic stability. Typically, this is achieved through financial commitments by CCPs and their members to the default management resources. The proportion of these commitments is a hotly debated topic.
There is no mathematical model for the ideal proportion, and it varies from market to market based on the structure. Since the objectives of these commitments ensure that members and CCPs have ‘skin in the game’ to ensure smooth functioning of the CCP and neither is unduly putting the other at risk, the commitments must be commensurate with their potential to create such systemic risk.
Let’s take two examples. First, consider a market of OTC credit derivatives where the members are about ten banks, which are cleared through an independent CCP. In such a market, significant responsibility may be laid on to the members in terms of commitment to default resources.
Consider a second example of a market which consists of hundreds of clearing members dealing standardised exchange-traded index derivatives matched anonymously and cleared under a vertically integrated exchange-clearing model, with margin and position limits set by the CCP. In this market, significant responsibility must be laid down on the CCP.
From an Indian perspective, we are closer to the second example. Hence, a significant amount of contribution to the default resources is made by the exchange and clearing corporations. 75% of the fund size needs to be contributed by the CCP and exchange put together, in addition to the other resources of central counterparties.
Therefore, whilst not undermining the importance of planning for Resolution and Recovery, in these times of various geo-political and economic factors affecting the markets on an ongoing basis, we need CCPs to concentrate on the financial resiliency of the ecosystem. This will allow the system to stand on its own merit, while also maintaining the balance to provide markets sufficient leverage and liquidity to ensure depth.