The financial stability challenges that arose from the Covid-19 pandemic, and more recently from the war in Ukraine, have reinforced the importance of having a resilient financial system and infrastructure, including exchanges and central clearing parties (CCPs). A great deal has been done since the Global Financial Crisis (GFC) to make over-the-counter (OTC) derivatives markets safer and more transparent and to strengthen the resilience of CCPs. This resilience is due at least in part to the significant reforms that the G20 agreed to after the GFC.
Since then, the financial system and CCPs in particular have weathered several shocks: the pandemic, supply chain bottlenecks, rapidly rising energy and commodity prices fuelling steep inflationary pressures, and the terrible war in Ukraine.
FSB member authorities have been continuously assessing potential risks to CCPs and financial markets:
Higher market volatility that can put banks under liquidity strains has led policy makers to revisit the procyclicality of margining practices and to examine their system-wide impact.
The heightened threat of cyberattacks has led the FSB to work towards achieving greater convergence in cyber incident reporting.
Another important area for the FSB relates to financial institutions’ reliance on critical service providers. While outsourcing may have provided additional resilience during the pandemic, it has increased interconnections in the financial system and the surface for cyber attacks. The FSB is examining financial authorities’ oversight of institutions, as well as common definitions and the terminology for third-party risk management and outsourcing.
Addressing climate-related financial risks in close coordination with other international bodies is high on the FSB’s agenda. It covers both supervisory and regulatory approaches to addressing climate-related financial risks and adequate disclosure.
The recent turmoil in crypto-asset markets has given rise to serious concern about the highly volatile nature of crypto assets and the vulnerability of so-called stablecoins, as well as the growing interlinkage between crypto-asset markets and the financial system. To address these concerns, the FSB is coordinating work at the global level and with international standard-setting bodies (SSBs) to develop strong regulatory and supervisory standards. The objective is to ensure that crypto assets are subject to effective regulation and supervised based on the principle of same activity, same risk, same rules.
The pandemic and its market impact presented a real-world test of derivatives and securities markets’ operations in the context of broader liquidity pressure that began in March 2020. It has brought back into focus the super-systemic nature of CCPs.
CCPs occupy a position in the financial system that makes them too important to fail through an official mandate. That underscores the need for CCPs to be designed to be super-resilient, and also for the official sector to have a credible and concrete contingency plan to resolve a CCP without government (i.e. taxpayer) solvency support should it ever fail.
Promoting CCP resilience, recoverability and resolvability remains high on the FSB’s agenda, given its clear financial stability mandate.
Whereas much progress has been made on resiliency through the effective implementation of the CPMI IOSCO Principles for Financial Market Infrastructures (PFMIs), not so much progress has been made on resolvability.
Necessary policy development has slowed in recent years as memories of the financial crisis have faded. Policy makers agreed the central clearing mandate for standardised OTC derivatives in less than a year after the GFC. Likewise, a new international standard for resolution (the FSB Key Attributes of Effective Resolution Regimes) was developed in less than a year. However, just a few years later, the development of the Total Loss-absorbing Capacity (TLAC) standard for banks took longer than two years to be developed. As for CCPs, work on CCP resolution resources has been ongoing since the joint (FSB, CPMI, IOSCO, BCBS) work plan on resilience, recovery and resolvability was adopted in 2015.
The key question that policymakers have been struggling with is who bears the losses in the very unlikely event that a CCP fails. This is more than simply a rhetorical question.
FSB members have continued to make progress in tackling this question. The primary objective of public sector efforts is to ensure that, in the event of a CCP failure, we can maintain the continuity of critical clearing functions and avoid adverse effects on financial stability, and especially protect taxpayers’ funds. To avoid the use of public monies, it is critical that both the nature and amounts of available resources at CCPs are adequate to absorb losses in an extreme failure scenario because history has taught us that such extreme, nonlinear events do occur.
To find out whether that is the case, the FSB over the course of the past year worked closely with the Committee on Payment and Market Infrastructures (CPMI) and the International Organisation of Securities Commissions (IOSCO) to analyse whether existing financial resources and tools would absorb credit losses in default and non-default loss scenarios extreme enough to require the use of recovery and resolution tools. FSB members also analysed the financial stability implications of the use of CCP resources, recovery and resolution tools, cash calls and VMGH on the liquidity and solvency of clearing members in stressed market conditions.
