Intercontinental Exchange (ICE) owns and operates six clearing houses in North America, Europe and Asia, with more than 390 unique clearing members. As the leading operator of clearing houses that clear a diverse set of exchange-traded and OTC derivatives, we know first-hand that clearing plays an essential risk-management role in the financial system and, as a result, is central to financial stability. The risk-reducing benefits of central clearing have long been recognised by users of exchange-traded derivatives, and were the foundation of the financial reforms put forward over the past decade for OTC derivatives.
Clearing, when provided by well-run and well-supervised clearing houses, has historically proven to be a fundamentally safe and sound process for reducing systemic risk. Clearing houses serve as the “central counterparty” (CCP) to the financial transactions they clear, meaning that the clearing house is the buyer to a clearing member seller and seller to a clearing member buyer. ICE clearing houses manage the counterparty performance risk associated with their clearing members in the manner visualised above.
We would like to touch on a few “Hot Topics” that are being discussed industry-wide and share ICE’s views on those topics.
Skin in the Game (SITG): Motivator or Loss-Absorption Resource?
In recent years, the position and thickness (value) of the CCP’s contribution – i.e. SITG – in the default waterfall has been a widely discussed topic. Clearing houses remain market neutral, maintain a balanced book of positions and reduce systemic risk by “centralising,” “netting” and “managing” risk in a highly collaborative, transparent, disciplined, sophisticated, and regulated manner.
CCPs do not create or maintain directional portfolios. Consequently, ICE does not employ a quantitative risk-based methodology when determining the amount of SITG it provides to the default waterfall. Instead, ICE attempts to provide an amount of SITG that further balances and aligns the risk-management interests of the clearing house and the interests of its clearing members. This level of our CCPs’ contributions should incentivise appropriate behaviour by all market participants and prevent the moral hazard of having too much SITG as the first tranche of the mutualised guaranty fund. This has a completely different purpose than the amount of guarantee fund contribution required from the clearing members, which is based on the direct risk of their netted portfolio’s exposure at the relevant CCP.
The foundation of central clearing was built on mutualisation of risk and creates incentives for various types of market players. ICE views SITG as a motivator; if SITG becomes a large loss-absorption resource, it could shift the balance of the incentives away from motivating clearing members to manage the risks they bring to the clearing house or to participate in default management, and related auctions. ICE pioneered the concept of SITG and, today, we have over US$410 million across our clearing houses in the form of our own capital on a voluntary basis, and well above any regulatory requirements. Additionally, certain of our exchanges also make SITG contributions to be utilised pro rata along with the clearing house contributions in the event of a clearing member default.
ICE also successfully introduced the concept of including “default insurance” to the pool of its default resources in 2019 and maintains a layer of default insurance in the amount of US$250 million, after and in addition to the SITG contributions and before the guaranty fund contributions of the non-defaulting clearing members. In aggregate, ICE has contributed in excess of US$660 million in the form of SITG and Default Insurance, both of which are not utilized when determining the size of our Clearing House Cover 2 default resources, since they are not intended to replace or reduce the position risk-based amount of the guaranty fund.
Instead, the role of these funds is to serve as an additional, distinct, and separate default resource pool that would serve to further protect the non-defaulting clearing members’ guaranty fund contributions from being mutualised in the event of a default.
Is There Value to a Second SITG?
ICE believes an introduction of a second tranche of SITG will fundamentally change the design of the default waterfall that has been carefully constructed to provide incentives for clearing members (and potentially pre-qualified market participants) to bid on defaulters’ portfolios and return the CCP to a balanced book. Specifically, the default waterfall has a hierarchy of charges incentivising members to bid economically on a defaulters’ portfolio to avoid, firstly, the use of the non-defaulting clearing members’ guaranty fund contributions and, secondly, the calling of assessment obligations. If a second tranche of SITG is inserted before the assessment rights, there is the real possibility for these additional resources to impact the final auction price and destabilise the ongoing operations of the service.
Does Higher SITG Lead to More Prudent Initial Margin Models?
Some market observers and participants have argued more SITG will reduce initial margin breaches and motivate CCPs to adopt prudent initial margin models. With regards to initial margin, ICE believes appropriate collateralisation of market risk through initial (original) margin is critical.
The levels of initial margin should be calibrated such that a portfolio the clearing house may be required to liquidate post a default can be closed or auctioned without recourse to resources other than those deposited by the defaulting clearing member, assuming an appropriate risk-confidence level and liquidation period. The combination of the ICE clearing houses’ base margins, margin add-ons (such as anti-procyclicality margins, and shortfall margins) result in a margin process supporting a defaulter-pays model.
Of course, good governance of such an operation should include model performance monitoring, independent model validation, member consultation, board and risk committee oversight and regulatory approval, which are critical components of determining our clearing houses’ margin methodology.
