The COVID-19 pandemic is a stark reminder of what a tail event feels like. COVID-19 not only tested our personal resilience and crisis preparedness, but also that of the financial system, and financial market infrastructures in particular. And it was the first major test of the G20 reforms adopted after the global financial crisis of 2008.
The FSB reported to the G20 that financial market infrastructures, and in particular central counterparties (CCPs), functioned well despite the very challenging operational conditions and heightened market activity in the early stages of the pandemic. CCPs themselves reported that their regular fire drills and business continuity planning had served them well in dealing with the pandemic.
While the COVID-19 event demonstrated the benefits that central clearing brings for global financial stability, it also served as a reminder of the growing systemic importance of CCPs. A key objective for policymakers is to future-proof the international policy framework for CCPs in a way that reflects their increased systemic significance.
The FSB has worked closely over the past years with the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) to ensure the resilience, recovery planning and resolvability of CCPs through the development of appropriate international standards and guidance, and through the monitoring of their implementation.
Systemically important CCPs
One practical example is the biannual publication by the FSB of a list of CCPs that are systemically important in more than one jurisdiction. The updating of this list is coordinated by CPMI and IOSCO on the basis of criteria set out in the FSB’s 2017 Guidance on CCP resolution and resolution planning. Criteria include, for example, the extent to which clearing participants are located in another jurisdiction and the volume and value of cleared transactions that originate in another jurisdiction.
Once a CCP has been identified as systemically important in more than one jurisdiction, the authorities are expected to develop resolution plans for the CCP as set out in FSB guidance; establish a crisis management group (CMG) that brings together the oversight and resolution authorities from the relevant jurisdictions; adopt a CCP-specific cooperation agreement that underpins cooperation and resolution planning and ensures that information can be exchanged; and launch a process of regular resolvability assessments.
Thirteen CCPs are currently qualified as “systemically important in more than one jurisdiction”. Authorities have established CMGs for almost all of them. They have also commenced resolution planning and initiated resolvability assessments.
The loss-absorption debate
A critical element of resolvability is the availability of financial resources that absorb losses in resolution. To support the assessment of the adequacy of resolution resources, the FSB issued specific Guidance on financial resources to support resolution and on the treatment of CCP equity in resolution in November last year.
The consultation on the Guidance gave rise to a lively debate about the incentives of CCP equity holders, management, clearing members and end-users. Their responses to the public consultation reflected their different positions. For example, clearing participants have the incentive to reduce the likelihood that they will have to bear any losses and therefore support more CCP skin in the game being potentially mandated at different points in the default waterfall.
CCP management and equity holders, in contrast, tend to be proponents of the status quo and want to let losses fall onto clearing members, as required by the rulebook, via the CCPs’ funded and unfunded member contributions. Many respondents to the FSB’s consultation seemed to converge on the need for clearer policy and for more predictability as regards the distribution of losses, and the order of loss allocation in recovery and resolution, in both default and non-default loss scenarios.
Respondents also raised concerns around the procyclical effects that the use of resolution tools and of the resources could have, and the impact on financial stability. A question raised during the consultation was whether new types of financial resources, for example convertible instruments or bail-in bonds, could provide an additional source of CCP loss-absorbing capacity and reduce the risk of procyclicality. Related to that, the question was raised whether there is a need to distinguish, for the purposes of loss absorbency capacity, between financial resources that are there to absorb losses and loss-absorbing resources that are “operational resources” closely related to the critical clearing function, and that can be avoided by members terminating business or closing-out contracts.
Current FSB Guidance specifies neither the amount nor composition of financial resources for CCP resolution. Overall, at present, there are no international standards that set an expected specific minimum amount or prescribe the exact composition of financial resources for CCP recovery and resolution.
The Chairs of the FSB, CPMI, and IOSCO, and of the FSB Resolution Steering Group therefore declared that they would conduct further joint work on CCP financial resources through their respective committees.
Such work will consider the need for, and develop as appropriate, international policy on the use, composition and amount of financial resources in recovery and resolution. It would also involve assessing whether any new types of pre-funded resources would be necessary to enhance CCP resolvability. The objective is to take a holistic approach that looks at resilience, recovery and resolution resources overall.
Since the G20 agreement to impose mandatory central clearing, we have come a long way. However, some critical gaps remain. We are not yet at a point where we can declare CCPs truly resolvable. Both private and public sector stakeholders have recognised the need to take action to find fair solutions for diverging interests that align their incentives more closely and promote resilience. Significant progress can be made if the adopted approach is evidence-based and analytical and focuses on the overall financial stability objectives, rather than on defending individual interests.
Global cooperation remains of paramount importance and the FSB will, together with the other standard-setters, continue to play its part in facilitating and helping coordinate the work needed to conduct the relevant analysis and explore policy options.
Key policy questions that should be addressed through this work include:
- Could the current use, composition or amount of CCP financial resources become a potential source of financial vulnerabilities? If so, in what scenarios and in what manner?
- What are the benefits and drawbacks of increasing the total amount of available or required financial resources, changing the composition of resources, and/or requiring new types of resources? What are the impacts of these options, under possible different scenarios, on financial stability, central clearing incentives, and incentives for default management and recovery? Are there possible unintended consequences of any of these options?
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.