Sean Downey, Executive Director, Global Clearing & Risk Policy, CME Group, and newly elected Chair of the WFE's CCP Working Group looks at how regulatory reform can lead to unintended consequences for CCPs.
The regulatory and policy framework for Central Counterparties (CCPs) has evolved significantly over the past 10 years.
We, in the CCP community, have appropriately focused much of our efforts on ensuring that our risk management framework is sound, and consistent with global principles such as the CPMI-IOSCO Principles for Financial Market Infrastructures (PFMIs). Overall, CCPs’ regulators and policy-makers have engaged with the CCP community to design reasonable and prudent regulatory frameworks that further improve the stability of cleared markets, without sacrificing the risk management standards and tools that served their market participants well during the global financial crisis of 2008.
While the efforts of regulators and policy-makers with expertise in central clearing have been admirable, the range of policy-makers and regulators that impact the risk management and cost incentives of cleared derivatives markets has expanded significantly. This increased attention - by policy-makers that have not traditionally focused on cleared markets - is a natural consequence of the increased prominence of central clearing as an antidote to the risk-taking that underpinned the 2008 financial crisis. The expansion is most impactful in the updates to bank capital and liquidity rules, generally referred to as the Basel III reforms. Even prior to the Basel III reforms, banks were required to capitalise their CCP exposures, but the regulatory guidance then did not contain the same level of granularity in the way those exposures were calculated as they do today.
Too much regulatory granularity can often create unintended consequences, and in the worst-case scenario these consequences could include increasing, rather than decreasing, systemic risk. Systemic risks are most likely to increase where prescriptive regulations are applied without an in-depth understanding of market structure, leading to regulations that are not appropriately tailored to the activity being regulated. We have observed this phenomenon repeat itself at each stage of the Basel III reforms as they apply to CCP exposures and centrally cleared markets.
The most well-known design flaw is the lack of offset for segregated, client initial margin for cleared derivatives exposures against bank Basel III Leverage Ratio requirements. However, the issues are much broader, including the lack of appropriate netting and delta adjustments for cleared options under the Leverage Ratio; the Liquidity Coverage Ratio’s inappropriate treatment of committed credit facilities provided to CCPs; and Net Stable Funding Ratio’s identical treatment for initial margin and guaranty fund contributions.
It is critical to minimising systemic risk that we address the question of “How do we fix these issues, and ensure proper treatment for cleared exposures in the future?” Therefore, the CCP community must increase CCP engagement and educational outreach with policy-makers that could impact the overall health and risk profile of cleared markets including, but not limited to, the Basel Committee on Banking Supervision, CPMI-IOSCO, central banks and local legislators.
To accomplish this goal, we must expand our universe to include analysis of policy and regulatory developments outside of those that directly impact CCPs, while improving our relationships with those policy-makers who, through their actions, can materially impact the health of our markets. This will increase the likelihood that future policy and regulatory reform that impacts CCPs will be well-designed, and serve our common goal of reducing systemic risk in the financial markets.