ICE’s default resource calculation methodology has withstood the test of time; and no ICE clearing house has been required to utilise its own capital or the default fund contributions of the non-defaulting clearing members. Instead, the margin and guaranty fund contributions of the defaulting clearing members have proven to be sufficient to allow ICE to manage all historical defaults experienced by the industry.
How Could Access to Central Bank Accounts and Central Bank Liquidity Facilities Further Improve Risk Management?
In their role as risk managers, ICE CCPs receive large U.S. dollar cash balances from their members in the form of initial margin and the guaranty fund. Although the CCPs continue to operate extensive collateral-management functions to ensure safety of the cash received, having direct access to the “riskless” Federal Reserve Deposit Account (FED deposit account) would only enhance this security.
Currently, only ICE Clear Credit, a systemically important financial market utility as designated by the Financial Stability Oversight Council (FSOC), has access to a FED deposit account. Central Bank accounts play an important financial stability role and could further help manage substantial risk in their jurisdiction. They are widely agreed by the industry and regulatory community as the safest option for the safekeeping of clearing member and client cash. In the case of custody and settlement risk arising from a defaulting custodian or settlement bank, although a CCP may have policies and procedures designed to mitigate such risk, the possibility of a custodian or settlement bank failure cannot be completely eliminated, and is outside the control of the CCP. In such a situation, a CCP should not be obligated to guarantee or backstop the liabilities of a failed custodian or settlement bank.
ICE has been advocating the use of accounts at central banks as “safe harbour” accounts for ongoing deposits to avoid over-reliance on repo markets or commercial banks, and in order to enhance management of short-term liquidity risk. ICE also advocates the availability of fully secured access to central bank liquidity facilities in extreme circumstances. ICE encourages central banks to make such accounts readily available for all regulated clearing houses.
For the avoidance of doubt, ICE has never expected or advocated such access would include any form of taxpayer bailout.
How Can Further Transparency be Brought to Centrally Cleared Markets?
Each quarter, CCPs are required by IOSCO and the Committee on Payments and Market Infrastructures (CPMI) to publish public disclosures on their websites, providing transparency around the clearing house’s financial resources, liquidity and risk controls.
ICE recognises the importance of operating highly transparent clearing houses so all market participants have information to fully understand the clearing process, and believes transparency is critical to supporting healthy derivatives markets. This is demonstrated by the significant amount of work led by ICE and undertaken by the CCPs globally in their public disclosure of quantitative and qualitative information.
ICE has further demonstrated its continued commitment to enhance existing disclosures by being the first of the CCPs to host interactive quarterly disclosure calls. To help promote this transparency and raise awareness and understanding of the IOSCO Public Quarterly Disclosures (PQD) in the market, each quarter at ICE we host a webinar to go through the quarter’s PQD results and explain what it means.
You can find out more here: https://www.theice.com/clearing/quarterly-clearing-disclosures.
However, the level of public disclosure provided by the CCPs is not currently replicated by market participants. Given this, ICE believes further transparency and disclosures can reduce systemic market risk; particularly similar reporting standards adopted by clearing members and large clients. Such clearing member disclosures could assist the CCP’s review of clearing member’s risk-management policies and practices.
How Important is the CCP’s Authority to Act During Recovery and Resolution?
ICE recognises the importance of ensuring adequate resources and tools are available in a resolution scenario to support the CCP’s orderly resolution and to minimise adverse effects on financial stability.
CCPs, together with their stakeholders and local regulators, have undertaken a substantial amount of work to enhance CCP resiliency and reduce systemic risk in the financial markets. CCPs existing recovery procedures have been:
1. Developed in consultation with the CCPs' clearing members and end-users;
2. Formally agreed upon by the clearing members pursuant to CCP rulebooks and member agreements and, where applicable, by customers pursuant to their clearing agreements;
3. Reviewed and approved by CCPs' regulators;
4. Incorporated in the CCPs’ rulebooks for purposes of transparency and certainty.
These recovery procedures are expected to manage most, if not all, known or potential difficulties faced by a CCP. ICE emphasises the importance of agreeing ex ante and defining within CCP rulebooks the tools that will be used in the event of a resolution authority’s intervention. However, once a CCP encounters a market stress event, ICE believes it is critical the actions taken by a resolution authority must be in accordance with the CCP's rules and arrangements agreed upon ex ante.
If resolution authorities are entitled or incentivised to intervene, or override a CCP's pre-agreed recovery process or otherwise act in a manner that is inconsistent with a CCP's rules, it will create uncertainty and instability in the market, impact members’ regulatory capital requirements by creating the potential for unlimited liability, and undermine the well-designed incentives during a recovery and resolution event.
The views, thoughts and opinions contained in this Focus article belong solely to the author and do not necessarily reflect the WFE’s policy position on the issue, or the WFE’s views or opinions.