The findings of this analysis were published in a report in March. The analysis produced some good news:
Firstly, all of the sampled CCPs would have had sufficient prefunded and recovery resources and the tools to cover losses in the default loss scenarios.
Secondly, the analysis found only limited impacts on CCP liquidity and solvency from the use of cash calls and VMGH by an individual CCP at the level of individual bank clearing members.
However, one of the non-default loss scenarios did reveal some weaknesses. The applied cyber-theft scenarios would have resulted in the need to use resolution powers in the majority of CCPs.
Despite the good news, FSB members concluded that the results weren’t sufficiently comforting to lean back and refrain from any further work in this area. That is because the results of the analysis need to be interpreted cautiously given a number of important limitations and assumptions:
For example, the FSB analysis did not consider the potential contagion, amplifying effects and interconnectedness across CCPs in the broader financial system that could cause the simultaneous default of the same clearing members in multiple CCPs.
The analysis did not consider the significant overlap of clearing memberships across many CCPs and the possibility that a clearing member may be subject to cash calls or VMGH from multiple CCPs.
The analysis did not consider the secondary and later order effects of the scenarios that might result in wider, knock-on market stress, including potential increases in margin requirements, liquidity pressure and collateral scarcity.
The quantitative analysis was limited to domestic bank clearing members subject to strong liquidity requirements. It did not include non-bank clearing members, which are typically not subject to equally strong liquidity requirements, nor did it include foreign bank clearing members for which data was not available.
The aggregation of results within a bucket masked individual variances within the sample.
Finally, the analysis assumed the availability of all recovery and resolution tools covered under international standards, but it did not consider the extent to which the tools were actually available for use by CCPs or resolution authorities under the applicable national resolution regimes.
The FSB drew two conclusions from this analysis:
Firstly, that continued work on implementing the recovery and resolution tools set out in the international standards is critical.
Secondly, that it is useful to undertake further work on financial resources that can absorb losses in the event of a CCP failure. FSB members agreed that it would be worthwhile to explore alternative financial resources that could potentially complement existing resources – in particular, but not limited to, addressing NDL.
In commenting on the March report, most representatives of CCP expressed the view that any additional work on CCP financial resources is unnecessary given how unlikely CCP resolution scenarios are.
For default loss scenarios, they cited the positive results of the scenario analyses under severe assumptions. For non-default loss scenarios, they expressed the view that the focus should be on preventative measures, such as an appropriate cybersecurity policy. On the other hand, clearing member representatives welcomed additional work by the FSB and suggested that further work should be undertaken not only for non-default losses, but also for default losses.
FSB members concluded that it is important to consider “what if (something goes wrong)” scenarios and to be prepared for such scenarios given the low probability, but very high impact of any CCP failure. Recent unanticipated geopolitical events demonstrate that shocks could be even more extreme than past historical events. We all remember that the Titanic was designed to be unsinkable.
Possible alternative resolution resources that may be considered in the analysis going forward will include those proposed in previous stakeholder consultations. One such proposal consists of requiring clearing members to subscribe to bail-in-able bonds, which in the event of a CCP going into resolution would be written down to cover the losses, and partly converted into equity to restore the CCP equity. Other proposals include increased pre-funded equity to be held by CCPs to improve loss-absorbing capacity, in particular for specific NDLs; a second tranche of pre-funded dedicated own resources to be used at different stages of the default waterfall; contractually agreed committed resources from a CCP’s parent and/or affiliated company to provide financial support in resolution (a form of internal TLAC); dedicated pre-funded emergency funds, for either each individual CCP or on a cross-CCP basis, that can be called upon by a resolution authority in resolution to absorb excess losses, to recapitalise a CCP, to provide liquidity and to compensate for NCWOL breaches; and contingent resources based on contracts, such as insurance policies.
The ongoing work on alternative resources is at this stage exploratory. FSB members will undertake a thorough analysis of not only benefits, but also of the costs (including the impact on incentives) and consider their suitability in the light of certainty of cover, performance risk and other factors.
The FSB’s work will take account of, and be complementary to, other ongoing international work, in particular by CPMI IOSCO on CCP practices to address non-default losses. FSB members attach great importance to working collectively – that is together with CCPs and clearing members – to further strengthen resilience and resolvability. Ensuring resolvability is not an isolated goal in itself. Rather, it is critical to maintaining financial stability while protecting public funds, thereby benefiting not just the financial system, but society as a whole.
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.