• Melissa van der Merwe (Director)

Considerations in Choosing a CCP

As mandatory clearing of certain standardized OTC derivatives products starts to gain traction globally, as a potential Clearing Member (CM), it is pertinent to identify what factors one should consider in choosing a central counterparty clearing house (CCP). Many CCPs have sprung up in the market, each offering slightly different services, and not all CCP rules are consistent. For example, not all CCPs have the same default waterfall mechanics, or standardized events of default for CMs and CCPs, or segregation models or calculations for margin calls or other risk management techniques. This means it is important to understand fully what each CCP provides for, and to choose a CCP that fits best within your firm’s risk profile and policies.

It has been argued that the CCPs will become the most systemically important market infrastructures, and as a result the main consideration should be around assessing the potential risks of being a CM to a CCP. This article unpacks the main risk-related factors that should determine how you choose a CCP.

Transparency and disclosure: CCPs should disclose enough information and provide sufficient certainty around their procedures, rules and risk mitigation methodologies. In this way, potential CMs will be able to identify and manage credit, liquidity, operational and legal enforceability risks.

  • Pre-default data transparency: A CM must be assured of being able to see how well a CCP is managing its risk. For example, the CCP should be able to disclose their stress test scenarios, how they calculate the required size of their default fund and liquidity resources they have access to.

  • IM calculation transparency: The CCP should also be fully transparent about how they calculate IM (Initial Margin). This will enable the potential CM to anticipate their IM requirements.

  • Non-default loss transparency: Potential CMs must also be able to understand how the CCP assesses and allocates non-default losses. These are losses like custody and investment risks, liquidity risk, general business risk, technology and systems risks and operational risk.

  • Allocation of risk transparency: A potential CM would also find value in being able to see how a CCP will allocate risk in the event of a significant CM default scenario. The CCP should therefore be transparent about what tools it would use to allocate post-default losses and in which order (a default waterfall). As part of this disclosure, it would be important for the potential CM to be able to understand how much 'skin in the game' the CCP has in a post-default scenario. In other words, what CCP capital will be tapped into and when?

  • Transparency in the emergency powers of a CCP: Another factor to bear in mind is what emergency powers does the CCP have in times of stress or default? Do the CCP rules allow the CCP to make unilateral changes to its rules or IM requirements in a time of stress? If so, this would adversely impact the ability of the CM to plan for these situations, and therefore increase the risk it would face. If a CCP is equipped with effective and transparent recovery tools, it is unlikely that it would need to rely on emergency powers.

Ensuring the continuity of a CCP: It would benefit no one to have a CCP go into recovery or resolution and therefore a key focus in assessing which CCP to choose, should be around what structures and procedures a CCP has in place to avoid going into recovery or resolution.

  • Isolating and allocating risk: Ensure that the CCP has enforceable limited recourse rights and limited liability for non-defaulting CMs. This will avoid the risk of contagion to other CMs and other market infrastructures and will potentially reduce systemic risk.

  • Ensuring sufficient capital and insurance polices for non-default losses: A CM should not bear the cost of non-default losses. This is because the nature of non-default losses are such that only the CCP would be able to monitor and manage these sorts of risks.

  • Liquidity and collateral types: One of the ways in which the CCP can protect itself is to ensure that it only accepts high quality liquid collateral from CMs. It is therefore possible for a potential CM to assess the robustness of a CCP's liquidity by checking on the types of collateral it will accept. It is not always preferable to go with a CCP who accepts ‘cheap’ collateral, as this won’t protect you as a CM in a default scenario.

  • Haircutting: If there are insufficient resources in the default fund to absorb losses, it may be necessary for the CCP to apply haircutting. This can be done in a manner of ways but mainly either through initial margin haircutting or gains haircutting.

  1. Initial margin haircutting often incentivizes CMs to flatten their risk by reducing their IM to zero. In other words IM haircutting often results in a rush by CMs to exit, as CMs would be less likely to want to engage in auctions, hedges and support the CCP's risk management techniques. This would in fact have the adverse effect of causing the CCP to go into resolution.

  2. Gains haircutting involves the foregoing of future value, and therefore supports the goal of CCP continuity as it encourages CMs to participate in a post default auction process. Losses may be shared pro-rata amongst the CMs to create the right incentives amongst all CMs and aid in continuity of the CCP. The CCP rules should be clear about how CMs will be compensated for losses as a result of gains haircutting.

  • Conflict of interest and competition: CCPs are subject to conflicts of interest, where the interest of stakeholders may not align with those of the CMs. It is important to assess the CCP's approach to risk taking to the extent that such risk taking would impact on the CMs. In terms of competition between the various CCPs, it is unlikely we will see a ‘race to the bottom’ where CCPs try and lure CMs by offering lower IMs or accepting lesser quality collateral. It is more likely competition will be around the prudent risk mitigation and governance techniques employed by the CCP and the fees charged.

  • Protection of initial margin: Probably one of the most crucial factors in choosing a CCP is how many models of segregation does the CCP offer? IM should be robustly protected from the CCP's own assets and potentially from other CM's assets. Allowing CCPs to hold cash IM at the Central Bank will further protect that margin from commercial bank default, especially as most commercial banks will also be CMs.

DeriviDoc offers the following clearing training:

An Introduction to Central Clearing

24 October 2017 in Cape Town

09 November 2017 in Johannesburg

The Legal Agreements Required for Clearing

25 October 2017 in Cape Town

10 November 2017 in Johannesburg

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